Market offers opportunities for an easy score

In basketball, the presence of a star player on the court can be an effective catalyst for layup opportunities, because defenders lather so much attention on the star that they occasionally fail to notice a teammate standing alone beneath the basket.

In the stock market, investor preferences play the role of the star player on the basketball court. Whenever investors concentrate their attention on a common investment theme — the “star player” — chances are good that some other set of stocks — call them the “plodding giants” — might be wide open for a layup.

While everyone is focused on stocks rising because of the cyclical recovery — the superstars — the plodding giants are blue-chip growth stocks. This is great news for anyone who missed the recent 56% surge in stocks because it suggests that the best stocks to buy today — even after the surge in the overall market — might also be the safest stocks to own for the long run.

Investors shouldn’t feel like “chickens” for owning old standbys such as Johnson & Johnson (JNG), Microsoft Corp. (MSFT), Procter & Gamble Co. (PG) and Wal-Mart Stores Inc. (WMT) during these uncertain times. Rather, they should consider themselves savvy because these stocks look like bargains.

One way to support this claim is to compare the average price-earnings ratio for blue-chip growth stocks to the P/E ratio of the overall stock market over time.

For this column, I used the 25 largest companies in the S&P Barra Growth Index as a proxy for blue-chip growth stocks, and the 1,600-plus universe of stocks covered by the Value Line Investment Survey as a proxy for the overall stock market. A sampling of valuation comparisons between these two stock universes over the past decade shows how wide the swings in investor preferences can be, and how “wide open” certain stocks can become when they fall outside the range of the prevailing investor preferences.

Consider first a sampling from March 2000 — the top of the greatest speculative bubble in the history of the U.S. stock market. It shocks most investors to learn that the median P/E ratio among the 1,600 stocks in the Value Line universe at that time was just 13.4 — a bargain under almost any circumstance.

Investors were so infatuated with growth stocks at the time, particularly technology stocks, that literally everything else in the market could be had for a song.

By comparison, the median P/E ratio within our blue-chip growth proxy in March 2000 was 33.6 — two-and-a-half times the level for the market as a whole. Three stocks within this list — Cisco Systems Inc. (CSCO), Oracle Corp. (ORCL) and Qualcomm Inc. (QCOM) — had P/E ratios in excess of 100 at the time.

The bear market that followed from the spring of 2000 to the fall of 2002 was really only a bear market for large-cap-growth stocks.

The S&P 600 Small Cap Index increased 17.39% from 2000 to 2002. The S&P 500/Citigroup Growth Index, meanwhile, declined 32.99% during the same time period.

Can anyone say layup?

When the tech bust hit bottom in October 2002, much of the premium valuation for blue-chip growth stocks had been wrung out of the system, but not all of it. The median P/E ratio among our 25-stock proxy dropped to 23.1 by the fall of 2002.

During the same time period, the median P/E ratio for the Value Line universe expanded to 15.4, leaving blue-chip growth stocks at a 50% premium to the broader market, even after a cycle of horrific relative performance from 2000 to 2002.

Seven years later, in the fall of this year, it seems the same stocks that saw double coverage from investors at the start of the decade are now being ignored in favor of the new stars in the game — companies leveraged to the economic cycle.

On Oct. 2, the median P/E ratio for the Value Line universe was 17.5 (note that this figure was 13.4 at the top of the 1990s bull run). On the same date, the median P/E for our blue-chip growth proxy was just 15.9.

These data suggest that many of the most dominant business franchises in the world can be acquired at a discount to the rank and file.

It is like shopping for a car and finding the price for the Mercedes is less than the Chevy Cavalier. Peer through the double-team in your face and you might spot Wal-Mart waving its arms beneath the basket and screaming, “I’m a $49 stock that can earn $3.60 per share for you this year, and $5-plus a few years after that … my dividend goes up every year like clockwork … I’m wide open … throw me the rock!”

Keith Goddard is president of Capital Advisors, which manages $750 million in assets, and co-manager of the Capital Advisors Growth Fund (CIAOX).

For archived columns, go to investmentnews.com/investmentstrategies.

Related Topics: Investment Strategies