As Stocks Shoot Higher, ‘Value’ Concepts Diverge
Every savvy investor knows what to do when the stock market is “too high”: To avoid overpaying, you buy only those shares that are true values, naturally.
But what’s a true value today, with nearly every major U.S. stock index, and many foreign ones, at or near record levels?
Like beauty of any other kind, value nowadays must be exclusively in the eye of the beholder--because many different stock mutual fund managers had many different ideas about the subject at fund tracker Morningstar Inc.’s two-day annual conference in Chicago last week. Railroads, paper companies, life insurers, banks, small retailers and even emerging foreign markets all made the value list, depending on the speaker.
In part, those widely varying views reflect the increasingly sophisticated (or, some would say, desperate) strategies fund managers are using to screen stocks for some sort of “cheapness.”
Not too many years ago, value was a fairly simple concept: Stocks that sold for relatively low prices compared with their underlying per-share earnings, dividend payouts and-or per-share book (net asset) value were lumped into the generic value category, and that’s where value investors fished.
But as David L. King, co-manager of the Putnam New Value and Putnam Growth & Income funds said at last week’s conference, the rise of powerful personal computers has meant that every investor has the tools to quickly identify all of the stocks which, by traditional measures, appear cheap.
“Today we all can agree on what are the 100 [stocks with the] lowest price-to-earnings ratios,” King noted. But precisely because everyone can see the same list, there would seem to be far less of an advantage in merely prospecting among those issues. There’s no “edge” there.
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The other reason for the variance in opinion about what constitutes value in this market is that, given how high most stocks are flying, it behooves virtually every fund manager to come up with some value-based justification for the shares he or she owns.
On some level, “all investing is value investing,” said Brian Posner, manager of the Warburg Pincus Growth & Income fund.
Well, sure. Who, after all, would want to admit to buying value-less securities in this market?
Morningstar President Don Phillips put it a different way. Because most money managers, and many investors, live in terrible fear of how this newly roaring U.S. bull market in stocks will end, the constant talk about value hunting today is managers’ response to an industrywide question that is more than rhetorical: “How do we behave in a market which we know is not going to go on forever?”
Buy “value,” of course--and hope your definition of it rings true.
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For Putnam’s King, finding real value in this market amounts to locating stocks that promise “cheapness and change,” he told conference attendees, who included many financial planners and other investment advisors.
Rather than buy low-valuation stocks for their own sake, King wants “cheap stocks with a high probability of successful change.”
One major stock sector that fits that definition, he said, is the railroad industry, including such names as CSX Corp. ($54.75 on Monday, New York Stock Exchange), Union Pacific Corp. ($69.625, NYSE) and Norfolk Southern Corp. ($100.50, NYSE).
The stocks’ price-to-earnings ratios are well below the market average P/E (now about 22, using the Standard & Poor’s 500-stock index), yet the industry continues to undergo consolidation (i.e., change), and deals are occurring at prices that indicate the businesses have substantially more long-term “franchise value” than the market credits to them, King said.
Assets of Conrail Corp., for example, were recently split between CSX and Norfolk Southern, and Conrail’s final takeout price in the deal was $115 a share--more than double its low price last year.
“I’m really not sure why Warren Buffett types aren’t all over” the railroad stocks, King said.
Similarly, he believes that Pharmacia & Upjohn ($34.375, NYSE), a dismal performer among major drug firms, has limited time left either to fix itself or be grabbed by a bigger company in the industry at some premium to its current depressed share price.
“The pharmaceutical industry has been very successful [overall], but the one company that hasn’t been is Pharmacia & Upjohn,” King said. This is a case, he said, where he expects “cheapness to create change” by luring buyers to Pharmacia & Upjohn’s franchise assets if the stock stays down.
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If price-to-earnings is your only criteria, one stock sector that continues to look at least nominally cheap is the financial services business, including many banks and mortgage companies.
On one Morningstar panel, veteran bank stock investor James Schmidt, who manages the John Hancock Regional Bank stock fund, insisted that although regional bank stocks are in many cases trading at record highs after spectacular gains over the last two years, “even assuming no [additional] merger activity, the banks still are cheap.”
Throw in the likelihood that mergers will continue at a brisk pace, Schmidt said, and he can still find many attractive banks.
One strategy he has employed, Schmidt said, is a focus on the “battleground states” of bank consolidation--places where big players in the industry still are looking to buy market share. Along those lines, he likes Los Angeles-based Imperial Bancorp ($25.875, NYSE) and Compass Bancshares ($35.375, Nasdaq) in Alabama.
Meanwhile, fellow panel member David H. Ellison, manager of the FBR Financial Services fund, said the two titans of the mortgage business--Fannie Mae ($46.875, NYSE) and Federal Home Loan Mortgage Corp. ($35.875, NYSE)--may be about to enter a new phase on Wall Street, wherein their values are based not on their stellar earnings histories, but on the prospect that they might become completely private corporations.
Currently, the two companies are quasi-governmental entities that must focus exclusively on the residential mortgage business. If allowed to go private, they could enter a host of new, even more profitable businesses, Ellison said.
While privatization of the companies is only a Wall Street fantasy today, “that will be the issue that will drive the stocks higher over the next 10 years,” Ellison said.
He noted that the stage has been set by the current battle by some shareholders of the Student Loan Marketing Assn., or Sallie Mae ($134.125, NYSE), to take it private. Sallie Mae invests in student loans in the same way Fannie Mae and Federal Home Loan Mortgage invest in residential mortgages.
