Tough times can lead to great opportunities for investors that keep their heads, do the work, and buy solid income stocks that the broad market has turned its back on, writes Julie Carnevale of F.A.S.T. Graphs.
We believe that based on earnings, 2012 is starting out with the stock market undervalued. We believe in the long-term ownership of great businesses purchased at sound and attractive valuations. Consequently, we view the stock market as merely the store that we shop at in order to buy the businesses we want to own.
Furthermore, we do not rely on the market to set the price at which we are willing to buy or sell. Instead, we prefer to calculate the intrinsic value of the business based on the company’s earnings power. If the market price is at or below that level of valuation, we will be a buyer. If not, we either look elsewhere or patiently wait for the True Worth™ valuation to manifest.
Conversely, if the market significantly overprices a company, even one that we like very much, we will sell to avoid long-term risk. Based on years of research and reviewing the earnings and price relationship on thousands of companies, we are confident that the proper value will inevitably be applied to a business by the market; it’s only a matter of time.
Shares of stock represent ownership in the business. In the long run, business success and shareholder returns will inevitably correlate. However, it is also an undeniable fact that the stock market can and will temporarily either over-price or under-price a business. And, it is also an undeniable fact that a company (business) derives its true value from its earnings power, in other words, the amount of cash flow it is capable of generating on its shareholders’ behalf.
Therefore, contrary to what many people are willing to accept, is the indisputable reality that the business results of the company behind the common stock you own is far more important to wealth creation, than what the stock market may be mispricing it at over a short period of time.
Mispricing happens when emotions erode rational thinking, thereby manifesting either greed or fear. It is important that investors maintain a reasoned and rational approach and avoid the emotional response at all costs.
When reviewing the broader stock market in the context of market price versus intrinsic value, we emphatically state that the stock market is significantly undervaluing many best-of-breed American corporations. We believe this is primarily due to extreme pessimism that has been promulgated by the masters of the media.
Currently, when you review America’s best of breed companies from the perspective of operating results—i.e., earnings power—you will discover that in the aggregate, there are a large number of businesses that performed extremely well in calendar year 2011.
Stated more simply, there are numerous businesses that grew at above-average rates during 2011, but alas, the stock market did not reward that growth according to what it should have. Therefore, based on price action, many of America’s best businesses had a down year.
However, when you measure earnings power, the same companies generated significant business growth. In time, we contend that it is inevitable that these fine businesses will be rewarded according to their business achievements. Once again, it’s only a matter of time.
Income Bargains
We remain very frustrated by the low, and what we consider to be ridiculous, valuations that the market is applying to many great businesses.
It is inconceivable to us that strongly above-average franchise names such as Hewlett-Packard (HPQ), Aflac (AFL), or Teva (TEVA), the world’s leading generic pharmaceutical company, could be trading at single-digit PE ratios when the more than 150-year-old historical normal PE ratio for the S&P 500 has been 15, as it is today.
To be clear, many average companies with significantly lesser earnings power are trading at earnings multiples approaching 2 to 3 times greater than many above-average companies are trading at. This makes no logical sense, and therefore, we believe it represents a rare and significant opportunity for those investors with the foresight to consider earnings power over what is often a very fickle stock market.
We believe that these low prices simply mean that many stocks are currently illiquid, and not that they are poor or bad investments. In this context, we are suggesting they are illiquid because they cannot be currently sold for what they are truly worth based on fundamentals. Selling a stock, or any asset for that matter, for less than it is worth is not a wise decision, in our opinion.
To be fair, many undervalued holdings have experienced moderate to even minor issues that spooked investors. After being traumatized by the 2008 market crash, investors remain fearful. Therefore, even the slightest bit of negative news can result in panic, even when it’s mostly unjustified.
We believe the reactions with the three examples featured in this article have been extreme. Consequently, we further believe that the opportunity that these reactions have created represent an incredible long-term opportunity. The above emotional reactions do not reflect the fundamental strengths and future potential of those fine businesses.
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