Finding Value in the Dow

Erik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Many investors have recently been concerned about rising valuations and a potential pull-back in stock prices. Yet, stocks have continued their climb. On Tuesday, the Dow Jones Industrial Average broke through its record high, thanks in part to the latest statistics, including the Institute for Supply Management’s non-manufacturing index, which points to improving economic conditions. Not all components of the Dow are trading at sky-high multiples. In fact, value investors can still find some opportunities here. But careful digging is still required.

The Dow has had a nice rally, climbing about 8% this year, slightly outpacing the return in the S&P 500 Index. The gains have been impressive, particularly given some of the headwinds: signs of sluggish hiring, the mess in Europe, and uncertainty surrounding budget issues in Washington, just to name a few. Of course, one cannot diminish the impact of the Federal Reserve’s commitment to keep interest rates low among the factors helping to drive the rally. And valuations have obviously increased. In fact, 11 of the Dow components are priced at premiums to their respective industry averages, when we look at P/E ratios based on trailing 12-month (TTM) earnings. Four of those stocks are priced at more than 25% above the industry average.

In such an environment, it is often easy to want to sit on the sidelines until economic and political conditions improve a bit more. And that’s completely reasonable. However, it is worth noting that there are ten stocks in the Dow that have P/E ratios that are at a discount of at least 15% to their respective industries, suggesting that value hunters can still find good opportunities among blue chip companies.

In looking for value in the Dow, it might be helpful to consider multiple metrics, not just P/E. P/Sales is also a reasonable choice. There are five Dow components that are priced at a 15% discount to their peers on the basis of both P/E and P/Sales. For value investors looking for solid companies, here is a good place to start.

When it comes to construction and mining equipment, Caterpillar (NYSE: CAT) is a key player. Construction activity looks like it is picking up. Mining activity might have taken a bit of a hit early this year, with industrial production falling 1.8% in January according to the Federal Reserve, yet it is up 1.8% year over year. Even though the Dow has had a nice rally, Caterpillar shares are essentially flat year to date. The stock has a P/E of 10.6 relative to an industry average of 14.5. Its P/Sales ratio stands at 0.9, against an industry reading of 1.2. While there are clearly issues with incorporating estimates for future growth, we use the best crystal ball we have. That stated, the stock’s PEG ratio, or P/E based on future expected earnings divided by expectations for long-term growth, is about 0.8. Even if this number is off slightly, the key take-away here is that Caterpillar shares are relatively cheaply priced.

When thinking of software, it is easy to think of one company that has clearly shaped the industry. More to the point, Microsoft (NASDAQ: MSFT) also appears to be on sale. Its shares have climbed about 5.5% this year, but its P/E is still hovering around 15.4, well below the industry average of 22.6. Similarly, its P/Sales ratio is 3.3 versus 4.1. Based on estimates for future growth, the stock has a PEG ratio of just over 1.0. Just like we saw with Caterpillar, even if the analysts are off slightly with their estimates, shares of this tech giant are still cheap.

Health-insurance company UnitedHealth Group (NYSE: UNH) is another Dow component that seems to be on sale. Its stock has faced a tough time lately, losing about 2% year to date. As Fool Matt Thalman pointed out last week, investors are concerned about the impact of the government’s Medicare Advantage rates and they fled insurance companies. With the potentially bad news priced in, UnitedHealth shares are a bargain to the industry. Its P/E is 10.1, when the industry norm is closer to 20. Looking forward, its PEG ratio is 0.8, which is low enough to catch much attention from value investors.

So far, we’ve seen stocks that appear cheap based on recent performance, as well as on expected future growth. Two oil giants also appear to be attractively priced. But initial impressions can be misleading. In an industry where the average P/E is 16.2, both Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) appear on sale, with readings of 8.8 and 9.2, respectively. Moreover, the industry average for P/Sales is 2.2, while Chevron and ExxonMobil come in at 1.0. At first glance, it seems like these two are also great bargains. That picture changes quickly when taking into consideration expectations for future performance. At present, analyst estimates put the respective PEG ratios at 3.0 and 3.2. Clearly, no value investor will consider PEG ratios this high. Seeing such high numbers should also send up flags. Consider Reuters analyst estimates for ExxonMobil for a moment. Here, the long-term growth rate varies between a positive 3.1% and a decline of nearly 1%. In other words, someone is looking for earnings to grow; someone else is expecting earnings to fall. No one has a perfect crystal ball, and it is important to recognize the uncertainty of estimates when considering valuations based on future performance. Still, based on these numbers, it is reasonable to conclude that analysts aren’t looking for much to happen to earnings. If that’s the case, then it is also plausible that there is no significant catalyst on the horizon to help the stock price, and better opportunities can currently be found elsewhere.

In sum

 Although the Dow has broken through its previous record high, not all stocks have climbed to frothy valuations. Value investors can still find appealing opportunities, but it is important to weigh both past and expected future performance. Chevron and ExxonMobil both appear cheap based on past performance, but are priced well out of value range based on expected future earnings. At this point, value investors looking for blue-chip opportunities would do better to take a look at Caterpillar, Microsoft, and UnitedHealth.

Erik Dellith has no position in any stocks mentioned. The Motley Fool recommends Chevron and UnitedHealth Group. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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