Sidestepping Value Traps
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Most investors are well aware of the fact that valuation is the primary determinant in long-term total return expectations. Therefore, many investors often gravitate toward stocks with cheap valuation in anticipation that this single factor will lead to out-performance. Unfortunately, many stocks have cheap valuation ratios, but their prices continue to fall or stay stagnant for years on end. The reason this happens is because earnings remain range-bound or even fall. Ah, the dreaded value trap. The best catalyst for a cheap stock is earnings growth! Below are a couple cheap stocks that have seen the average analyst estimates start to move higher in recent weeks. On top of that, they all pay a nice healthy dividend to line your pockets just in case there is a little trouble getting out of the starting gate.
If you think rising earnings estimates are commonplace, you may want to think again. Earnings growth has started to hit a stumbling block of late and according to Factset Research, the negative to positive forecast by companies for the second quarter is 3.4 to 1, the worst since the fourth quarter of 2008!!! Factset notes that the estimated earnings growth by analysts for the 2Q is +4.3%, but take out Apple and Bank of America and this drops to -1.6%. Markets can go up when earnings are declining, but it is hit or miss and almost always happens when inflation is falling. This is the case now, but the market does have some serious near-term warning flags even if it does offer compelling long-term value.
Refining Stocks Poised for a Breakout?
Valero Energy Corporation (NYSE: VLO) is the largest independent refining and marketing company in the United States. The company generates more than $130 billion in annual revenues and has daily throughput of more than 2.5 million barrels a day. The stock has been languishing ever since it’s unconscionable rise and fall in the 2003-2008 time-frame. Four years after the Great Recession, this volatile stock may be poised to breakout if global growth can bounce back from its recent soft patch.
Analysts have raised their full-year earnings-per-share estimates from $3.65 a month ago to their current level of $3.73. This may not seem like much, but as I showed above, positive earnings revisions are becoming harder to come by. Also, when the stock trades at a paltry 5x earnings there is plenty of bad news and fear baked into the cake. With earnings estimates ticking up, a cheap stock, and a 2.7% dividend yield, investors with a bullish outlook on the economy should give Valero plenty of consideration.
Other refiners also offer compelling value. I highlighted the compelling case for Marathon Petroleum Corporation (NYSE: MPC) and I much prefer it to Valero thanks to considerable upside potential as the mid-stream assets are spun-off to shareholders in the form of an MLP. Marathon has been the beneficiary of a recent up-tick in expected earnings by analysts as well. At $6.75 for full year earnings-per-share, this is a notable advance from $6.44 just 30 days ago and is one of the larger upward revisions among S&P 500 constituents.
Raytheon (NYSE: RTN) is a prominent defense contractor and makes for a compelling investment opportunity. But what about defense cuts? True, and how much do think earnings are forecasted to decline in the next two years? According to average analyst estimates, they are forecasted to rise 3% in 2012 and another 8.7% in 2013. There is also an under-appreciated earnings catalyst- the willingness of this industry to ratchet down labor costs in the face of revenue headwinds. The $5.20 forecast for fiscal 2012 is up from $5.06 in mid-April.
There is a whole lot more to the Raytheon story that makes it a great bond substitute for those looking to generate the necessary returns to reach retirement goals. The company has annual revenues approaching $25 billion and they are the most diversified defense contractor trading on the public markets. No contract accounts for more than 5% of sales! Thus, they are not susceptible to losing one key contract. They operate in five diversified segments ranging from missile systems to communication systems to advanced technology systems. All told, they are well positioned to generate modest revenue and earnings growth for the next couple of decades. And lastly, the company pays a dividend that amounts to a 3.8% yield. That is 1.5% more than the company’s bonds which mature in eight years. There is no opportunity for growth in the bonds, but the stock has a payout ratio of 32% and has grown dividends at a 12% annual rate during the last five years.
Has Hewlett-Packard Bottomed?
Hewlett-Packard (NYSE: HPQ) has had a tumultuous ride in the last eighteen months in which the CEO was ousted and the stock dropped more than 50%. Some have tried to catch the falling knife to no avail. Is now the time to bottom fish in the name? With second quarter earnings the company announced that it would cut 27,000 jobs, which is more than 7% of the workforce. And more importantly, they reaffirmed full-year earnings-per-share guidance of at least $4. Now, for the first time since they dropped the bomb on earnings back in August, average analyst estimates are moving higher. After sliding nonstop from $5.31 in August 2011, they bottomed at $4.02 a week ago and now reside at $4.08. The stock, with a 6.6x P/E ratio and 2.4% dividend yield, now may finally see earnings expectations increase. Those three facts make fishing in Hewlett-Packard a much more favorable risk/reward experience.
Earnings growth headwinds are staring corporate America in the face. However, there are some cheap value stocks that are bucking the trend and seeing their earnings estimates rise. This makes for a compelling one-two punch. Throw in the attractive dividend yields and you have quite the foundation for relative out-performance. Investors should focus on near-term earnings expectations as a catalyst to propel some cheap stocks out of their funk. The names referenced above all make sense. Those more bullish should look to MPC, whereas those still a bit fearful may be better served giving Raytheon top priority.
market8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Raytheon Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.