Analysts expect value stocks to continue to outperform growth stocks as interest rates rise and the economy falters.
To find the most valuable names to consider, according to Hulbert Financial Digest, I recently checked in with three value-oriented equity letter writers with solid long-term records. We also share 6 names and a market outlook for 2023.
John Buckingham, wise speculator
Market and economic outlook: We will be in a mild recession in 2023. Stocks will hold up because the recession is already discounted.
“The idea of not factoring in a recession is absurd,” says Buckingham.
In terms of corporate earnings, even in a recession, nominal GDP growth remains positive (before adjusting for inflation). This supports reported earnings.
“There will be no drastic reduction in profit,” says Buckingham. This comes as an upside surprise, as a significant drop in profits is priced in. If the economy slows significantly, the Federal Reserve could be forced to cut rates, which could provide a tailwind for equities.
Bears pushes back his paper, claiming that “something is going to break.” They believe that higher interest rates create systemic stress that deprives financial players, which could pull others down.
Buckingham responds that given the sharp decline in bonds and the amount of leverage used in bond investing, if anything could break, it would have happened by now.
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The key is to buy blue chip stocks that have been hit hard because of the assumption that earnings growth will suffer.
“I want to invest in beaten-down companies that can weather the coming recession,” Buckingham said. “A business that has been through wars before and has a strong balance sheet that can emerge on the other side.”
Historically, the best companies have recovered the fastest.
Goal
target,
: Shares of the popular retailer have fallen 40% since late April on concerns over slowing consumer spending, rising costs and rising inventories.
Given the expected price-to-earnings ratio of 18, the stock isn’t technically “cheap”.
“Even if it slows down, we will see improved earnings as inventory conditions improve,” Buckingham said.
He expects positive year-over-year earnings in the second half of 2023 as the second half of 2022 has been plagued by increasing inventory issues.
Target, on the other hand, pays a 2.85% dividend yield and gets a good brand.
“Even though changing consumer sentiment and supply issues are weighing on us in the short term, we believe Target’s great appeal to consumers remains intact,” he says.
Buckingham has a multi-year price target of $217 based on where it thinks sales and profits will go over the next three to five years. The stock recently sold for $152.
Ram Research
LRCX,
: This company sells wafer fabrication equipment to chip manufacturers. The stock is down 43% from its 2022 highs as it faces two big problems.
First, the United States imposes export licensing requirements that make it more difficult for companies to do business with China. This is a big deal, as Ram gets his 30% of revenue from sales in China.
On top of that, demand for semiconductors, especially memory chips, is weakening. Lam now expects 2023 spending on wafer fab equipment to fall by more than 20% from his.
In the long term, end market growth and continued advances in chip manufacturing methods will continue to drive strong demand for the company’s advanced chip manufacturing equipment. This will increase the demand for specialized equipment manufactured by Lam Research.
At $414 per share, the stock trades at around 12 futures P/E.
“We’re discounting a much worse environment than we expected,” says Buckingham.
He said analysts expect earnings to recover almost fully after the 2023 rough patch. Lam Research, on the other hand, has a strong balance sheet, so it shares cash flow with investors through share buybacks and his 1.67% dividend yield. He has a price target of $599.
Kelly Wright, Investment Quality Trends
Market and economic outlook: Fed overdoes it in its inflation fight, triggering a recession leading to a 20% drop in the S&P 500 SPX.
From this already low level, we have lowered the benchmark index to 3,000-3,200 points.
“The first half of the year will not be good,” Wright predicts.
Part of the problem is that too many investors still have a rosy outlook. This suggests that there is a lot of potential sell-off as it will turn the tide during a recession.
“Many market participants do not understand this environment because they only know quantitative easing,” says Wright. “But now they are facing a real bear market that the Fed has neither eased nor bailed out. Since 2009 everything has been quantitative easing, so this is the first real bear market we have had in a long time. It’s the market.”
As evidence that the market has more downsides, Wright cites data from his own stock selection system. To find stocks to buy, Wright tracks a universe of nearly 300 select blue-chip stocks with attributes such as solid financial strength and at least his five years of dividend increases over the past decade. . These stocks look undervalued in his system when they trade so low that their dividend yields reach historic highs.
Since 1966, the market has hit a big bottom when 72% of the names he tracks appear to be undervalued. The market was at a major peak when the number of undervalued stocks fell below his 17%. Recently, just his 20% of his world seemed to be underestimated.
“This shows that we have more downsides,” he says.
Analysts have cut earnings forecasts. Fed Chairman Jerome Powell has called for growth to plateau to 0.5 percentage points this year. “Where’s the rosy picture?”
Wright doesn’t expect the market weakness to continue into the third quarter.
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There are stocks that Mr. Wright already considers attractive. To find stocks that look cheap enough to buy, he looks for financially sound stocks that historically trade at high yields. Assuming no dividend cuts, yields will rise when stock prices fall.
West America Bancorp
WABC,
: When a recession looms, investors flee banks for fear of diminishing returns from bad debt. However, the bank is relatively safe with very high lending standards and low cost of funds, so it already looks buyable in the current weakness.
A California bank provides loans and banking services to small businesses through Westamerica Bank. Depositors are small businesses and receive little or no interest on their checking account balances, so they don’t pay much for their funds. Banks have very high lending standards and tend to issue variable rate loans that reduce interest rate risk. We also earn a lot of net interest income from investments in securities as opposed to loans.
“Because the cost of funds is almost zero, banks can earn a significant net profit margin from investing in securities,” Wright says.
Historically, bank stocks have been undervalued when dividend yields climbed to 3.15%. At $58 a share, his dividend yield is 2.85%. The bank is also trading at $31, less than double its book value.
“This is a very well run local bank,” he says. “They don’t really make a lot of loans unless the customer is completely pristine.”
eastman chemical
EMNs,
: Highly cyclical companies are hit hard when recession fears rise. But Mr. Wright’s system now shows that Eastman Chemical’s stock is down enough to make it look attractive. Eastman markets specialty chemicals and materials including additives, plastics, polymers and films used in food, personal care products, agriculture, building and construction, and electronics.
Historically, stocks have gotten cheaper every time the dividend yield has risen to around 3.5%. That level was reached when the stock fell to $90. Since then, it’s dropped another 10%, and his dividend yield has risen to 3.88%.
Investors are concerned about the impact of the recession on their business, but Eastman has a sufficiently strong balance sheet and cash flow to take advantage of industry weakness to offer companies in the sector discounts. Other than that, it has an excellent track record of returning cash to shareholders through share buybacks and dividend increases.
Bruce Kaser, Cabot Turnaround Letter
Market and economic outlook: There will be a recession, but it will not be severe. Instead, it will be a “slow-motion recession” that wears down industry after industry. 10-Year US Treasury Note TMUBMUSD10Y,
Yields remain in the mid-3% range. The lower the bond yield, the more attractive the stock looks. Kaeser expects the market to remain flat for the rest of the year and the economy to grow moderately at 1% after adjusting for inflation.
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“A lot of companies are going out of business,” says Kaser. He prefers blue-chip companies operating in attractive niches that are well below historical valuations and market multiples.
gates industrial
GTES,
: Gates is a good example. The company sells specialty “power transmission” products such as belts, hydraulic hoses and tubes used in industries such as transportation, construction and energy.
Investors are selling stocks because this means Gates has a cyclical impact on the economy. But Kaser thinks it’s a mistake.
Gates parts are critical components in expensive machines, so the cost of downtime is high. Therefore, that part is often replaced on a regular basis as part of preventive maintenance. Approximately 63% of revenue comes from replacement parts.
“When building expensive equipment, the last thing you want to do is spend $4 on cheap hoses and belts and the whole thing is wasted for days,” says Kaser.
Here, Gates’ price-to-earnings ratio is about 10x. Compared to his 12-13x return on peers and his 17x return on the broader market, it looks like a bargain. Blackstone owns nearly two-thirds of his stock, but Kaser doesn’t see this as a risk. “I don’t think they are aggressive sellers,” he says.
Vodafone
VODs,
: Many stocks have been devastated by bear markets, but few have performed as badly as Vodafone, which provides telecommunications and cable services in the UK, Europe and Africa. In the low $10s range, the stock is trading at a 10-year low.
The company’s acquisition of Liberty Global’s German and Central and Eastern European assets in 2019 did not produce the expected gains.
“They failed to consolidate and missed the opportunity to consolidate the market,” says Kaser. “Performance continues to be weak. Costs keep rising, debt keeps rising.
Even activist investor Cevian Capital threw in the towel by cutting its stock after not seeing any changes that could boost its performance.
But now it could be a new beginning for Vodafone. Chief Executive Officer Nick Reid will step down at the end of 2022.
Kaser is betting on selling the division and bringing in an outsider who can focus on its core wireless and cable business in Europe. He believes this could eventually push Vodafone’s stock price back into the $25 range.
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any of the stocks mentioned in this column. In his stock newsletter, Brush Up on Stocks, Brush proposed He TGT and He EMN. Brush is the editor of the Cabot SX Cannabis Advisor. Follow him on Twitter @mbrushstocks.
