It’s a Bargain-Hunters’ Market, Says

This Financial Analyst

By Dr. Charles Lieberman

The dramatic decline in stock prices during the week ending July 26 (2002) reflects a panic by investors who are selling because stock prices have gone down.  Such indiscriminant selling reflects fear, not fundamentals.  And it creates extraordinary bargains.  In truth, it is too late to sell.  Rather, it is really time to buy.  Positive economic fundamentals have been ignored, while investors have focused on accounting scandals and other problems.  In time, likely sooner rather than later, the economic fundamentals will overcome these other issues.  So, rather than join the Chicken Little crowd, investors should remain invested and hang tough, even if the ride remains volatile.

Is It Time to Get Out?

            Many investors are hurting from the plunge in stock prices and are getting out to preserve what capital remains.  The fear driving these decisions reflects the new accounting scandals and other adverse developments being reported each day.  And it is the decline in stock values that is driving additional selling.  In effect, selling begets more selling.  But investors who sell today are likely getting out at severely depressed prices, the exact mirror image of the highly destructive buying of technology stocks in 1999 and 2000 after they had run up to nosebleed levels.

Indications of Value

            There are many ways to try to assess the value of a company’s stock, all of which require some judgment and are sensitive to underlying assumptions.  So, stock valuation remains something of an art, not an objective science.  Still, we review a number of approaches below.

            The Standard & Poor’s Index is 840 at this moment and earnings are estimated at $45 to $50 in 2003, implying a forward price earnings multiple for the S&P of 17.7.  That is quite close to the average P/E (share price of a stock, divided by its per-share earnings over the past year) since the end of World War II, although interest rates and inflation are exceptionally low, which justifies a higher P/E multiple.  It is also provides an attractive entry point into the market, in my judgment, given that corporate earnings are badly depressed since we’re just now coming out of recession.  If there is any kind of economic rebound, even a weak one, earnings will recover and stock multiples will prove to be low.  Moreover, these figures are averages.  Therefore, there are many stocks with multiples well below these figures, so potentially quite a few stocks are very cheap and attractive.

            Sticking with the top down approach a moment longer, companies are starting to report higher earnings.  So far, about 300 out of 500 S&P companies have reported for the second quarter and earnings are up about 9 %, after five consecutive quarterly declines.  Earnings should rise even faster going forward, particularly since the third quarter of last year bore the impact of the 9/11 terrorist attack, so earnings comparisons are relatively easy.  In fact, the results are already turning somewhat more favorable.  Companies that are reporting are typically matching or beating earnings estimates.  Roughly 200 companies have beaten earnings estimates so far, versus about 80 that have matched.  And many more companies are matching than are coming in below estimates.  Perhaps companies have been very conservative in their guidance, but the market is priced for quite negative expectations.

            Another way to test market valuation is to look at individual securities to see if stocks with low valuations are commonplace.  It appears they are.  I’ll provide a few examples.  Consider AmSouth Bancorp (ASO), E-Trade Securities (ET), Flextronics (FLEX), Perry Ellis International (PERY), and Meristar Hospitality (MHX) to pick five in highly divergent industries.  Amsouth is a bank with an excellent franchise, operating in Alabama, Florida and other states in the Southeast, yielding 4.3%, expected to earn about $1.65 in 2002 and $1.80 in 2003.  It is also a perfect takeover target for a larger institution that would like to build a business in one of the faster-growing parts of the country.  And, there are many banks with such characteristics.

            E-Trade Securities is an Internet broker that is fast becoming a financial supermarket, offering banking, mortgages, and other financial services, in addition to discounted stock brokerage.  Unlike most Internet-based companies, E-Trade is making money, at least 40 cents this year and more than 60 cents next year.  Moreover, I expect it to continue growing rapidly at the expense of larger traditional brokerage firms.  At its recent price below $4, it is trading at a P/E multiple below 7 on next year’s earnings. 

            Flextronics is a manufacturer for technology companies that outsource the production of their products.  While technology sales weakened sharply over the past two years, Flextronics remains profitable.  It earned 58 cents last year, and it should earn 37 cents this year and 60 cents next year.  The stock is currently about $7, which is very cheap for a company that will participate in the likely recovery in technology goods.

            Perry Ellis owns and is diversified across many brands, including Ping golf shirts, Jantzen bathing suits, Munsingwear, Manhattan and John Henry, among others.  The stock is currently $11.50, but the company is likely to earn about $1.60 this year and $2.50 next year.  Unlike their clothes, the market is giving away the stock.

            Meristar, like other hotel REIT’s, was badly hurt by the terrorist attacks of 9/11, but business will rebound along with the economic recovery.  Funds from operations of $2.40 are expected next year, so the stock sells at a price to FFO (FFO, or funds from operations, is an accepted measurement of net income, or earnings, for REIT’s) of about 5.0, compared with roughly 10 for all REIT’s.  And the dividend, when it recovers to pre-9/11 levels, would yield 16.8% on the current stock price.  Needlessly to say, when the dividend recovers, the stock price should be significantly higher.

            Most important, the examples given above demonstrate the variety of industries in which there are cheap stocks.  I could have provided numerous other examples.  In fact, it is now possible to find good values even within the large capitalization sector of the market.  A few months ago, I regarded large caps as the most overvalued sector, with few worth buying.  The underlying message is quite clear; there are now many stocks trading at low valuations relative to their earnings prospects, which implies that this is a time to be buying stocks, not to be selling.

            The recent increase in merger and acquisition announcements, as well as leveraged management buyout activity, suggests that businessmen who know their industry regard market values as low.  Even more significantly, many more of these deals are being paid for with cash, not with securities.  Cash deals really show that these transactions reflect low stock valuations.  And the businessmen doing these deals either are betting their companies or their own financial future on these deals.  This is a very strong affirmation of their view that these are attractive businesses selling at overly low prices.

            Psychologically, it is hard to buy when stock prices are falling, although that is usually the best time to buy.  Investors should hold their nose and buy, if they can.  Otherwise, they should hold what they have.  As usual, Chicken Little will be wrong.

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As investment strategist, Dr. Charles Lieberman oversees the  "Portfolio Partners" investment program of Advisors Financial Center, LLC (AFC), a provider of managed portfolios and financial services for industry professionals and their clients.  Additionally, he provides guidance to the AFC Wealth Coordinators, who integrate the work of financial advisors, financial planning, tax, estate and portfolio management professionals to build, protect, and maintain clients' wealth. You may contact him by phone at 845-368-0938, or e-mail him at chuckl@portfoliopartners.com.

Although the information included in this report has been obtained from sources that Advisors Financial Center, LLC believes to be reliable, we do not guarantee its accuracy.  All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice.  This report is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

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