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The current stock market, highly volatile and trending lower this year, makes this a daunting time for individual investors seeking to identify companies with reasonable risk and good long-term growth potential.
Concerns about overall market performance — as of mid-March, the S&P 500 Index had had the fifth-worst start to a year since 1927 — means investors are acutely aware of various negative forces: the highest inflation in 40 years, an expected series of interest-rate increases that has already begun and Russia’s invasion of Ukraine. Thus far, these and other factors have made 2022 a year of great uncertainty.
Uncertainty muddies market waters, yet investors willing to wade in can do so more confidently with the informed vision to spot opportunities through the mud.
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Currently, three sectors — technology, health care and industrials — have relatively high concentrations of companies with low-risk characteristics, low valuations and good earnings growth projections.
Say yes to technology
There are low valuations in technology? The poster-child sector for growth stocks and the polar opposite of value investing? That is correct.
The sector’s price-earnings ratios have declined significantly with falling prices this year. As of mid-March, at least 50 stocks in the Nasdaq Composite Index were down at least 50% from their highs, putting them well into bear territory. Also pushing prices down has been the market’s anticipation of interest-rate increases, which tend to disproportionately punish growth stocks with high P/Es, a common tech characteristic.
Yet even before this year’s slide, Nasdaq 100 P/Es were in a slow decline that started in mid-2020. The cumulative effect: As of March 17, the index’s average P/E was 27, down from 35 in August 2021.
This trend has sharpened the existing contrast between quality, earnings-rich tech companies (some even pay dividends) and earnings-challenged firms that, like Icarus in Greek mythology, perilously fly close to the sun with astronomical P/Es.
For example, in late March, negative earnings of high-fliers Zscaler and Snowflake meant they had no positive P/Es and ethereal forward P/Es of 400 and 1,356, respectively. But quality tech firms with real earnings are firmly rooted in terra firma. For example, Oracle and Qualcomm, in mid-March, had forward P/Es of 8 and 15, respectively, significantly lower than the S&P 500’s forward P/E of 19.
The higher a company’s P/E, the more investors pay for earnings and the less attractive it generally is, so high P/E stocks can drag indexes down. Thus, the widening P/E gap supports the case for investing actively by buying individual stocks rather than passively by buying index funds or ETFs.
The new category of low-valuation tech is heavily populated by companies in the semi-conductor industry, hardly surprising amid the current, unprecedented demand for chips, used in everything from cars to toasters — and even toilets.
In addition to relatively low P/Es, some chip stocks — Applied Materials, KLA Corp., Lam Research and Qualcomm, among them — have other fundamental characteristics indicating low risk, as well as projected average annual earnings growth well into double-digits over the next five years, according to Factset’s average analysts’ projections.
Yet tech stocks with these characteristics aren’t limited to the chip industry. Others include: Apple, Microsoft, Oracle, Seagate Technologies, Skyworks Solutions and VMware Inc. (Class A).
Seeking health care
Health-care costs haven’t increased as much as many items in recent months, but with or without inflation, people are going to seek it, especially now that virus fears have ebbed.
The big consumer group in this sector, of course, is baby boomers, many of whom are now in their late 60s and naturally seeking more care, including elective procedures they postponed during the pandemic. The return of elective surgery bodes well for medical and surgical device companies like Medtronic, and will have a follow-on effect for other types of health-care companies as these returning patients are prescribed more tests and medications.
Like technology, this is a sector where passive funds may not be the best way to invest these days. Average valuations are now fairly low but share price trends have been sharply divergent recently; this is a split sector.
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The price divergence probably reflects investor confusion over the sector’s future in a generally uncertain market. This makes it all the more important to focus on fundamentals.
Health-care companies with relatively low trailing P/Es and good earnings projections include: Anthem, Cigna, CVS Health Corp., Danaher, HCA Healthcare, Humana, , Merck, Mettler-Toledo International and Vertex Pharmaceuticals.
Looking at industrials
Industrials are hardly a sexy sector, but investors are keenly aware that industries need to make a lot of stuff to meet current demand.
As industrials crank up to supply manufacturers with equipment and services, they face higher input costs. But many of these companies have pricing power in an environment where demand for many items far outstrips supply.
This sector has declined less than most in recent weeks, but it didn’t have as far to fall, as prices have been pretty flat for about a year for some companies and even longer for others. For example, in mid-March, Cummins, which manufactures commercial gasoline, diesel, and hydrogen-fuel-cell engines, was priced about where it was in 2018.
Supply chain problems remain, exacerbated by the war in Ukraine, higher energy prices and Covid lockdowns in China. Yet, as the supply chain smooths out in the coming months, growth in this sector should pick up. And to the extent that materials and parts are available in the meantime, manufacturers will pay more for them.
Companies with lower risk profiles, reasonable P/E ratios, and good projected earnings growth include: Cummins, Deere & Co., Emerson Electric, General Dynamics, Honeywell, Norfolk Southern Corp., Parker-Hannifin, W.W. Grainger and United Parcel Service.
Of course, the same market forces have resulted in good opportunities in other sectors. Yet these three sectors currently stand out for their concentrations of attractive companies with good long-term potential.
— By David Sheaff Gilreath, chief investment officer/partner with Sheaff Brock Investment Advisors and Innovative Portfolios
