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How to Evaluate the Stock Market
By: Cabot Heritage Corporation
Is the Stock Market Overvalued?
Two Undervalued Stocks
A Final Thought
Will the Stock Market Go Up or Down?
I am often asked whether the stock market is going to go up or down in the weeks or months ahead. No one knows for sure which direction the stock market is going to take, because many variables influence the stock market. Unforeseen events can negate the best research and analysis.
I cannot predict what the stock market will do next, but I know I can enhance my investment performance if I invest more conservatively when the stock market is high, and take advantage of bargains when the stock market is low. This, of course, begs the question, "How can we gauge what is high and what is low?"
Some investors are capable of assessing the market's current status by studying charts. I prefer to determine whether the stock market is overvalued or undervalued by "running the numbers."
How to Evaluate the Market.
I start by calculating a few ratios. The price to earnings ratio (P/E) is simple. First, I add up the prices of all 30 of the Dow Jones stocks. Then I add up all of the earnings per share ( EPS ). Finally, I divide the total prices by the total EPS to find the P/E. To determine the EPS, I use the past two quarters and estimates for the next two quarters. The current P/E is 14.4. The historic P/E for the Dow Jones Industrial Average for the past 10 years is 13.9. Therefore, I can conclude that the current stock market as measured by the P/E for the Dow is slightly overvalued at 14.4 compared to the historic average of 13.9.
Not only do I calculate a simple P/E ratio to gauge whether the stock market is overvalued or undervalued, I also compare current and historic ratios for price to sales, price to cash flow, price to book value and dividend yield. In addition to being slightly overvalued according to price to earnings, the Dow is overvalued using price to cash flow ratios and dividend yield. I conclude that the market is a tad higher than it should be right now. Therefore, caution is advised, although the Dow Jones Industrial Average could rise another 2,500 points before becoming clearly overvalued.
What about the future? By using some forecasting tools and formulas I developed, I can calculate that the overvalued and undervalued ranges for the Dow Jones will be 17,129 and 11,907 for the next two years. Notice I didn't predict that the Dow will reach either extreme, but if I had to guess, I would predict that the Average will stay in the mid part of the range.
As I mentioned previously, I want to know if the market is overvalued or undervalued so that I can invest cautiously when the market is too high and invest aggressively when the market is low and undervalued. After the market's recent run-up, I advise using some caution. As a long-term investor, though, you should look for the market to move higher and continue to buy undervalued stocks.
Which Stocks are Undervalued and which are Overvalued?
The recent stock market advance has pushed many stocks well past undervalued status, and some are now overpriced and should be sold. Today I checked my database of 1,000 companies to find which stocks are undervalued and which are overpriced. According to my calculations, 92 stocks are currently undervalued and are buy candidates, and 285 stocks are overpriced and probably should be sold.
There are many ways to determine whether a stock is undervalued or overvalued. S&P (Standard & Poor's) and other investment services provide ratings to indicate which stocks are considered undervalued. Most brokerage websites provide access to S&P data which can be screened to find stocks that fit your criteria. Stocks with S&P Fair Value Ratings of 4 or 5 are undervalued.
With the U.S. and global economies growing at an agonizingly slow pace, I searched for companies that are bucking the trend: companies with exceptional growth prospects for the next 12 months and beyond.
Based upon my forecasts, I expect 17 undervalued companies to increase their earnings by 15% or more during the next 12 months. In addition, the companies will likely produce at least 15% earnings growth per year during the next five years.
Undervalued companies with exceptional growth prospects will very likely outperform the stock market during the next one to two years. If you would like a list of my 17 elite undervalued companies, please send me an email at email@example.com and I'll send you the list for free!
The following two healthcare companies clearly stand out in my list of 17 undervalued companies.
Actavis (ACT: Current Price 97.85; Max Buy Price 98.83), formerly Watson Pharmaceuticals, is a leading manufacturer of generic drugs whose goal is to produce difficult off-patent drugs. The merger of Watson and Actavis Group in October 2012 created this leading U.S. generic drug company. Generic drugs account for about 75% of revenues, and their use is growing fast.
Actavis markets 160 generic drug products in the U.S. and 54 in Canada, comprising a wide range of therapeutic categories. ACT's international division, Arrow Group, markets 50 generic products in Europe, Asia, South Africa and Australia.
Actavis currently has about 130 Abbreviated New Drug Applications (ANDAs) with the U.S. Food & Drug Administration (FDA). An additional 500 applications are on file outside the U.S. The company sells its products primarily through distributors and chain drug store operators, including McKesson and Walgreen.
Actavis' sales will likely advance 27% and EPS will jump 30% during the 12 months ending 3/31/14. The recent merger and promising new product introductions will spur results. In addition, the Patient Protection and Affordable Care Act will boost sales and earnings in 2014 and beyond. With a price to earnings ratio (P/E) of 12.1 times my forward 12-month EPS estimate of 8.12, ACT shares are low risk and clearly undervalued.
I expect ACT shares to reach my Min Sell Price of 129.65 within one year.
United Therapeutics (UTHR: Current Price 61.16; Max Buy Price 61.96), Based in Silver Spring, Maryland, United Therapeutics develops and markets therapeutic products for patients with chronic and life-threatening illness, including cardiovascular disorders, cancer, and infectious diseases. United Therapeutics is gaining market share and has become the U.S. leader in the pulmonary arterial hypertension (PAH) market with its highly successful Remodulin, Adcirca and Tyvaso treatments. In addition, exciting new products are being discovered in the company's laboratories.
The U.S. Food and Drug Administration (FDA) acknowledged the resubmission of the new drug application for treprostinil diolamine extended-release tablets for the treatment of pulmonary arterial hypertension. The FDA classified the resubmission as a complete, class 1 response to FDA's October 23, 2012 complete response letter. United's previous submission had been rejected by the FDA.
Sales and earnings have soared during the past two years, and United is well-positioned to produce solid growth in 2013 and beyond. Sales will rise 12% and EPS will advance 16% during the next 12 months ending 3/31/14. New treatments for unmet clinical needs are under development. Expansion into foreign markets also offers great opportunities for the company.
At 9.1 times my forward EPS estimate of 6.70, UTHR shares are a bargain. New drugs could boost results considerably higher than my forecast. United pays no dividend and is medium risk. UTHR's share price will likely rise to my Minimum Sell Price of 101.57 within two years.
My Final Thought
Investing is a serious business. We are investing our life's savings, saving for college expenses and retirement, and putting money away for many other important life events. Just as serious, though, is our state of mind toward each other and toward the world we live in. The tragic events in Boston re-emphasize what can go wrong when anger and misconceptions collide.
How did these two young men get the idea that the United States of America is a terrible place to live? I don't know, but Boston is coming together because of this tragedy. Neighbor is helping neighbor. Friend is helping friend. Moms and dads are helping children.
No matter where you live, we can all come together. We can all begin to set better examples and help our children, friends, co-workers, and even strangers to become kind and friendly. Together and individually, we can make this a better world in which to live.
Editor of Cabot Benjamin Graham Value Letter