This Stock Market Is Not a 'Great Value'

Editor's note: With this column, we introduce Robert Marcin, the principal of Marcin Asset Management, a private investment firm. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). Marcin's investment philosophy employs strict valuation guidelines; these guidelines will also inform his column. As always, let us know what you think.

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I am going to explode if I hear another analyst/strategist/portfolio manager/journalist contend that the stock market represents good value right now! Because of the recent decline, culminating in the panic selloff on Sept. 21, many investment commentators contend that the equity markets are bursting with compelling values -- just oozing with cheap shares.

Nonsense. I have made a tidy sum over my investment career purchasing compellingly cheap stocks. During that disastrous week in September, all stocks were down, but few stocks were cheap. Down is not a synonym for cheap. If it were, I would have my entire personal portfolio in AskJeeves.com and Internet Capital Group. "Down" is not value either. Down is simply down. Cheap stocks are determined by company valuations. My favorite valuation ratios include enterprise value, or EV, to cash flow and sales, and the more common price-to-earnings, or P/E.

Absolute valuation levels that have represented good opportunities over my investment career (the past 20 years) would be P/E ratios in the 8-to-15 range, EV/EBITDA in the 4-to-7 range, and EV/sales in the 0.5-to-1.5 range. There are very few decent companies in these valuation ranges today.

I do not contend that highly valued stocks cannot appreciate. Buying high and selling higher still has a big fan club with big money attached to it. It made a few investors, especially owners of momentum investment companies, quite rich in the past few years. But fallen momentum angels rarely represent attractive values. Usually they just burn out. And, that's what this market is replete with: burnouts.

Higher-quality companies are not burnout candidates, but they also are not low-valuation stocks. Most large-cap sectors maintained very high absolute P/E and EV/sales ratios, even in the depths of the September crash. The recent October rally only expanded valuation levels significantly as higher share prices met lower revenue and profit levels.

Yet many folks continue to implore the masses to purchase shares in "good companies at low values." Some stocks did get cheap last month and represented good value. Selected industrial, retail, financial and energy shares became cheap on normalized revenue and profits. I even did some modest buying. Most of the compelling values occurred in the small- and mid-cap area.

Examples of companies still trading at extreme discounts include Health Net (HNT) (trading at 10 times cash EPS), Cendant (CD) (trading at 11 times cash EPS), Tommy Hilfiger(TOM) (trading at eight times cash EPS), Sybase (SY) (trading at 10 times cash EPS), Republic Services (RSG) (trading at 12 times cash EPS) and Capital One (COF) (trading at 10 times cash EPS).

That said, most stocks simply become less expensive in a downturn like we are having now. Mega-cap stocks like Wal-Mart(WMT), Pfizer(PFE), IBM(IBM), DuPont(DD), Schlumberger(SLB), Coca-Cola (KO) and Texas Instruments (TXN) never became cheap and never represented compelling value. Shares in these companies may never get cheap. They may perpetually trade in the range between fairly priced and expensive. Then again, I don't have to own them.

The next time financial commentators contend that the market or an individual stock represents good value, don't listen unless they justify their contention with legitimate revenue/profit forecasts and fair valuation targets. And study some stock market history so you can judge for yourself the definition of value.

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