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Where to Find Value in a Pricey Market

Here are a few stocks to keep some skin in the game.

I can't believe my ears! On CNBC, talking head after talking head is asserting that stocks are cheap. Stocks have gone nowhere for seven years and earnings have doubled, so stocks must be cheap. Interest rates are low, so stocks are cheap. Private-equity firms are buying like crazy, so stocks must be cheap.

Give me a break. Stocks are absolutely not cheap. This column will show why and explain how a value investor deals with such a market, and also give you some stocks to check out for your own portfolio.

The most common rationale for the cheap-stock contention is the

S&P 500's

15.5 price-to-earnings ratio on consensus 2007 earnings estimates. However, the S&P 500 is not the market. The index includes a disproportionate chunk of energy and financial stocks, which chronically trade for 10 to 12 times earnings. Removing them reveals an industrial component at 20 times trailing and about 18 times estimated 2007 profits. That's not cheap.

It gets worse. Profit margins, the cyclical and most important component of a company's earnings stream, are at peak levels. That's correct: We have very high P/E ratios on historically unsustainably high profit margins. Few market commentators acknowledge this. One wonders if they even understand it. Even the bullish few who get this contend that it's different this time. To which I can only reply, "Repeal the business cycle? Ha!"

Another way to measure the valuation of stocks is to look at a broader slice of the market. I prefer this method to using a mega-cap-weighted index like the S&P 500. According to two different sources, the excellent Leuthold Group and Value Line, the median P/E ratio of the largest 3,000 companies is 20.5 times trailing earnings.

The current P/E ratio is higher than 95% of all monthly observations in the past 35 years. And remember, this is occurring on peak profit margins. If you use long-term average profit margins, the median stock trades closer to 25 times normalized profits. So, again, that's not very cheap.

In fact, the actual current median valuation is much higher than it was in the fall of 2000. In October of that year, with the S&P 500 at 26 times earnings, the median P/E ratio of the largest 3,000 companies was only 14.0. At the last secular market

top

, the average stock was much cheaper than it is today!

Now, after all that ranting, here's my dirty little secret. Stocks are expensive, but they deserve to be. Conditions that affect share valuations are pretty close to ideal. Economic growth is neither too hot nor too cold. Inflation and interest rates are low. Corporate profits and, more importantly, free cash flows are at record high levels. Liquidity is abundant. It's no wonder share-repurchase programs, as well as M&A activity, are off the charts!

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One day, maybe even soon, conditions will change. I don't need to list all of the things that could reverse the now-ideal conditions. The Cult of the Bear does that regularly. Heck, maybe even this column will inflame the gods of Booyah-ville and bring wrath upon shareholders all. But for this moment in time, circumstances support an expensive stock market. Just don't kid yourself that it's cheap.

So how do I handle conditions like this in my fund? I stay conservatively invested in individual situations that really do represent compellingly undervalued stocks. In 2003, when stocks were actually cheap, I espoused a shotgun strategy: Get market exposure all over, especially in mid- and small-caps. Today, I prefer rifle shots, mostly in the mid- and large-cap arenas.

With this posture, I have enough exposure to participate in the "relentless rally," but not so much that I would get torched in a no-more-mo-mo downdraft. Here are some of my favorite names these days:

  • Western Digital (WDC) - Get Western Digital Corporation Report: At $20, the shares trade for only 8.5 times earnings and 0.65 times sales on my calendar 2007 estimates. That is dirt cheap, even for a disk-drive stock. The sell-side still underappreciates the much-improved competitive dynamics in the global hard-drive industry. I forecast accelerating unit growth in drives from many new emerging consumer applications, as well as tempering price declines. Also, I expect even more consolidation from the perennially money-losing Japanese vendors. Before long, hard drives could represent an attractive hardware group! A target P/E of 12-13 would generate a $30 stock. It has lately been trading around $20. Remember, the average stock trades for 18 times 2007 estimates.
  • Caterpillar (CAT) - Get Caterpillar Inc. Report: Still unloved by most investors because of its U.S. housing construction and heavy-duty trucking-related exposures, Caterpillar trades for only 12.5 times 2007 estimates and 10.5 times my 2008 earnings estimates. In my opinion, this name represents the highest-class way to participate in my "industrial revolution" theme. Wait, didn't that happen like a million years ago? It didn't for a few billion inhabitants of planet Earth, but it is now. Buy Caterpillar for its exposure to the global infrastructure play. The cycle should have another three or four years. If this company hits its $9 earnings-per-share target in that time frame, the stock could double from its current level of about $67. With an average 18 P/E, this market offers much room for multiple expansion.
  • Nabors (NBR) - Get Nabors Industries Ltd. Report: Here's a neat, contrary idea. Buy Nabors, by far the best-of-breed land driller, because day rates are starting to tumble. That's correct: Buy the stock because a slew of new rigs are hitting the market, and prices are dropping. Shouldn't one wait for the bottom? Heck no, then it's too late. Look at the huge trade in housing- and trucking-related stocks. These stocks didn't rally until the businesses turned down. And because every analyst knew about the industry declines, they all missed the trade. Nabors has very little support from the investment community because of the imminent industry downturn. It should rally big because of it. The 2007 consensus earnings estimate is $4 a share. The stock will trade up in the $40s, even if the company only makes $3 a share. (It's now trading at about $30.) When setting a valuation target, remember that the median stock trades for 18 times 2007 earnings.
  • Cummins (CMI) - Get Cummins Inc. Report: Woe is CEO Theodore Solso. After his company dramatically improved and diversified its revenue and profit structure, Wall Street analysts still label Cummins exclusively a deep cyclical, heavy-duty truck company. This year, with a plunge in heavy truck engine sales, Cummins gets a chance to prove otherwise. Despite the marvelous job that management has done in improving profitability, "there's more Cummins." The company will only make a 7% operating margin this year, excluding minority joint venture income. No respectable industrial company has such low margins. A more acceptable 9% margin on 2008 revenue plus joint venture income would generate earnings of $15 to $16 per share. This wonderfully geographically diversified industrial conglomerate should trade above $200 if it hits my 2008 earnings targets, compared to its current $145 level. Why? Because an expensive market trades for 18 times 2007 estimates and 16.5 times 2007/08 estimates. Cummins' 13 P/E target is appropriate with those valuations.
  • ConocoPhillips (COP) - Get ConocoPhillips Report: At $67, Conoco trades for only 7.4 times my 2007 earnings estimate and yields about 2.5%. I know, this stock has been a dud over the past year, but it remains one of the cheapest stocks in the U.S. market. It has been held back by a few small operational problems and one big reserve-replacement issue. At the upcoming annual analyst meeting, CEO Jim Mulva will try to prove that ConocoPhillips can indeed find oil somewhere besides an AutoZone store. Also, the company has reversed its high-spending, acquisitive ways. Its new strategy is to maximize profits and cash flows from all of its new assets and return significant cash to shareholders. I think investors underappreciate the company's true earnings power. A P/E closer to that of Chevron (CVX) - Get Chevron Corporation Report would generate a $90 stock price for ConocoPhillips. Only a 10 P/E in an 18 P/E market? It is still Conoco, after all.

So what's the takeaway from this column? Stocks are not cheap -- they're actually rather expensive. However, fundamental conditions do support an expensive market. Stocks can stay expensive for a while longer. Heck, there's no magic ceiling to an 18 P/E ratio, either. Stocks can get even more expensive. When conditions change for the worse, pricey shares will be a risky bet. We do not know when Goldilocks conditions will reverse.

That high valuation level cuts both ways. It also provides an opportunity for major P/E multiple expansion when a cheap company achieves some conceptual appeal in the minds of investors. That is the reason why many analysts and investors have been underestimating appreciation potential in some of their sectors. A cheap stock with a good story, even a traditional value stock, doesn't have to stop working at 12 or 13 times earnings in an 18 P/E market.

It's OK to keep some skin in the game, especially if you invest in solid companies at low valuations. Just remain cognizant of the risk to a market priced for ideal conditions. And ignore the claim that stocks are cheap. There are three proverbial big lies; you can tack this myth on as the fourth.

At the time of publication, Marcin was long Western Digital, Caterpillar, Nabors, Cummins and ConocoPhillips, although positions may change at any time.

Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of commentary by Marcin, both before and after it is posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback;

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