After two months of intense market volatility, a correction in the S&P 500 and much mumbling in the financial media about how more than half of the stocks in the S&P 500 are already in a bear market, I thought it was time to do another power screen. For most of last year, I had been screening hundreds of stocks but coming up with almost nothing to interest a true value investor. But now my hope was that I would find some high quality, previously-overvalued stocks whose prices had dropped to where they would be excellent buys now, even if the market were to continue dropping.
I didn't.
Robust S&P 500 Stocks With Decent Earnings are Still Very Overvalued - Even After Dropping 20% or More
Many stocks that I'd want to own have seen their share prices drop by double-digit percentages. But even so, they are still priced at multiples that can't be justified by their future earnings prospects.
Note: all prices and graphs in this article are as of 2/26/2022.
ADP Is Still Overvalued Even After a 21% Drop
Automatic Data Processing (NASDAQ:ADP) is a good example of what I mean. It's a wonderful stock that has outperformed the S&P 500 over just about any time frame you can select. Its earnings have grown steadily, even during recessions. Though its price has fallen during recessions, it has swiftly recovered. It has an AA- credit rating, which is far higher than the BBBs I'm seeing for most other stocks. It has manageable long-term debt, which is something that will become a huge issue if rates continue to rise. ADP is a Dividend Aristocrat, too, and one of the rare Aristocrats that still can increase earnings at a double-digit rate.
And yes, its price has fallen enough to consider it in a bear market. By January 27, 2022, ADP's price had come down 21% from its early January high. (A Bear Market is defined as a drop of 20% or more.) Its share price has risen just a bit since then, but is still down 17% YTD. So it should be a deal now, right? Exactly the kind of stock you'd want to own if the market kept going lower?
Not at all. Look at its FAST Graph.
Even after dropping almost 20%, it is still priced at a level that gives it a P/E ratio of 31.21 (based on Adjusted Operating Earnings). That's nosebleed level for a company that only grew its earnings by 2% last year and that analysts expect will only grow them at an average rate of about 12.5% a year going forward - and we all know that the farther away they are forecasting, the more optimistic analysts tend to be.
I assume that rosy 2-year forecast assumes that employment levels will stay high. But if stubbornly rising inflation continues to eat away at companies' margins and sends us into a recession, those earnings could drop back to the single-digits where they were from 2020-2021 very quickly.
ADP's P/E ratio has averaged 24.81 for the last decade. It would have to drop below $169 to reach that P/E ratio, which would still be a premium P/E, though arguably one that, being a top stock, it deserves.
But it wouldn't even take a recession to drop ADP's price to that range. When the Fed last raised rates at the end of 2018, as you can see from the chart above, ADP's price dropped to $125.37, a price that gave it a P/E ratio of 25.23. Rates are going to be rising again, barring the kind of disaster that brings about a swift recession. This tells me there is just no way to justify ADP's current P/E ratio. But keep in mind that December 2018 P/E ratio. We'll be returning to it again.
Dozens of Other High Quality Stocks Have Corrected But Still are Severely Overvalued
The charts of most tech stocks you'd want to own look very similar to that of ADP. For example, Adobe (ADBE) has an A+ credit rating and another long history of outperforming the S&P 500. It has dropped 29% over the past 6 months, which puts it well into bear territory. But ADBE still has a P/E ratio over 36, though its annualized earnings growth over the next couple years is only forecast to be 14.57%.
It isn't just tech stocks that have charts like this. I could show you dozens of other charts of high quality stocks that show a similar pattern. BlackRock (BLK) has already seen its price fall by 17.99%, but still could give investors a 12% loss if its P/E ratio reverts to the 15.62 level it was at the last time the Federal Reserve raised interest rates in 2018.
Costco (COST) has fallen less, only about 9%, but it still has a P/E ratio of 43.40 though its earnings are only forecast to grow by an annualized rate of 11.25%.
Drug company Abbott (ABT), another dividend aristocrat, has already seen its price drop over 13%, but it still has a P/E ratio of 23.76. Its earnings are forecast to decline by 7% next year, and even with more optimistic forecasts for subsequent years its average annualized earnings growth rate is likely to come in only somewhere around 8.63%.
And while there are plenty of other stocks in the S&P 500 that may look better valued now if you only look at their current numbers, these stocks are not the premium stocks buy-and-hold investors would want to own through a bear market and for decades beyond.
As is so often the case, when I screen stocks many of the stocks I see that look well-valued now are the same stocks that have looked well-valued for the past three years but whose prices can't rise out of the level that keeps them looking well-valued for any significant amount of time.
T. Rowe Price Group (TROW) falls into that category. After years of looking undervalued, its price soared during lockdown, only to lose 26% since the beginning of January 2022. TROW looks undervalued again but its recent behavior has confirmed my belief that during a raging bull market any stock that hasn't had its price pushed up to an over-valued level is one you want to avoid. Big investors who have much more inside information than you do have been avoiding these stocks, which is why they looked undervalued, and so should you.
New entrants into the list of stocks that look far better priced, on closer examination turn out to be stocks that are very cyclical, or are second tier competitors in challenged industries like health insurers Cigna (CI) and CVS (CVS) owner of Aetna, where the combination of inflation and increased claims from customers dealing with health issues they postponed during the Pandemic overshadow their futures.
Other apparently well-valued stocks are those of companies that are strongly cyclical, once faddy stocks that are no longer popular, stocks of companies being out-competed by rivals, hampered by aging business models, or loaded with debt and keeping their earnings rising through buybacks that used money that should have gone into innovating new, competitive products.
Many companies with relatively modest P/E ratios also have histories of even more modest earnings growth which is not expected to improve.
Warren Buffett apparently agrees with me. At his annual letter to his stockholders, which was published this past weekend, he told investors he is still sitting on a ton of cash because he sees “little that excites us” in the stock market and that “stocks, apartments, farms, oil wells, whatever,” are still priced too high, thanks to low interest rates.
Now Is the Time To Window Shop and Make a Bear Market Shopping List
That said, for reasons we are all too well aware of, it is quite possible that stock prices will continue to fall through the rest of this year and possibly beyond.
Though many stocks held in the S&P 500 have seen their prices decline by double-digit amounts, the S&P 500 as a whole is still just flirting with a correction, which is a decline of only 10%. There are plenty of catalysts that could take it down another 10% or more.
The market faces growing challenges, even setting aside the devastating war in Europe - which I find hard to do, as my heart is being torn out by what the heroic Ukrainian people are being forced to suffer. Inflation is at a level that only us old folks who were working in the 1980s remember clearly. And what we old folks also remember is that when inflation rises, companies see their margins shrink. They have to raise wages to keep employees and raise prices just to cover their costs. If they don't, they fire people which can push the economy into recession.
All of which means it is quite possible we will see a bear market, possibly a severe one. And a true bear market is the time when investors can buy the very high quality companies, whose valuation has hitherto put them out of reach at attractive prices. .
That's why I'm now drawing up a list of the highest quality stocks I'd like to buy and hold and setting target prices for them using a combination of valuation metrics and good old fashioned common sense.
The Characteristics of the Stocks You Want to Buy In the Next Bear Market
These are the criteria I apply when drawing up my shopping list:
- Stocks must be well known names in the S&P 500. Investing in lesser known companies can be very profitable, but the better known names are more closely followed, actively traded, and more likely to persist over time. I want to avoid companies that could be acquired by others if possible.
- Stocks, ideally, should have a history of outperforming the S&P 500 over many different time periods. I already own a lot of shares of the Vanguard S&P 500 ETF (VOO) and the Vanguard Total Stock Market ETF (VTI), so the whole point of buying these high quality stocks in a bear market is to outperform these market indexes going forward.
- Analysts must expect the stock to grow its earnings at an average rate over 10% over next two or three years. If we have a recession, earnings are likely to shrink, so stocks that start out with higher expected earnings are more likely to still earn some profits even if the economy tanks and earnings shrink.
- Stocks selected must have a history of growing earnings over the past decade. I don't believe that back testing gives us all the answers. In fact, it can often be very deceiving. But a company that was having trouble earning money during this past decade of easy money is likely to have a lot more trouble when rates go up or the economy shrinks.
- Stocks must be issued by companies with excellent credit and manageable debt levels. I want to avoid companies that have maintained their EPS by using borrowed money for nonproductive uses like dividends and stock buybacks. Companies with heavy debt loads are going to see earnings shrink when that debt must be refinanced at higher interest rates. Companies with a lot of debt will also have more trouble staying solvent as inflation pushes up the prices of their raw materials and employee wages.
- Stocks selected must not be cyclical. I stink at market timing. I want to buy and hold and not have to jump in and out of stocks. If we get another excellent buying opportunity, I want to use my free cash to buy stocks I can look forward to owning for a decade or two (if I'm lucky enough to live that long.)
- The companies issuing the stock must sell goods or services that are still in demand when times are tough. Looking at how these companies performed during the 2000 and 2008 recessions is informative. So is using my brain to think about the world now and what products or services people will still have to buy if they had a lot less money to spend is also useful.
- Companies must be in businesses whose broad outlines I can understand. Many stocks that might provide excellent returns going forward are off my list because I find their descriptions of what they sell so incomprehensible they might as well be written in hieroglyphics. Most semiconductor stocks and many software stocks fall into this category as do many financials and industrials. When executives dumb down technical issues while addressing investors, you may think you understand what you are buying, but mostly you don't.
- Dividends are a plus, but only if they come with earnings growth. Dividends have their place in my investing, but during the kind of buying opportunity we saw after the Financial Crisis or in March 2020, I'd prefer to buy the stocks that are going to give me the best total return going forward, not the IBMs (IBM) or AT&Ts (T) of the future.
How To Calculate a Realistic Bear Market Price
Using the criteria above, after spending far too much time, I came up with a short list of 12 stocks that looked like they might be worth investing in if we experienced a bear market.
I will admit I was forced to drop quite a few stocks that I had thought before conducting this analysis I would like to buy during a bear because they couldn't meet my screening criteria. In particular, two I already own: Lowe's (LOW), which made it almost to the end of my screening process but failed because of its debt load, and Hershey, (HSY) which is not predicted to grow earnings at a high enough rate going forward.
Almost all of the 12 stocks on my final list are priced too high right now to be interesting. So the question was, at what price would they become good buys?
Usually I look at a company's average 5- and 10-year P/E ratios to get an idea of what a reasonable price would be for a stock. But many of the highest quality stocks in the S&P 500 have experienced such dramatic price surges over the past 2 years that their longer-term average P/Es have become distorted. That makes me not want to use that technique right now to estimate a fair price.
A Company's P/E Ratio During the Brief 2018 Taper Tantrum Bear Helps Us Set a Reasonable Price
After much thought, I came up with a better way to set price targets for the high quality stocks I'd want to buy during a bear market. I took each of the 12 stocks I'd screened out, checked out what their P/E ratio had been in December of 2018 when the market experienced a very brief but deep plunge after the Fed raised its overnight rate to 2.50%.
Since inflation and rising rates are the biggest threat to the current market, the way the market reacted in December 2018, which was the last time rates rose, should be highly relevant to stock pricing going forward.
I then multiplied that bear market P/E ratio by either the stock's most recent earnings or, if its fiscal year didn't end in December, by the earnings amount analysts are estimating for its next year's earnings. That gave me a Bear Market Price.
PayPal (PYPL) was the one stock I couldn't value this way, because PayPal's momentum in 2018 was such that it barely noticed the Taper Tantrum of 2018. But it did react very strongly to the Covid-19 Swoon of March 2020, so I used its P/E ratio from that period instead to calculate a Bear Market Price.
Below you see the results of these calculations.
Bear Market Price Targets for 12 Top Stocks
All 12 of these stocks have a lot to offer investors when bought at reasonable prices. As you can see, over the past 10 years they all have grown their EPS at a rate far higher than that of the S&P 500 (whose data you can see on the first line of the table above.)
They are all rated A- or above except for those without S&P Global ratings. But those stocks without ratings have manageable amounts of Long Term debt.
These stocks represent quite a few different sectors. They range in size from mega caps Microsoft (MSFT) , Visa (V), and NIKE (NKE) to far smaller, more aggressively growing companies: Monster Beverage (MNST), STERIS (STE), Old Dominion Freight Line (ODFL), and Signature Bank (OTC:SBNY) whose market caps range between $20 and $45 Billion. The rest of the stocks on this list, including Intuit (INTU) and Estee Lauder (EL) have market caps somewhere between $85 Billion and $140 Billion.
Though there isn't room in a single article to go into the details, I put considerable time into reading about each of these companies and can assure you every one of these stocks is worth researching further.
It Will Take a Severe Downturn to Bring Most of These Stocks Down to Bear Market Prices
If you look at the chart above, you can see that the current prices of most of these stocks right now are far above a price that would give them a P/E ratio like the one they had just three short years ago. Investors are in love with these stocks right now and it will take a frighteningly deep market collapse to get them to abandon them. If we get that kind of collapse, I'm definitely a buyer of Microsoft. But I'm not holding my breath.
I have already provided several different entry points for Microsoft in my recent article, The One Top Stock to Buy If The Market Crashes. The highest price suggested, which was based on Microsoft's history of exceeding analysts' forecasts was $269, which is a price we may see if the market continues to struggle. But right now I'm more interested in the stocks whose prices are more likely to become appealing.
The Top Stocks More Likely to Become Value Buys
Anthem (ANTM), Visa, and ADP are currently priced at levels that are more likely to be reached if the market as a whole heads downwards. Of these three, ADP, which you can see graphed above, is my favorite.
ADP Is the Most Well Rounded of these Stocks
ADP is primarily known as a payroll services company, though it also provides "benefits administration, talent management, HR management, workforce management, insurance, retirement, and compliance services" as well as outsourced HR for small and mid-sized businesses. Obviously, it will do best when employment is strong. But even when employment has crashed, as it did during the Financial Crisis, ADP continued to generate positive earnings.
ADP Has Steady Free Cash Flow
The other reason I prefer ADP to Visa and Anthem, which are two other stocks whose prices are more likely to drop into a value range during a bear market, is that it has had steadier cash flow than the other two companies. Anthem's Free Cash Flow dropped 19% last year and analysts expect it to drop another 15% next year before recovering. Given the uncertainty about healthcare costs and the lingering health effects of the COVID epidemic, Anthem is riskier than ADP.
ADP's Price/Free Cash Flow History
Visa's free cash flow is healthier than Anthem's, but it does fluctuate.
ADP Offers a Far Superior Dividend
ADP is a Dividend Aristocrat whose current dividend yield, even at its inflated price, is 2.04%. Visa's is only .68%. Anthem has only been paying a dividend since 2011, though its yield is slightly better than Visa's at 1.13%. But with that short dividend history, if times get tough, Anthem is more likely to cut its dividend.
If ADP's price were to fall to that Bear Market Price of $172.07, its predicted estimated 2022 dividend of $3.86/share would give it a yield of 2.24%. Given that bear markets historically have lasted a whole lot longer than the brief dips we saw in 2018 and 2020, ADP's higher dividend would at least give you some return while you waited for recovery. Visa's 2022 dividend at its Bear Market Price would still only be a minuscule .81%.
Bonus Pick: PayPal Offers Investors More Risky Bear Market Opportunity Right Now
PayPal has a very short earnings history, not the long-term record I'd prefer to see. But unlike the others, it is currently at a price that could be considered a value price.
PayPal Has Not Been Priced Any Better than This, Ever
Though it has only been public since 2015, PayPal has been in business since the late 1990s. I have a lot of personal experience with them as a small business owner who has used them to process many tens of thousands of transactions since 2005. I have always found their services easy to use and simple to integrate into our own custom business software. They continue to offer me far more useful services than do competitors.
PayPal's Strong Cash Flow is a Plus
Its free cash flow has also grown at an impressive rate, averaging 19.47% a year during its brief life as a public company. It is predicted to keep growing at a rate above 20% a year.
The FAST Graph below shows you how PayPal's Free Cash Flow has fluctuated over the years. Looks good to me!
PayPal's Healthy Free Cash Flow
The 16% annual EPS growth rate analysts are still predicting after PayPal's 4th quarter earnings call makes it one of the few companies with A credit ratings that are still growing aggressively.
With that steady cash flow, PayPal may very well begin to pay a dividend, especially if it is trying to attract new investors after being abandoned by aggressive growth investors.
PayPal's Biggest Risk is Downward Momentum
The risk I see with PayPal is that we often see that when a stock has become extremely overvalued, as PayPal has, its valuation can plunge to overcompensate. So it is quite possible that PayPal's price may continue to decline, even though it has already dropped 63.7% from its July 2021 high of $308.53. This is especially true if the market as a whole tanks.
All in all, PayPal still looks to me like an interesting buying opportunity. After concluding the research for this article this past weekend, I began to cautiously buy into PayPal. I'll be watching it closely to see if I want to invest more.
Conclusion: Now Is the Time to Get Your Shopping List Ready for the Next Bear
The opportunity to buy extremely high quality stocks at reasonable prices comes rarely, almost always during a severe bear market, and given how short recent bear markets have lasted, it pays to be prepared.
Except for PayPal, none of the 12 top quality stocks that met my criteria are now priced at levels that make them appealing to a value investor. But I get the feeling that we are heading into a market where patience may be rewarded.
So I'm going to be setting price alerts near these stocks' Bear Market Prices. If they trigger, I'll take another look at analysts' earnings estimates. If they haven't changed radically - which does happen when the economy starts to tank - I'll be buying.
ADP is my clear favorite of all these stocks, especially for a long period when the economy may stagnate. But all these stocks could be wonderful "forever buys" if a bear market does show up.
Psycho Analyst
Though I have done quite a few different things over the course of a long life, I am best known as a writer of bestselling books about business and health. My success has come because I am a very curious person who doesn't just follow the herd and trust whatever the experts tell us to believe. I do my own research. I collect the facts, look at them objectively, and draw my own conclusions. Over the years, I have been amazed at how much of what everybody "knows to be true" is based on poorly designed studies, many of them impossible to replicate. I approach Investing with the same open mind, challenging the orthodoxies that attract the herd, studying how things really work, and doing my best to come up with an approach, based on facts, that works for me and would appeal to those who find thinking worthwhile.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of CVS, HSY, LOW, PYPL, VTI, VOO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I am not a registered investment advisor. I am an ordinary investor who does research to clarify my own understanding of stocks, ETFs, and the market in general. Before you invest based on anything you might read in my articles or those of any other person offering investment advice online, do your own research to confirm the soundness of what you might have read.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
