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The Value Stock Comeback

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5 Likely Winners for Savvy Investors

The past several years have not been easy for value-focused fund managers such as John DeGulis who have avoided high-flying stocks of fast-growing companies ranging from Amazon.com and Netflix to Nike and Tesla. These managers concentrate on beaten-down stocks that they believe are undervalued relative to the current fundamentals of the company—rather than riskier stocks of companies with great growth potential. From August 2008 through the end of 2015, value stocks in the broad Russell 3000 index lagged behind the growth stocks by an average of three percentage points a year.

But that appears to be changing. This year, value stocks are becoming more competitive and are possibly even going to displace growth stocks at the head of the pack. Through April 30, the Russell 3000 value index gained 3.8%, while the growth index suffered a 0.4% loss.

We asked DeGulis how Bottom Line Personal readers can take advantage…

THE FED SIGNAL

Since 2006, US economic growth has been weak and short-term interest rates dropped to near-zero. That led investors to pay high prices for shares of companies whose growth outlook was not hurt by the anemic economy and that used cheap financing to expand. During this period, growth stocks had an amazing run.

But last December, the Federal Reserve started to raise interest rates in the belief that the economy is on “a path of sustainable improvement.” That has sent a signal to the stock market that economic growth is gaining traction, creating a good environment for value stocks. In a healthy economy, when unemployment is low and consumer spending is strong, value stocks tend to outperform because their businesses often are tied to broad growth in the economy. And by now, the best value stocks have grown so cheap that the economy doesn’t even need to grow ­robustly for them to continue to rally. It just has to do better than the 2% ­annual growth we have been seeing.

HOW TO PICK VALUE WINNERS

The following strategies help ensure that you will pick the most attractive value stocks…

Focus on financially sound companies whose share prices have been beaten down due to temporary problems. These problems can include such things as earnings disappointments…an acquisition that is taking a while to digest and pay off…legal issues and/or negative publicity…and major changes in their industries. The companies still should be profitable and have strong enough free cash flow to pay investors dividends, buy back their own shares and/or use the money to expand their businesses.

Make sure the stock really is a bargain. Look for a low price-to-earnings ratio (P/E) compared with its historical levels and with the industry average…and a relatively low price-to-book ­ratio (P/B), which compares the market value to how much the company would be worth if it sold off its tangible assets. This helps you avoid stocks whose investors are overly optimistic. Both ratios can be found at Morningstar.com.

Look beyond traditional value sectors. For example, many mature technology companies no longer are considered fast growers. But they still are solid businesses whose future performance and ability to innovate may have been overlooked.

Wait for signs of a turnaround. To reduce risk, I look for businesses that have already begun their turnarounds as evidenced by increased profitability and/or promising new products or services. This cautious approach, which I favor even though it may mean that I miss out on the early part of the ­rebound, helps me avoid companies that have such extensive problems that their share prices may never recover.

MY FAVORITES

These five stocks fit all of my criteria…

BP (BP) is one of the largest oil companies in the world, with operations across much of the world. Its stock is down by 46% since its peak in 2010, when one of its rigs exploded, resulting in 11 deaths and spilling more than three million barrels of oil into the Gulf of Mexico. In addition to $56 billion in fines and legal settlements, BP has faced a crumbling oil market as the price of oil plunged.

What investors are missing: Global scrutiny and new management have given BP a big head start on the rest of the industry in cutting costs and boosting efficiency. Such changes will allow it to rebound strongly as oil prices recover. Even if the price of oil takes years to rise, investors will benefit from the high yield on BP’s dividend, which the company will be able to sustain with its strong free cash flow. Recent yield: 7.2%. Recent share price: $33.58.

Capital One Financial (COF) is one of the largest credit card issuers and banks in the US. Its stock has trailed the Standard & Poor’s 500 stock index by an average of five percentage points annually since the 2007–2009 recession as low interest rates hurt profit margins at major banks. Banks also have been hurt by increasingly stringent regulatory requirements.

What investors are missing: The bank’s heavy emphasis on credit card lending should benefit from a strengthening economy…and a likely rise in interest rates will help as banks widen their profit margins on loans. Recent yield: 2.2%. Recent share price: $72.39.

International Paper (IP) is a global manufacturer of packaging products and printing papers. The stock plunged 27% last year. Earnings have been hurt because the global economic slowdown has reduced the volume of product packaging and because the market for sheet paper has continued to evaporate as consumers and offices shift to computers and the Internet for communication, billing and information.

What investors are missing: International Paper is remaking itself as a smaller, more profitable company that focuses on growth trends such as the ­e-commerce boom, supplying ­Amazon.com and other online retailers with packaging. The company now is the world’s leading producer of the ­containerboard used to make corrugated brown shipping boxes. Recent yield: 3.9%. Recent share price: $43.27.

Merck & Co. (MRK) is the ­second-largest drug company in the US, with annual revenue of $40 billion and products ranging from treatments for cancer and high cholesterol to vaccines for humans and animals. Over the past three years, Merck’s stock price has lagged behind the S&P 500 by an average of 2.7 percentage points a year, partly because of the expiration of some major patents, but that underperformance has begun to turn around.

What investors are missing: Merck has made it through the worst of its patent losses. Currently, it has a pipeline of more than two dozen drugs in late-stage clinical trials, including one for Alzheimer’s disease. Its newest FDA-­approved cancer drug, Keytruda, designed to harness the body’s own immune system against tumors, is likely to become a blockbuster with sales of more than $1 billion a year. Recent yield: 3.3%. Recent share price: $54.84.

Oracle (ORCL) is one of the world’s largest makers of database software and hardware that help big companies ­manage and customize all their data. The stock fell 18% in 2015 because Oracle has been slow to adapt to a monumental shift in its industry toward cloud-based software and services.

What investors are missing: Oracle now is aggressively transitioning to the cloud and will retain most of its core customers because it is very costly and disruptive for companies to switch from one database provider to another. Recent yield: 1.5%. Recent share price: $39.86.

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Source: John P. ­DeGulis, comanager of the Sound Shore Fund (SSHFX), which had annualized returns of 6.5% over the past 15 years, versus 5.4% for its large-cap value stock category. He is president of the investment committee at Sound Shore Management, based in Greenwich, Connecticut, which has $5.7 billion under management. SoundShore.com Date: June 1, 2016 Publication: Bottom Line Personal
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