Stocks that trade at bargain prices have struggled for years as shares of fast-growing companies raced ahead. But many analysts say that is changing as the economy recovers from last year’s pandemic-induced recession. Reason: The performance of many undervalued companies is closely tied to how well the economy fares, and a robust economic recovery seems likely this year as COVID-19 vaccines help unleash pent-up consumer demand.
How To Pick Value Stocks
To help you find the most attractive value stocks for your portfolio, Bottom Line Personal spoke with stock picker Chuck Bath, CFA.
Reallocating assets in your portfolio is important if the portfolio is heavily weighted toward growth, given how much leading growth stocks, especially stocks such as Amazon and Facebook, have gained already. Growth stocks will underperform their value competitors if they fall short of Wall Street’s high expectations, a possibility as life returns to normal and consumers get out of their homes. In contrast, even a small improvement in the corporate earnings of undervalued companies will give their shares a big boost. My advice on how to find the best value stocks without getting hurt…
Look for stocks in the market’s most beaten-down sectors, which could rebound strongly in 2021.Often when a sector has been very out of favor, stocks of the most promising companies get dragged down along with those with less potential.
Beware value traps. Many stocks are cheap because the companies face long-term problems…have limited growth potential…and/or suffer from changes in their industries. Example: Energy was the stock market’s worst-performing sector in 2020, down 37%. But even though major oil stocks might seem relatively cheap, they made up only about 2% of my portfolio recently. Reason: With a global oil glut and subdued demand, oil prices are likely to remain low. Alternative energy sources are gaining market share, and the long-term viability of fossil fuels is being questioned. To avoid value traps, I focus on businesses that can grow earnings steadily for years…have strong cash flow and solid balance sheets…have lasting advantages over competitors…and are run by strong management teams.
My Favorites Now
Here are three attractive sectors and my favorite stocks in each…
Financial services—the second- worst-performing sector of the S&P 500 in 2020, behind energy. Banks and insurance companies are my portfolio’s biggest sector weighting because in strong economies they typically make more loans or sell more policies and improve earnings and profit margins. My favorite financial-services stocks now…
American International Group (AIG) is one of the world’s largest insurers. Its stock was down about 24% in 2020. Investors were worried that AIG would face more commercial insurance claims due to the pandemic. In fact, AIG losses have been manageable and the company has benefited from reduced claims as activities decreased. Post-pandemic, AIG should be able to increase premiums on insurance products as it has done after disaster-related events in the past.
Truist Financial (TFC) became the sixth-largest US bank, serving more than 10 million households, as a result of a December 2019 merger between two regional powerhouses, BB&T Corp and SunTrust Banks Inc. The stock fell 12% in 2020 as the merged banks suffered during the recession. Earnings should improve significantly this year, and Truist expects to save more than $1.6 billion annually in operating costs from the merger.
Travel-related businesses.COVID-19 slammed travel and leisure companies in 2020, creating some opportunities now. However, investors must be cautious. For example, even though airlines should see higher revenues this year, many have borrowed heavily to survive and are burdened with massive debt. My favorite travel-related stock now…
Booking Holdings (BKNG), the world’s largest online travel service by sales, operates Priceline, OpenTable and Kayak. The company’s revenues were crushed in 2020, and it was forced to close global offices and lay off a quarter of its workforce. But with $14 billion in cash, it has a solid balance sheet to help weather the crisis. It will benefit from a resurgence in travel demand as the economy normalizes and consumers look to take long-delayed vacations. In addition, its strong competitive advantages should allow it to gain market share from weaker competitors that have been affected more severely by the economic impact of the pandemic.
Commodities. Increasing demand for construction and manufacturing materials is a reliable indicator of an economic upturn. In the last six months of 2020, prices of silver, copper and timber rose sharply. My favorite commodity stock now…
Weyerhaeuser Co. (WY) is one of the world’s largest timber companies, manufacturing products such as plywood and lumber. The stock struggled in 2020 because of wildfires in the West that affected some of Weyerhaeuser’s timberland, a slowdown in production at its mills and its decision last May to temporarily suspend its dividend to preserve cash. Weyerhaeuser has since reinstated the dividend, and it will benefit from strong new-home and home-renovation markets, which are keeping lumber prices high.
Chuck Bath, CFA, is manager of the Diamond Hill Large Cap Fund (DHLAX) whose 10-year annualized returns of 11.6% rank in the top 9% of its category. Diamond-Hill.com
Best Value Funds
If you don’t want to pick individual stocks and are looking for broadly diversified exposure to undervalued companies, Tony Thomas, PhD, says there are several top-rated mutual funds that specialize in value investing and are in a strong position to outperform the market this year and beyond if value stocks surge…
AMG Yacktman (YACKX) focuses on about 50 beaten-down large-, mid- and small-cap stocks, including consumer-goods businesses with well-known brands. The fund is best-suited for patient, more conservative investors because it’s willing to hold large amounts of cash until it finds compelling opportunities. 10-year annualized returns: 11.4%.*
Dodge & Cox (DODGX) has used the same disciplined, contrarian approach since its launch 56 years ago. It invests in about 70 large companies with solid prospects but bargain-priced shares because of temporary problems. The fund’s performance ranks in the top 3% of its category over the past decade, although its bets on big turnarounds make it more volatile than its peers and better for aggressive investors. 10-year annualized returns: 12.1%.
Vanguard Equity Income (VEIPX) picks about 175 large, undervalued companies able to grow dividends quickly. It keeps a total of one-third of its portfolio in the health-care and financial-services sectors. With a 2.61% recent yield, its best for income-seeking investors willing to endure moderate volatility. 10-year annualized returns: 11.8%.
Tony Thomas, PhD, is associate director of equity strategies at Morningstar, Inc., Chicago, which tracks 620,000 investment offerings. Morningstar.com
*All performance figures are through January 15 and are from Morningstar, Inc.