Analysts expect value stocks to maintain outperformance over growth stocks as interest rates rise and the economy falters.
To find some of the best value names to consider, I recently checked in with three value-oriented stock-letter writers who have solid long-term records, according to Hulbert Financial Digest. Here are six names they favor, and I also share their market outlooks for 2023.
John Buckingham, The Prudent Speculator
Market and economic outlook: We will have a mild recession in 2023. But that doesn’t mean stocks and corporate profits will take a big hit. Stocks will hold up because an economic contraction is already discounted.
“The idea that we have not priced in a recession is a bunch of hooey,” says Buckingham.
As for corporate earnings, even in a recession we will still have positive nominal GDP growth (before adjusting for inflation). This will support reported earnings.
“Profits will not decline significantly,” says Buckingham. Since a big decline in profits is priced in, this will be an upside surprise. If the economy slows significantly, the Federal Reserve may have to cut rates, which could provide a tailwind for stocks.
Bears push back on his thesis by arguing that “something will break.” They believe rising rates will create systemic stress that takes out a financial player, which could bring down others.
Buckingham responds that if something were going to break, it would have happened by now, given the sharp declines in bonds and the amount of leverage used in bond investing.
The key is to buy quality stocks hit hard because of the assumption that earnings growth will be destroyed.
“I want to invest in companies that have been beaten up that are able to weather the coming recession,” says Buckingham. “Businesses that will be able to emerge on the other side because they have been through the wars before and have strong balance sheets.”
Historically, blue-chip companies have had the quickest bounce back in recoveries.
: Shares of this popular retailer are down 40% since late April because of concerns about a consumer spending slowdown, rising costs and elevated inventories.
The stock is not technically “cheap” given that it has a forward price-to-earnings ratio of 18. But the key is that earnings are at a trough.
“We will see improvement in earnings as the inventory situation gets worked out, even if we have a slowdown,” says Buckingham.
He expects positive year-over-year earnings comparisons in the second half of 2023 because the second half of 2022 was plagued by elevated inventory issues.
Meanwhile, Target pays a 2.85% dividend yield and you are getting a great brand.
“We think the considerable appeal Target holds for consumers remains intact even as shifting consumer sentiment and supply issues weigh in the near term,” he says.
Buckingham has a multiyear price target of $217 based on where he thinks sales and earnings will go over the next three to five years. The stock recently sold for $152.
: This company sells wafer fabrication equipment to chip makers. The stock is down 43% from 2022 highs because it faces two major problems.
First, the U.S. has imposed export license requirements that make it harder for companies to trade with China. This is a big deal because Lam gets 30% of its revenue from sales in China.
On top of that, semiconductor demand has been weakening, especially for memory chips. Lam now expects 2023 wafer fabrication equipment spending to fall by more than 20%.
Over the longer term, demand for its advanced chip manufacturing equipment will remain strong because of end market growth, and ongoing advances in how chips are made. This increases demand for the kind of specialized equipment that Lam Research makes.
At $414 per share, the stock trades for a forward P/E of about 12.
“It has discounted far worse an environment than we are likely to see,” says Buckingham.
He notes that analysts expect a near full recovery in earnings after a 2023 rough patch. Meanwhile, Lam Research has a strong balance sheet, so it shares cash flow with investors via buybacks and the 1.67% dividend yield. He has a $599 price target.
Kelly Wright, Investment Quality Trends
Market and economic outlook: The Fed will overdo it in its inflation fight, creating a recession that will lead to a 20% decline in the S&P 500
from this already low level, sending the benchmark index down to 3,000 to 3,200 points.
“The first half of the year will be bad,” predicts Wright.
Part of the problem is that too many investors still have a rosy outlook. This suggests there’s a lot of potential selling ahead in any downturns, as they change their tune.
“A lot of market participants don’t understand this environment because all they know is quantitative easing,” says Wright. “But now they’re up against a real bear market where the Fed isn’t easing and isn’t bailing them out. This is the first real bear market we have had in a long time because since 2009 everything has been quantitative easing.”
For evidence that the market has a lot more downside, Wright cites data from his proprietary stock selection system. To find buyable stocks, Wright tracks a universe of nearly 300 select blue-chip stocks that have qualities like solid financial strength and at least five years’ worth of dividend hikes in the past 10 years. These stocks look undervalued in his system when they trade low enough that their dividend yields hit historically high levels.
Since 1966, the market has been at a major bottom when 72% of the names he tracks look undervalued. The market has been at major tops when the number of undervalued stocks dwindles to 17% or less. Recently, just 20% of his universe looked undervalued.
“This says that we’ve got more downside,” he says.
Analysts are reducing earnings estimates. Fed Chair Jerome Powell is calling for flat growth to a half percentage point of growth this year. “Where in there lies a rosy picture?”
Wright doesn’t expect respite from the market weakness until the third quarter.
There are stocks Wright considers attractive already. To find stocks that look cheap enough to buy, he hunts for financially sound names trading at historically high yields, which suggests their stocks are bottoming. Assuming no dividend cuts, yields rise when stock prices fall.
: Investors flee banks when recessions loom because of worries that bad loans will bring down earnings. But this bank has such high lending standards and low-cost funds, it is relatively safe so it already looks buyable in the current weakness.
The California bank offers loans and banking services to small businesses through Westamerica Bank. It doesn’t pay much for funds because its depositors are small businesses which receive little to no interest on their checking account balances. The bank has extremely high lending standards, and it tends to issue floating rate loans, which reduces interest rate risk. It also derives a lot of its net interest income from investing in securities, as opposed to loans.
“With a cost of funds that is almost zero, the bank can earn a respectable net interest margin by investing in securities,” says Wright.
Historically, the bank’s stock has been undervalued when its dividend yield rises to 3.15%. At $58 a share, the dividend yield is 2.85%, so it is close. The bank also trades for less than two times its book value of $31.
“This is a very well-run regional bank,” he says. “They really don’t do a lot of lending unless a customer is absolutely pristine.”
: Cyclical companies with lots of exposure to economic trends get hit hard when recession fears mount. By now, though, Eastman Chemical’s stock has fallen enough that it looks attractive, according to Wright’s system. Eastman sells specialty chemicals and materials including additives, plastics, polymers and films used in food, personal care products, agriculture, building and construction, and electronics.
Historically, the stock has been cheap whenever its dividend yield rises to around 3.5%. It hit that level when the stock fell to $90. Since then, it has fallen another 10%, pushing the dividend yield up to 3.88%.
While investors are worried about the impact of recession on business, Eastman has a strong enough balance sheet and cash flow to power through, and possibly take advantage of sector weakness by buying discounted companies in its space. Otherwise, it has a good record for returning cash to shareholders via buybacks and dividend increases.
Bruce Kaser, Cabot Turnaround Letter
Market and economic outlook: We’ll have a recession, but it won’t be a deep one. Instead, it will be a “slow motion recession” grinding through one industry after another. By now, this scenario may be priced in, assuming the 10-year Treasury
yield stays in the mid-3% range. Stocks look more attractive when bond yields are lower. Kaser expects the market will wind up flat for the year, and the economy will post modest 1% growth adjusted for inflation.
“A lot of companies are just being thrown away,” says Kaser. He favors well-run companies operating in attractive niche markets that are trading significantly below their historical valuations and the market multiple.
: Gates is a good example. The company sells specialized “power transmission” products including belts, hydraulic hoses and tubing used in industries like transportation, construction and energy.
This means Gates has cyclical exposure to the economy, so investors have been selling the stock. But Kaser thinks that is a mistake.
Gates’ parts are critical components in expensive machinery, so the cost of downtime is high. Therefore, its parts are often routinely replaced as part of preventative maintenance. About 63% of revenue comes from replacement parts.
“If you make expensive equipment, the last thing you want to do is spend $4 on a cheaper hose or belt, and the whole thing goes down for a few days,” says Kaser.
Down here, Gates sells for a price-to-earnings multiple of around 10. That looks cheap compared to a peer group multiple of 12-13 times earnings and a broader market multiple of 17. Blackstone owns nearly two-thirds of the stock, but Kaser does not view this as a risk. “I don’t see them being an aggressive seller,” he says.
: A lot of stocks have been trounced by the bear market, but few are as bad off as Vodafone, which offers telecom and cable services in the U.K, Europe and Africa. In the low-$10s range, the stock is trading at its lowest point in a decade.
The company’s 2019 acquisition of Liberty Global’s assets in Germany, and Central and Eastern Europe failed to produce the expected payoff.
“They bungled the integration and missed opportunities to consolidate their markets,” says Kaser. “Earnings continue to be sloppy. They continue to have bloated costs, and debt keeps going up. It has been an awful situation.”
Even the activist investor Cevian Capital has thrown in the towel, trimming its stake after failing to see changes that might have boosted performance.
But now, there’s a possible new beginning on the horizon for Vodafone. Chief Executive Nick Read stepped down at the end of 2022. (Vodafone lost around 40% after Read was appointed in October 2018.) CFO Margherita Della Valle will serve as interim chief executive while the company looks for a replacement.
Kaser is betting they will bring in an outsider who can sell off divisions to focus on the core wireless and cable business in Europe. He thinks this could eventually drive Vodafone stock back up into the $25 range.
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested TGT and EMN in his stock newsletter, Brush Up on Stocks. Brush is editor of the Cabot SX Cannabis Advisor. Follow him on Twitter @mbrushstocks.