One of the hallmarks of improved investor sentiment is when folks are willing to pay ever greater premiums for equities in expectation of future profit growth. And since the market started rallying from its early March lows, it's clear that sentiment seems to be improving, at least in certain corners of the market.
One indicator of improved sentiment is the rise in forward price-to-earnings multiples. Forward P/E is derived by dividing a company's share price by analysts' average estimate for future earnings per share; for the 500 stocks in the Standard & Poor's 500 Index ($INX), this ratio has risen to 16 from 13 in March, according to The Wall Street Journal Market Data Group.
Such growth is a clear indication that investors are starting to shake off the shock of last year's meltdown and have regained some appetite for risk, says Hank Smith, the chief investment officer of equity at Haverford Investments in Haverford, Pa.
As risk appetite grows, Smith says, many bigger, "safer" shares have been left in the dust; that's keeping a lid on the Dow Jones Industrial Average ($INDU). The forward P/E on this bastion of the bluest of blue-chip stocks is less than 14, down from nearly 18 in March, according to Dow Jones Indexes. In other words, as the broader market has gotten more expensive, the Dow has become cheaper.
Such low valuations could lead one to believe that the Dow is just chock-full of blue-chip bargains. In some cases, that's true. But sometimes cheap stocks are a steal, and sometimes they're cheap for a reason.
Here is a look at the Dow's cheapest stocks, as measured by forward P/E, including an assessment as to whether these inexpensive bets are likely to become investor darlings or dogs in the next 12 to 18 months.
1. Boeing
Forward P/E: 9.3.Five-year average forward P/E: 18.4.
Discount to five-year average: 48%.
As the world's largest maker of commercial and military aircraft, Boeing (BA, news, msgs) is more sensitive than most companies to a global slowdown. Of more immediate concern is the status of its vaunted 787 Dreamliner program, so woe unto Boeing shareholders when the company said on June 23 that the first test flight of the giant jet would be delayed -- yet again.
"Boeing has got to get the 787 in the air," says Jefferies analyst Howard Rubel, who rates the company's shares at "outperform." True, the aerospace industry isn't experiencing the same vicious boom-and-bust cycle of previous recessions, Rubel says, so Boeing could be in for a soft landing.
Also favoring the company are opportunities for further cost cuts, and, with oil back up at $70 a barrel, renewed demand for its newer, more-fuel-efficient jets. For investors with three- to five-year horizons, Boeing looks compelling at these levels. But uncertainty over the 787, as well as a rebound in global air traffic in 2010, makes these shares look fairly priced over the next 12 to 18 months.
Bottom line: dog.
2. Merck
Forward P/E: 7.8.Five-year average forward P/E: 13.7.
Discount to five-year average: 46%.
The market's shift away from defensive stocks in sectors like pharmaceuticals and the Obama administration's proposed health care reforms are just a couple of issues weighing on Merck (MRK, news, msgs). Shares in the Whitehouse Station, N.J., company are also being hobbled by company-specific problems, such as disappointing sales of asthma treatment Singulair, its best-selling drug, as well as increased competition, patent expirations and a pipeline of drugs with poor prospects for Food and Drug Administration approval.
Fortunately for Merck investors, the company's pending acquisition of Schering-Plough (SGP, news, msgs) should go a long way toward easing many of these problems, especially Merck's poor drug pipeline and its ability to remain competitive, says Morningstar analyst Damien Conover. "Merck greatly improved its long-term outlook by agreeing to acquire Schering-Plough," the analyst says.
Bottom line: darling.
3. Pfizer
Forward P/E: 7.0.Five-year average forward P/E: 11.1.
Discount to five-year average: 41%.
Pfizer (PFE, news, msgs) investors are grappling with plenty of uncertainty, including its $68 billion merger with Wyeth (WYE, news, msgs) and the fact that blockbuster cholesterol drug Lipitor will face competition from generics in just three years.
Nevertheless, the New York company's foundation remains solid, based on strong cash flow from its diverse portfolio of drugs, says Morningstar's Conover.
"I think one of the things keeping a lid on Pfizer is that it's a defensive stock, and as the market starts to accelerate there is a shift toward stocks that will outperform in up times," he says. Conover also said he thinks proposed health care reforms will be less harmful than the market fears. If he's right, investor relief could provide a catalyst for Pfizer and other pharma stocks.
Bottom line: darling.
4. Hewlett-Packard
Forward P/E: 9.2.Five-year average forward P/E: 13.8.
Discount to five-year average: 33%.
As the world's biggest maker of personal computers and printers, Hewlett-Packard (HPQ, news, msgs) has two knocks against it -- neither of its major markets is particularly attractive these days, says Kim Caughey, senior analyst at Fort Pitt Capital Group in Pittsburgh.
"In the PC market, HP is fighting deflation," Caughey says. "Next year's hardware is always going to be faster, better, cheaper."
The Palo Alto, Calif., company's printer and printing business is suffering as companies downsize, she says; fewer workers translates into less printing.
Even worse is what could happen to HP's margins as demand grows for tiny, cheap netbook computers. "I'm looking into people's pockets and I believe they will be sending their kids back to school with netbooks," says Caughey. "The (profit) margin on netbooks is terrible."
That's part of the bigger problem with a company as consumer-focused as HP. If folks don't have the money, they can't spend it. For that reason, Caughey thinks Hewlett-Packard's shares, while valued at a low multiple, are unattractive.
Bottom line: dog.
5. Travelers
Forward P/E: 7.7.Five-year average forward P/E: 8.4.
Discount to five-year average: 8%.
Travelers (TRV, news, msgs), the insurance giant and newly-minted Dow component, has never traded at a big premium. Property and casualty insurers historically don't. But there are other factors keeping Travelers from enjoying the same kind of multiple expansion found elsewhere in the market, says Keefe, Bruyette & Woods analyst Clifford Gallant, who rates the St. Paul, Minn., company's shares at "outperform."
"(The stock) never went down as much, so there was less of a rebound," Gallant says. "It was viewed as a safe place to hide and now, particularly among institutional investors, it is being used as a source of funds."
So if the market is selling Travelers to buy more cyclical stocks, what's to like? Stability.
"Insurance is not a very sexy place but it is a pretty stable place right now, and to me, that is attractive," he says.