STOCKS

It may be one of the ugliest rallies in recent memory, but stocks have had a nice run, and there are still some solid pockets of long-term value left for patient investors, writes John Reese of Validea Hot List.

While Superstorm Sandy has dealt the US economy some short-term blows, it appears that the country's broader, overall economic engine is continuing to push forward.

Industrial production, for example, fell 0.4% in October, according to a new Federal Reserve report. (All month-over-month changes cited here are seasonally adjusted; year-over-year figures are not.)

But Sandy negatively impacted the figure by nearly a full percentage point, the Fed said, meaning that production would have been solidly positive if not for the storm's short-term impact. Manufacturing production was down 0.9%, the Fed said, though when Sandy's impact was taken into account, it was about flat for the month.

Retail sales, meanwhile, fell 0.3% in October, according to the Commerce Department. But Sandy's impact on that figure, which the department said could not be quantified, is not known. It stands to reason, however, that with major metropolitan areas like New York basically shutting down for long periods, the impact was a negative one.

One area of the economy that we know is continuing to improve is the housing market. Existing home sales increased 2.1% in October over September, according to the National Association of Realtors, and are now 17.8% above their year-ago level. Median sales prices were up slightly for the month, and are now about 11% above the year-ago level.

Housing starts also increased in October, according to the Commerce Department. They rose 3.6%. Permit issuance for new homebuilding fell, however, by 2.7%. Both permit issuance and housing starts remain far ahead of where they were a year ago.

Sandy has made the labor market picture tough to discern, meanwhile, as new claims for unemployment spiked two weeks ago thanks to the storm, then fell rather sharply this week.

Since our last newsletter, the S&P 500 returned -0.2%, while the Hot List returned 2.4%. So far in 2012, the portfolio has returned 12.5% vs. 10.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 154.3% vs. the S&P's 39% gain.

Checking In On Valuations
From the US elections to the "fiscal cliff" drama to the continued periodic debt crisis flare-ups in Europe, a number of major macroeconomic factors have been impacting stocks over the past couple of months. Investors have largely focused on these sort of macro developments, jumping into stocks when hopeful signs emerge and bailing when fears rise.

Of course, great investors like Warren Buffett or Joel Greenblatt or Kenneth Fisher don't make such macro-driven, emotional decisions, so we don't either. We focus on facts and figures and long-term data. With that in mind, I think it's a good time to check in on where we stand with the broader market's valuation, and with the valuation of some Hot List stocks.

We'll start with the broader market, and earnings. Using the S&P 500's price of about 1,390 (which is where the index stood in mid-afternoon trading on November 21), the index is trading for about 15.9 times trailing 12-month (TTM) as-reported earnings per share, and about 14.2 times TTM operating EPS. Those figures are just a shade lower than where they were when last we looked at broader market valuation back in late August.

Using projected earnings for the next year, the operating figure is about 12.7, down from 13.1 in late August, and the as-reported figure is 14.1, down from August's 14.4, according to S&P data. All in all, these short-term earnings figures paint a picture of a market that is pretty fairly valued, and perhaps a bit undervalued.

The S&P's price-to-sales and price-to-book ratios, meanwhile, remain right where they were back in August. The index trades for about two times book value, according to Morningstar. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners.

The S&P's current price-to-sales ratio of 1.3, also according to Morningstar, is higher than the historical average cited by Comstock and Ned Davis. But it doesn't seem astronomical—my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

As for dividend yields, they continue to look pretty solid. The S&P is yielding about 2.2%, well above the 1.66% yield on ten-year Treasury bonds. That's historically rare.

One figure that has improved since August is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It has fallen to 89.5% (from 97.7%), according to GuruFocus.com. That puts it at the top end of the "Fair Valued" range, (90% to 115%), based on the site's analysis of historical data; back in August it was in the "Modestly Overvalued" range.

The ten-year cyclically adjusted price-to-earnings ratio remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 20.9, using Yale Economist Robert Shiller's earnings data. That's down from 21.9 in August.

It's still well above the 16.5 historical average (which dates back to 1871). But as I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.3. (The distinction is significant because after World War II, inflation became a permanent part of the US economy. Since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor).

Tobin's Q also indicates that the market is significantly overvalued. Developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter.

As of the most recent report, which came at the end of the second quarter, the Q ratio was 0.92. Since then, stocks have gained about 2%, so using today's market prices, the current ratio would be slightly higher. That makes it significantly higher than the historical average of 0.7 using the arithmetic mean and 0.65 using the geometric mean, according to Doug Short of Advisor Perspectives.

As has been the case for some time, the current Q indicates the market is significantly overvalued, but not nearly as high as it has gotten at some market tops.

Since we last looked in August, the valuation picture has thus gotten a little better overall. Conflicting metrics remain—Tobin's Q shows the market to be significantly overvalued, for example, while several other metrics show it to be fairly valued or undervalued. All in all, I'd say the broader market remains somewhere near the fair value range.

Looking at individual stocks, numerous bargains are out there. Take Hot List newcomer Main Street Capital Corporation (MAIN), which gained 7.5% during a previous stint in the portfolio back in August. Main Street has been posting impressive growth in recent years, yet it trades for just 8.3 times trailing 12-month earnings and 1.7 times book value. In addition, it comes with a stellar 6.1% dividend yield.

Another Hot List newbie, Russian oil power Lukoil (LUKOY), trades for 5.7 times TTM earnings, 0.38 times sales, and 0.67 times book value. It also comes with a solid 3.8% dividend yield.

Do both of these firms have some questions and issues surrounding them? Surely. Main Street is a small-cap financial, the sort of stock that would be particularly sensitive to short-term mood swings of macro-focused investors. Lukoil is another economically sensitive firm, and is from a country whose government isn't the most reliable or stable.

But that's what value investing is about—buying shares of good companies whose shares aren't getting the love they should because of other investors' fears. And history shows that time and time again, those fears cause investors to overreact and undervalue these types of companies.

That can make for a bumpy ride in the short term, but over the long term taking advantage of those undervalued bargains is a winning strategy—from Benjamin Graham more than half a century ago to gurus like Warren Buffett and Joel Greenblatt today, that's what history has shown. And going forward, I see no reason why the success of long-term, value-focused investing won't continue.

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Related Reading:

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Elections, Energy Policy and Coal

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Tickers Mentioned: MAIN, LUKOY

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