S&P 500 Stocks With Highest P/Es Poised to Win, UBS's Golub Says

Investors should purchase stocks with the highest price-to-earnings ratios because their valuation premium to the cheapest shares is too low, according to Jonathan Golub at UBS AG.

The gap between the Standard & Poor’s 500 Index industries with the highest and lowest P/Es narrowed to 3.6 last month from 9.6 in 2006, according to UBS, which used projected earnings for its valuations.

The disparity suggests purchasing expensive stocks may boost returns during the next 12 to 24 months, the UBS strategist said. The three industries with the highest multiples in the S&P 500 are industrials, consumer discretionary and consumer staples, according to UBS.

“This is akin to purchasing a Picasso when high-priced artwork is out of favor,” Golub, the New York-based chief U.S. market strategist, said in a telephone interview yesterday. “On a relative basis, cheap stocks are overvalued because they are much closer to the market average. It’s not that I want to overpay for companies, but rather traditionally high P/E stocks are cheaper than they should be.”

Since falling to this year’s low on July 2, the S&P 500 rose 14 percent through yesterday on expectations the Federal Reserve will buy bonds to stimulate the economy and avoid a second recession in three years. The benchmark measure of U.S. stocks surged 8.8 percent in September, the most for the month since 1939.

GDP Growth

Investors who only buy stocks can take advantage of Golub’s recommendation by purchasing shares with high P/E. Those who also short should bet against companies with low valuations, he said. He said the long-short strategy is probably best implemented through a swap, a derivative through which investors exchange rights.

U.S. gross domestic product will grow 2.7 percent in 2010, 2.5 percent in 2011 and 3.1 percent in 2012, according to the median projections in a Bloomberg News survey of economists. The nation’s GDP contracted 2.6 percent last year.

“The economy is strong enough for fundamentals to become relevant again,” Golub said. “If you have a less macro-driven environment, individual companies’ characteristics are appreciated for their uniqueness and therefore multiples tend to be more unique.”

Golub said that the strategy of buying high P/E stocks when their valuation gap is small versus cheap shares tends to work better in a “stronger” stock market.

“I’m not making this as an up-market call, but if the market is just lousy, then it’s not likely to work,” he said. “If the trends seen in September continue, high P/E stocks should rise while others remain relatively unchanged. There have been many times in history when this has added between 5 to 10 percent or more value over a period of one to two years.”

To contact the reporter on this story: Rita Nazareth in New York at rnazareth@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net.

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