From the perspective of last spring, this is a stock market that looks very expensive. From early March to the recent peak in mid-October 2009, the Standard & Poor's 500-stock index blasted 65% higher, before beating a small retreat in late October.
The big rally of 2009 has made it difficult to find stocks trading at cheap valuations. "Trying to find undervalued stocks in this kind of market is fraught with danger," warns Beth Larson, portfolio manager at Evermay Wealth Management. Much of the easy money has already been made, she says. "By this point, you have to be very careful what you're picking."
But that doesn't mean there aren't stocks with potential. Mark Travis, chief executive of Intrepid Capital Management, says many stocks in early 2009 seemed to be trading at 50% of their intrinsic value. Now, it's more common to find good buys at 80% or 85% of their real worth, he says. That still allows for a significant gain—more than the nonexistent returns these days on bank savings accounts or money market funds. But, he says, "it's definitely harder than it was in late February."
Rally Ignored Telcos Many in February and March were predicting the worst for the economy and financial system, and panicked investors pushed stock values to dirt-cheap levels. Especially hard-hit were equities seen as risky—companies pummeled by the recession or loaded up with too much debt. Having apparently survived their brush with death, many of these companies saw their share prices double, triple, or quadruple. "This a rally that has been led by the risky stuff," says John Buckingham, chief investment officer at Al Frank Asset Management.
The rally has been very generous to some sectors while it bypassed other areas of the market. For example, according to Standard & Poor's, the technology sector is up 48% in 2009, and the consumer discretionary sector has jumped 35%. By contrast, the telecommunication sector has languished, down 7% this year, while utilities have gained less than 3%.
Thus, there are wide swaths of the market that have been left behind by the broader market rally. That could be an opportunity for investors looking for stocks set to move higher, Buckingham says. "Investors should be gravitating toward the names that really haven't had a great performance in the [market] recovery," he says.
Verizon's Dividend Attractive If you're putting new money to work in this market, he advises starting with large, dividend-paying companies with a reputation for safety. He is buying Wal-Mart (WMT), Verizon (VZ), Lockheed Martin (LMT), and Abbott Laboratories (ABT).
Verizon may be locked in fierce competition in the wireless telephone market, but its stock sports a 6.6% dividend yield, a substantial payoff when interest rates are at historic lows.
Russell Croft, portfolio manager of the Croft Value Fund (CLVFX) is also giving an extra look to stocks left out of the 2009 rally. "We look at things that might not have moved [and] might not be getting as much credit in this environment," Croft says. That led Croft to buy Procter & Gamble (PG) and Lowe's Companies (LOW), which are both down slightly for the year.
"Cheap for a Reason" However, he doesn't rule out stocks that have made big gains, but still have potential for other reasons: Croft's fund also holds shares of Cisco Systems (CSCO), up 45% this year.
Just because a stock has lagged doesn't mean it's a good buy. "You might think they're cheap, but they might be cheap for a reason," Larson says.
A BusinessWeek screen, relying on data from Capital IQ, found examples of 25 stocks that have significantly lagged the market and, according to Wall Street analysts, remain undervalued. Several telecom stocks, including Sprint Nextel (S), Verizon, and AT&T (T) appear on the list. But Larson and other stock experts warn that these companies are in a fiercely competitive industry that requires significant capital expenditures. At the same time, they also must deal with the decline of their landline phone businesses.
Health-Care Stocks Hurting Another value play that might be dangerous is certain energy or material outfits that still look cheap according to valuation metrics like cash flow and earnings. Don't forget, Larson says, that their fortunes are tied to very unpredictable commodity markets.
"I'm looking for a company that is cheap, but has an ability to exceed expectations," says Terry Morris, senior equity manager at National Penn Investors Trust.
He sees the "greatest value" in the consumer staples and health-care sectors, where financially strong, well-run firms have seen their stock prices stuck in neutral. Health-care stocks have been hurt by Washington's discussion of health-care reform, he says, while consumer staples have lost out to faster-growing sectors like technology. Morris owns Johnson & Johnson (JNJ), which is flat for the year.
Quality Will be Rewarded Predicting the market's next move is next to impossible. But long-term investors operate on the assumption that, eventually, the market recognizes quality companies and rewards investors who buy them at the right price.
See the accompanying slideshow http://images.businessweek.com/ss/09/10/1029_25_undervalued_stocks/index.htm for 25 underperforming stocks that may have upside potential for the patient investor.