Where to Find Cheaper Alternatives to Expensive Stocks
(Bloomberg Opinion) -- With cash yields near zero and safe bonds paying little more, many U.S. investors say they have no choice but to take more risk if they want to grow their money. While that may be true, investors also appear to be chasing the same investments in their quest for higher returns, stretching valuations and ratcheting up risk.
Notably, junk bonds, real estate and U.S. large-capitalization growth stocks are overrun with investors. Yields on junk bonds and real estate investment trusts are the lowest on record (yields and prices move in opposite directions). The U.S. stock market, which is dominated by large-cap growth stocks, is by most valuation measures more expensive than at any time except the peak of the dot-com bubble in 1999 — and by some measures it’s even more expensive.
The danger is that record high valuations have a habit of tumbling from their perch. There’s not much investors can do about junk bonds and REITs other than limit their exposure. But when it comes to stocks, there are many alternatives to large growth companies in the U.S., including small companies, value stocks and foreign markets. They’ve been horrible performers in recent years, leaving them cheap and unloved — which is precisely why they merit another look.
Small companies in the U.S. are as cheap as they have ever been relative to the broad market. The S&P 500 Index trades at a price-earnings ratio of 21.9, based on companies’ expected earnings for the current fiscal year, compared with 16.4 for the S&P Small Cap 600 Index. That spread of 5.5 points is only slightly smaller than the high recorded during the dot-com era. The same is true for U.S. value stocks. The P/E spread between the S&P 500 and the S&P 500 Value Index is 4.1 points, also the widest since the dot-com era.
The bargains are even better overseas. The MSCI EAFE Index, which tracks companies in developed countries outside the U.S., is 6.7 points cheaper than the S&P 500, the widest on record. And the spread between the S&P 500 and the MSCI Emerging Markets Index is 9.2, the widest in nearly two decades. Foreign value stocks are even cheaper relative to the S&P.
Markets are smart, though, and when one asset is more expensive than another, there’s usually a good reason. When it comes to stocks, the reason is often that more expensive companies are also more profitable businesses. That shows in the numbers, too. Return on equity for the S&P 500 is 22.8, based on expected earnings for the current fiscal year, compared with just 9.9 for the S&P Small Cap 600. Like the P/E spread, that 13-point ROE spread is also among the widest on record. The same is true for value and foreign stocks. Their ROE relative to the S&P 500 is smaller than ever, or close to it.
But it turns out investors don’t have to chase the S&P 500 to capture its profits. The index is dominated by some of the best money-making machines ever devised, including Apple Inc., Microsoft Corp., Amazon.com Inc., Google parent Alphabet Inc. and Facebook parent Meta Platforms Inc., which account for nearly a quarter of the index. The tech giants, however, are not representative of the field. Most S&P 500 companies fall well short of the index’s headline profitability, if they’re profitable at all, and many of them are not cheap.
By cutting out expensive and lackluster companies, investors can pay less without sacrificing profits. One way to do that is to buy only the cheapest companies and the most profitable ones. For example, a 50/50 blend of the iShares MSCI USA Value Factor ETF and the iShares MSCI USA Quality Factor ETF results in a P/E ratio that is a third lower than the S&P 500 with nearly identical return on equity. It’s addition by subtraction — the 50/50 value/quality blend holds half the number of stocks as the S&P 500. (Disclosure: My asset-management firm invests in iShares ETFs.)
A similar portfolio with foreign stocks also improves the price-profits trade-off relative to the S&P 500, although it doesn’t achieve the same level of profitability because few foreign companies are as profitable as the large U.S. technology companies. Still, a 50/50 blend of the iShares MSCI International Value Factor ETF and iShares MSCI International Quality Factor ETF results in a P/E ratio that is half that of the S&P 500 with return on equity that’s only a third lower.
Investors may have to take more risk to grow their savings, but that doesn’t mean they have to pile into the same high-priced investments. Now more than usual, it pays to shop around.
More From Other Writers at Bloomberg Opinion:
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
©2021 Bloomberg L.P.