AAII Investor Update: A Cheap Valuation Isn’t Always a Bargain

Thursday, August 2, 2012
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Making Sense of Profits
Several ratios help reveal a firm’s true profitability.

“Buy” and “Sell” of the Week
Each week, I discuss two stocks I like and dislike.

AAII Discussion Boards
Are you avoiding certain tech stocks because of competitive pressures?

Most Popular AAII Articles

  1. “Finding the Right Withdrawal Rate: One Key to Portfolio Sustainability”
  2. “The Good Investor Rule: Focus on How Not to Lose Money”
  3. “The Cash Flow Statement: Tracing the Sources and Uses of Cash”

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 30.4%, up 2.3 points
  Neutral: 34.6%, up 5.9 points
  Bearish: 34.9%, down 8.2 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Cisco Systems’ (CSCO) low valuation, balance sheet strength, revenue and earnings growth, and positive free cash flow caused it to appear on my personal stock screen. Based on these measures, the stock looks attractive, but there are risks.

This week I’m going to walk you through my analysis, explaining both what is positive about the stock and what worries me. The purpose is to show you why a low valuation does not automatically make a stock a bargain. Rather, thorough analysis is needed to identify any potential risks that would create concerns about the stock.

Cisco Systems, as many of you know, makes networking equipment. It is a leading manufacturer of routers, switches and other equipment that enable the digital transmission of voice, video and data. The company is on track for its sixth year of revenue growth in the past seven years. Earnings per share are forecast to have risen for the fifth time in seven years. (Cisco Systems’ fiscal year runs from August to July.)

The stock trades at a cheap price-to-book ratio of 1.6 and a price-earnings ratio of 11.7. Not only are these ratios far below the company’s historical averages, but they are also low on an absolute basis.

Cisco Systems is fiscally sound. It reported more than $48 billion dollars in cash and cash equivalents at the end of April. Meanwhile, total liabilities were less than $40 billion. The company consistently generates free cash flow and its return on equity of 15.1 is double the median for the technology sector.

There are risks, however, which become apparent when further analysis is conducted. The historical five-year growth rate for net income is 5.6 percentage points below the five-year sales growth rate (3.1% versus 8.7%), a sign of narrowing margins. The I/B/E/S consensus earnings estimate suggests profit growth will remain slow, with earnings rising 4% in fiscal 2013 and 6.5% in 2014. The stock’s price chart shows a downward trend characterized by steep one-day drops, including a 5.9% plunge that occurred last week. Plus, a low valuation can always go lower; beleaguered technology giant Hewlett-Packard (HPQ) trades at just 6.7 times earnings and 0.8 times book value.

These characteristics are a sign that all is not right. With Cisco Systems, concerns about competitive pressures and questions about management’s business strategy exist.

The issues with Cisco Systems are well known to technology investors. But what about when you have questions about companies that aren’t as large or well-known? Quarterly earnings reports, corporate press releases and conference calls often reveal a lot about what is occurring with a company. You can also read through the 10-K, an annual form required by the Securities and Exchange Commission (SEC), to see who the major customers and competitors are and then find out what factors are affecting them. And if you still can’t figure out what’s going on? Find another stock or park your money in an index fund until you do find an attractive stock.

More on AAII.com

The Week Ahead

Approximately 35 S&P 500 companies are scheduled to report earnings next week. Included in this group is Dow component Walt Disney (DIS), which will report on Tuesday.

The first economic report of note will be the initial estimate of second-quarter productivity, published on Wednesday. Thursday will feature June international trade data. Friday will feature July import and export prices.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

Federal Reserve Chairman Ben Bernanke will speak publicly on Tuesday.

AAII Sentiment Survey

Bullish sentiment rose to a four-week high, as pessimism ebbed in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.3 percentage points to 30.4%. This is the highest level of optimism registered by our survey since July 5, 2012. Even with the increase, bullish sentiment is below its historical average for the 18th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 5.9 percentage points to 34.6%. The increase puts neutral sentiment above its historical average of 31% for the fifth time in seven weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 8.2 percentage points to 34.9%. This is a four-week low for pessimism. Even with the decrease, bearish sentiment is above its historical average for the 13th consecutive week and the 16th out of the last 17 weeks.

Bullish sentiment has risen only to the lower end of the range where historical readings have typically registered. The sustained above-average pessimism and the above-average neutral readings indicate many AAII members are not convinced that the recent upward move in stock prices will continue. Market volatility, slowing global economic growth, Washington politics and the European sovereign debt crisis are all continuing to fray the nerves of individual investors.

Yesterday's trading problems at market maker Knight Capital Group occurred near the end of the survey period. The volatility created within certain stocks by the technology issues at the firm was another dark cloud for those investors who already lacked confidence in the stock market. Quantifying the actual impact is difficult, however, since most individual investors do not know where their orders are routed.

This week’s special question asked AAII members if they have recently begun bargain shopping or, if they haven’t, whether there was a price level that would encourage them to start looking for bargains. The majority of respondents said no, they have not started to look for bargains. Many in this group said a further price drop of 10% to 20% would encourage them to start bargain hunting. A small group of respondents said they were either already fully invested or are more focused on long-term allocation strategies.

Less than 20% of respondents said, yes, they are currently bargain hunting for stocks. Within this group, several said they were always on the lookout for attractive stocks at good prices.
Here is a sampling of the responses:

  • “Not yet. I’m worried about a macro event causing a 10% to 20% drop. Within that range, I would be buying.”
  • “A 20% drop would motivate me to consider buying dividend growth stocks, which are now fairly valued or overpriced.”
  • “A 10% drop would be good enough to start bargain hunting.”
  • “No. I keep a balanced portfolio of corporate bonds and equity ETFs. I rebalance twice a year, if needed.”
  • “I’m mildly and cautiously bargain hunting—a 20% drop would send me into a greed-fueled buying frenzy.”
  • “I’m always hunting for good stocks.”

» Take the sentiment survey

AAII Asset Allocation Survey

July Asset Allocation Survey

Stocks/Stock Funds:
    59.8%, up 1.0 points
Bonds/Bond Funds:
    19.4%, down 1.9 points
    20.8%, up 0.8 points

Asset Allocation details:
    30.5%, up 2.2 points
Stock Funds:
    29.3, down 1.1 points
    3.9%, down 1.7 points
Bond Funds:
    15.5%, down 0.2 points

Take the survey »

Cash allocations rose to a seven-month high in the July 2012 Asset Allocation Survey. Equity allocations rebounded modestly, while fixed-income allocations declined.

Stock and stock fund allocations rose 1.0 percentage points to 59.8%. This puts equity allocations just below their historical average of 60%.

Bond and bond fund allocations declined 1.9 percentage points to 19.4%. This is the lowest percentage of portfolio assets held in fixed-income since April 2012. Even with the decline, fixed-income allocations stayed above their historical average of 16% for the 37th consecutive month.

Cash allocations rose 0.8 percentage points to 20.8%, the largest percentage allocation since December 2011. This is the eighth consecutive month that cash allocations have been below their historical average of 24%.

Though optimism about the short-term outlook for stock prices fell to two-year lows, AAII members only made modest changes to their portfolios. Concerns about the pace of economic growth in the U.S. and developments in the European sovereign debt crisis are keeping equity allocations below their historical average. At the same time, low current yields and worries that interest rates could move higher in the future continue to leave many investors frustrated about their choices for income-producing investments and looking to dividend-paying stocks for portfolio income.

This month’s special question asked AAII members if there is a foreseeable catalyst that would cause them to shift money out of bonds and bond funds. Respondents fell into three main groups: those who said they had no intentions of changing their fixed-income allocations (mostly due to long-term allocation or bond-laddering strategies); those who would move money out of bonds if interest rates rose, stocks fell further or the economy improved; and those who are currently out of bonds.

» Take the Asset Allocation Survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor