Now might be a good time to buy.
That's according to a recent Morningstar analysis, which reported an apparent contradiction in stock prices. The market as a whole is expensive, writes Morningstar. But those prices are a steal compared to what the underlying companies should generally cost.
At the threshold level, share prices have risen significantly in recent years. As Morningstar writes, its U.S. market index is up about 8.6% in 2023 alone and 16.2% from the recent low of last October. This is despite inflation in 2022, which has largely but not yet fully abated, and ongoing concerns about a possible recession in late 2023.
“We still believe the US stock market looks expensive and has appreciated year-to-date,” Morningstar wrote, citing Jim Masturzo, chief investment officer for multi-asset strategies at Research Affiliates. “The market is holding up well given the macro environment.”
So where can investors find the best bargains?
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The best bargains can be found in value stocks
Look at the S&P 500, you too will see high stock prices. From a low of around 3,500 points in October 2022, the S&P 500 is now leveling off again at around 4,200 points. Even discounting the March 2020 low as a deviation, it's a huge gain from the pre-corona S&P 500 value of around 3,300 points.
So the stock market is doing well, with high prices that are steadily rising. Much of this, writes Morningstar, is due to tech stocks posting huge gains over the past few months and years. These are “the big tech stocks that dominate weights in broad market indices, like Apple (AAPL) — up 35% in 2023 — and Alphabet (GOOGL) — up 39% so far this year.” has made large growth stocks particularly expensive, according to some strategists.”
Expensive is a word for it. At the time of writing, Apple is trading at $177 and Alphabet is trading at $123. Stocks like Tesla (TSLA) and Meta (META) traded for $197 and $263 per share, respectively. However, in fairness, none of these compare to the likes of Chipotle Mexican Grill (CMG), whose current share price is $2,064.
But despite these high prices, Morningstar thinks now is still a good time to buy. “[B]”Morningstar's fair value estimate shows that stocks are actually undervalued by more than 9%, with value stocks looking particularly cheap,” writes Morning Star. “However, this market discount has narrowed significantly since the October low.”
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The key to this analysis is the term “value stocks.” Morningstar sees a market rich in value stocks.
Stocks are considered value stocks when their share price is low compared to the underlying value of the company. For example, if you looked through a company's books and found that it was fairly valued at around $20 per share but is currently trading at $15 per share, you would consider it a value stock.
Value stocks are generally considered a good buy for long-term investors. Historically, the market has been good at restoring a company's stock price to its fundamental value, a process known as “market efficiency.” Investors who buy a stock below the company's fair valuation can generally expect the stock's price to rise to its base value level over time. (Some economists have criticized the market efficiency theory in the age of rising valuations in the technology sector.)
The hard part is figuring out the underlying value of this company.
How to analyze a company's underlying value in search of cheap stocks
Investors use a number of different metrics to decide what a company should trade for, including indicators such as volatility (lower volatility tends to mean higher value), dividends (higher dividends mean stronger cash flow), and peer/competitor share price (higher-valued competitors). suggest). a valuable industry). However, the most common indicator that investors reach for is a company's price-to-earnings ratio, or P/E.
The AP/E ratio measures a company's stock price compared to its total earnings per share. Let's say a company is trading at $40 a share. The company has a total of 1 million shares issued and posted total earnings of $20 million last year, which translates to earnings of $20 per share. The company's P/E ratio would be 2 ($40/$20).
The price-to-earnings ratio shows how much value you are getting for every dollar invested in a particular stock. For example, in our case above, you pay $2 in stock price for every $1 in company earnings. In other words, for every dollar you invest in the company, you acquire a dollar in value.
Generally, 16 is considered the average price-to-earnings ratio across the market. That means that on an average investment, you're paying $16 for every $1 in underlying income. Companies with low P/E ratios, whether relative to their peers or the broader market, are generally considered value stocks. Other investors are likely to increase the price of this asset because it offers better value than comparable investments.
All of which brings us back to Morningstar's analysis.
As mentioned above, Morningstar sees a market rich in value stocks. This is due to a variety of factors, including both standard P/E ratios and an adjusted form of this analysis known as cyclically adjusted P/E or “CAPE” ratios. A CAPE analysis uses a company's inflation-adjusted earnings over the past ten years, rather than the company's most recent earnings report, to attempt to eliminate short-term anomalies in the business cycle. In both standard P/E and CAPE analysis, Morningstar writes, “fair value suggests stocks are undervalued.”
“The Morningstar US Market Index is up 8.6% so far this year and has a price-to-earnings multiple of 19.8, based on trailing 12-month earnings,” writes Morningstar. “That compares to a P/E of 24.2 at the peak in late 2021 and 17 at the bottom in mid-October 2022… [And] Value stocks are cheap compared to growth stocks [with] The materials sector trades at a P/E of 15, compared to an average that's closer to 18. Energy stocks are trading at a P/E of 7, compared to an average of 16.”
This is true even outside of the US, where emerging markets are trading at a P/E of 13.5.
Now it's important to understand that investors still have to look for value. The large-cap stocks, especially in the technology space, are expensive. “They are historically very high relative to interest rates, liquidity and inflation,” the Morningstar analysis said. In short, this means that technology stocks may have met or exceeded their fundamental value. These companies have experienced strong growth, which means there isn't much of a gap between their stock price and value.
The high-priced stocks, commanding hundreds of dollars a share, may grab the headlines, but they don't necessarily increase market value. Instead, look for stocks with strong business fundamentals and a low P/E ratio.
Because despite the strong market, they are out there and now could be a good time to buy them.
A recent Morningstar analysis suggests that now could be a good time to buy into the market. While prices are high, they are often low relative to the companies' overall underlying value, making this a powerful moment for potential investors.
Basic investment tips
The AP/E ratio is part of the so-called “fundamental analysis”. This means you look at the strengths and weaknesses of the underlying company to look for good investment opportunities. It's an essential part of any long-term investor's tool kit.
You know what else is an essential part of your toolkit? Good advice. Finding a financial advisor doesn't have to be difficult. SmartAsset's free tool puts you in touch with up to three verified financial advisors operating in your area, and you can interview the appropriate advisors for free to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
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The post Looking for Bargain Stocks? Morningstar Says These Are Cheap first appeared on the SmartAsset blog.