It’s easy to let winners keep on winning during an established bull market because speculation-fueled easy money or economic growth supports higher valuations. That’s a potentially risky recipe, however, in bear markets, when valuation is falling because rates are rising and the economy is stalling.
In tough markets like this, shrewd investors can use extreme valuation levels to determine when to sell into strength and buy into weakness. This active management style can reduce the risk of a drawdown in an expensive stock while providing cash to buy undervalued stocks with potentially more upside.
In “Investing Is All About Choices: Here's How to Choose Well,” Real Money Pro’s Paul Price shows how investors can benefit from applying this type of mean reversion strategy to valuation. He writes:
“Getting superior returns on your portfolios requires occasionally selling overpriced shares while rotating your cash into clearly undervalued ones…Almost everything in life suffers reversion to the mean behavior. Great times are followed by bad times, depressed moods give way to euphoria and unlucky periods finally turn around…Normalized valuations are what stocks revolve around. Once you have determined "normal" you can usually expect a particular stock to go back to that over time.”
To illustrate his point, Price highlights a stock trading at a historically high price-to-earnings ratio and another trading at an unusually low P/E ratio.
An expensive stock to sell
Genuine Parts (GPC) has been a standout performer in an otherwise dismal market this year. The company owns the familiar NAPA auto parts brand of stores and has enjoyed substantial earnings growth over the past two years, fueling investors’ interest. As a result, its share price has risen 32% year-to-date, a remarkable return, given the S&P 500’s fallen by 15%.
Reasons behind Genuine Parts’ outperformance include a solid balance sheet with plenty of cash flow to cover its dividend, earnings per share anticipated to increase 18% this year, and demand likely to benefit if economic weakness causes people to hold onto their cars longer, increasing demand for do-it-for-me and do-it-yourself repair.
Those bullish arguments, however, may already be fully priced into the stock. Price writes:
“Genuine Parts showed reasonable long-term growth across all major metrics. Earnings per share almost doubled. Its shares, however, far outpaced these fundamentals. Continuous shareholders over exactly 10 years earned just shy of 215% in total return.
There is only one way for that to happen barring a takeover or a leveraged buy-out. That is via price-to-earnings ratio expansion. That is great news for previous holders but horrible news for investors/traders looking to buy in now [emphasis mine].”
Indeed, the company’s earnings have climbed 97% over the past decade, outpacing 85% revenue growth. However, a return nearly twice the earnings growth means that its P/E ratio has climbed to the high end of historical norms, increasing the risk of mean reversion, especially if something were to happen, causing earnings growth to slow.
Back to Price:
“Since 2012, GPC carried an average P/E of 18.2 times, accompanied by about 2.92% in yield…Today's 23 times multiple is 26.4% above Genuine Parts' normal and is the second-highest P/E since 2012...Every one of the six best entry points (green-starred below) launched rallies from well below-average multiples. And 100% of those starting points came when investors were getting higher than typical yields. The three previous "should have sold" moments (red-starred) all reflected above-average P/Es along with below-average dividend yields.”
Price points out that investors would have done better by selling Genuine Parts in the past when P/E was near its historic highs and the dividend yield was near historical lows, such as now.
For example, as you can see in the following chart, the stock peaked in early 2019 when its P/E was 20.2, and its dividend yield was 2.74%. We’ve already established that the P/E now is near the highest in its history. How about its dividend yield? At 1.83%, it’s yielding less than the average annual yield for every year in the past decade.
“Why hang around waiting for a predictably negative total return? Those who failed to exit Genuine Parts in late 2014, the middle of 2016, and during March of 2019 all suffered through significant drawdowns over meaningful time periods.”
How much could Genuine Parts stock fall? Price calculates a price target of $157.25 if valuation retreats to its average 18.2 average over the past 10 years, about a $30 drop from where shares closed on December 2.
A cheap stock to buy
Instead of sticking around in Genuine Parts stock, Price thinks much more upside exists in the cable and communications giant Comcast (CMCSA) . He writes:
“[Comcast’s] outstanding decade-long growth across all major business metrics has not been adequately reflected for buy-and-hold owners. Yes, they [shareholders] pocketed north of 110%, yet EPS and dividends surged by over 220%...That means P/E compression has been at work…Times like those leave plenty of room for large upward stock price movements.”
Unlike Genuine Parts, shares haven’t kept pace with earnings growth, suggesting that mean reversion back toward historical norms in P/E ratio and dividend yield could produce profit-friendly mean reversion. Price writes:
“Comcast's average P/E ran about 16.5 times [over the past decade], accompanied by around 1.85% in yield. As of Dec. 4, 2022, Comcast Class A shares were offered at just 9.4 times its 2023 projected EPS while paying 3.02%...All six of the previous best entry points (green-starred below) saw the shares rise nicely from below-average P/Es like today. All of them also provided better-than-average current yields as well.”
If a low valuation and high yield cause a similar “best entry point,” Price thinks shares can rally 78% to $62 to $63 per share. That’s a pretty heady return that should capture a value investor’s attention.
The Smart Play
Knowing when to book a profit can be challenging in a bear market, so considering valuation relative to historical norms can be helpful, particularly if it keeps you from turning a winning investment into a losing one.
Of course, no rule dictates stocks can’t see valuation increase or decrease beyond a certain point. High-valuation stocks can get pricier, and cheap stocks can become more inexpensive. As a result, it’s essential to consider the quality of the company and likely future demand drivers too.
Genuine Parts is enjoying sales growth, but a healthy portion – some 9% last quarter – is from acquisitions rather than organic growth. It’s also riding a wave in industrial distribution demand, which has grown faster than auto-related revenue. Recent manufacturing data shows activity is slowing. So, given acquisition impacts and potential slowing on the industrial side, this could be “as good as it gets” for now regarding growth.
Nevertheless, growth investors still aren’t likely to want to give up on Genuine Parts as quickly as value investors, given the economy may support do-it-yourself trends and the company’s top and bottom lines are growing solidly. Also, they’re unlikely impressed by Comcast’s top-line declining year-over-year in the third quarter, either.
However, growth investors may not want to ignore Price’s point altogether. In bear markets, even the best stocks can sell off, quickly erasing gains. If you’re inclined to give Genuine Parts some breathing room, consider running a trailing stop loss below your position. The loss will increase if it keeps moving up, helping you profit a more significant gain. It will also protect a specific level of profit if shares drop. Value investors could use a similar strategy or pocket their profit.
As for Comcast, it’s a mature company in a mature industry. There’s always the risk to cable subscriber growth because of cord-cutting. However, streaming demand does support Internet demand, and the company isn’t isolated from streaming altogether, given its stake in Hulu and its Peacock network. Advertising demand could be a headwind if the economy worsens, making it potentially the bigger short-term negative. However, like Genuine Parts’ good news may be priced in, much of Comcast’s headwinds may be priced in, too, given its low valuation. If you agree and want to buy shares, consider spreading purchases over time and protecting the position via a stop loss below its 50-day moving average.