How To Find Market Bargains

As stocks have continued to rise over the past year, so too have price/earnings ratios. Back in mid-November of last year, for example, the S&P 500 was trading for just under 16 times trailing 12-month as-reported earnings. Today, that figure is up above 18.

The 10-year cyclically adjusted price-earnings ratio (CAPE), meanwhile, was just under 21 back then, but now is about 24. Throw in the fact that profit margins are at or near all-time highs, which some say is not sustainable, and many investors are starting to get a little wary about valuations.

I, for one, am not particularly worried by those figures, particularly given the low interest-rate environment we are currently in. Yes, the shorter-term P/E ratio has been rising, but is far from exorbitant; the CAPE, while on the higher side, is not astronomical, and is in many ways a flawed measure; and there is good evidence that, while profit margins may decline a bit, they're not going to go plummeting back down to long-term means.

Still, if you're not convinced that the P/E environment is an attractive one, there are plenty of other ways to value stocks than earnings-based measures. Benjamin Graham, known as the Father of Value Investing, used the price/book ratio (as well as the P/E). David Dreman used the P/B too, along with several other metrics. And Forbes' own Kenneth Fisher wrote an entire book about using the price/sales ratio (PSR) to find attractive stocks.

Over a decade ago, I developed Guru Strategies that mimic the published approaches of some of history's greatest investors, including Graham, Dreman and Fisher. Like the gurus themselves, these models use a number of non-earnings valuation metrics, like the price/book and price/sales ratios. And right now, they are finding plenty of fundamentally sound, attractively priced stocks using these non-earnings metrics. (I'd also note that the broader market is reasonably attractive using them, with a 1.5 PSR and 2.2 P/B ratio, according to Morningstar.)

Here are a handful that are catching their eyes. As always, you should invest in stocks like these as part of a broader, well diversified portfolio.

Annaly Capital Management Annaly Capital Management: New York-based Annaly ($11 billion market cap) is a real estate investment trust (REIT) that is currently paying out an 11.9% dividend yield. It gets strong interest from my Dreman-based model.

This contrarian approach looks for companies that are in the cheapest 20% of the market on any two of four valuation metrics: the price/book, price/sales, price/earnings, and price/cash flow ratios. Annaly is the rare firm that meets that target in all four categories (3.5 P/E, 6.4 P/CF, 0.90 P/B, 8.4 P/D).

Of course, being cheap doesn't mean much if the company is a dog, so Dreman looked at a number of other fundamentals. The model I base on his writings looks, for example, for companies that have high returns on equity. At 24%, Annaly fits the bill.

Telecom Argentina (TEO): This Argentine company ($3 billion market cap), which also offers cellular services in Paraguay, is majority-owned by Nortel Inversora SA Nortel Inversora SA (which in turn is majority-owned by Telecom Italia Telecom Italia).

TEO's P/E is low—8.1—but that's not the only sign it's undervalued. My James O'Shaughnessy-based growth model has strong interest in the stock in part because its PSR is just 0.74, well below the model's 1.5 upper limit. This approach looks for low-PSR stocks that also have strong momentum—O'Shaughnessy wanted to find stocks that the market was embracing, but which hadn't gotten too pricey. With a solid 12-month relative strength of 87, TEO makes the grade. The strategy also likes that TEO has upped earnings per share in each year of the past five-year period.

TEO's PSR is one reason my Fisher-inspired model also likes the stock. Fisher pioneered the use of the metric in his 1984 classic Super Stocks, and, while his approach has shifted since then, my Super Stocks-inspired model has kept putting up strong results. The strategy also likes TEO's long-term inflation-adjusted growth rate of 20%, and its three-year average net profit margins of 13%. And my Dreman-based approach likes that TEO's P/E and price/cash flow ratios are both in the cheapest 20% of the market, and that it has a 28.9% return on equity and 4.6% dividend.

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