November 9, 2021

What Are the Best Value Stocks—and the Ones to Shun?

Northern Trust screens for the top of the class, and also to red-flag the less appealing bargain plays.

Reported by Larry Light

Art by Jam Dong

Some value stocks are misunderstood diamonds, waiting to be discovered. Some are toxic waste that should remain in the green-gunk pool. And in between are those from solid-enough companies that somehow fall short of championship material. Maybe their shortcomings are a lack of sufficient new products or too much debt or stumbling business plans.

At our behest, Northern Trust Asset Management screened for what it views as desirable value names, and then for some less desirable examples to avoid. Or, in Northern Trust’s parlance, “high quality” versus “low quality.” It came up with three on the high end and three on the low, a by-no-means exhaustive list, yet an instructive one. While the low-quality businesses are hardly teetering on the brink of insolvency, to Northern Trust, they likely won’t give shareholders much price appreciation up ahead. The firm’s head of quantitative strategies, Mike Hunstad, explained that his methodology was to “look at profitability, cash flow, and balance sheets—how well they use their capital.”

The incessant talk about rising interest rates in the third quarter proved a good test for his choices, he said. During that period, Hunstad found, “value stocks with high levels of debt and low margins underperformed their benchmarks by about 4%. In contrast, value stocks of higher financial quality have historically reacted positively to rising rates.”

What does the smart money think? Asset allocators in general are style agnostic, in that they want well-rounded portfolios that draw from all philosophies. Robin Diamonte, CIO at Raytheon Technologies, said her team and its outside managers “don’t implicitly invest in value stocks,” and want a globally oriented approach, with “a broad mandate to generate alpha.”

“I generally prefer deep value managers who run concentrated portfolios,” said Robert Hunkeler, CIO of International Paper, who stresses that he and his managers also buy growth stocks.

The lot of value investors has been relatively disappointing for some time. Last spring, value briefly overtook growth, as the prospect of higher interest rates temporarily shook faith in the momentum names—increasing rates tend to harm these hot shots’ prospects for growth, especially tech shares. One reason: Discounted cash flow calculations portend slimmer profits going forward for the tech darlings. Nevertheless, since April, growth has reclaimed its lead.

The superiority of growth nowadays is seen in the performance of two exchange-traded funds (ETFs) that track these opposite investment styles. Thus far this year (as of last Friday), the iShares Russell 1000 Growth ETF has returned some 27%, versus 23.5% for the iShares Russell 1000 Value ETF. The contrast was even more stark in rocky 2020, when the growth fund logged 38.2% to the value ETF’s minuscule 2.7%. Over five years, growth advanced more than twice the return for value. Over 10 years, growth’s lead was still pretty wide, 19.4% to 12.8% annually.

Within the value universe, Northern Trust’s Hunstad argues that some clear choices are apparent. For his three recommended value stocks and his three other ones, there is a single obvious difference: The lagging value stocks sport higher debt loads, which mean bigger interest tabs and hence less money available to put into operations or to give back to shareholders. Those on his value A-team don’t have such hindrances.

Top-Performing Value Stocks

In Northern Trust’s view, this trio of stocks is affordable, with staunch fundamentals that bode well going forward.

eBay. After a spell of sluggish revenue and earnings gains, one of the world’s largest online marketplaces has ridden the pandemic consumer buying spree to solid earnings. Spurred by new CEO Jamie Iannone, a former eBay executive who went on to a successful run as chief of Walmart’s e-commerce division, the company has enlarged its payments platform (90% of the site’s transaction volume) and ramped up its advertising business. What’s more, eBay has shown good results pushing niche items such as handbags and watches. Two other initiatives that have helped: simplifying digital payments, and combining claims and returns in one area. While eBay’s buyers have shrunk somewhat lately, that’s part of the company’s strategy to maximize its resources.

The price-to-earnings ratio (P/E) is a bargain at 19, only just a bit more than the S&P 500 average. As of Sept. 30, the end of the last quarter, the ratio of debt to equity was a low 0.18, by Northern Trust’s figures—a pretty comfortable level. The stock has taken off since the pandemic’s onset, and this year, as of last Friday’s close, is up almost 54%.

Eli Lilly. Analysts sees solid margins and revenue growth ahead for this pharma firm, largely on the strength of its solid existing drug portfolio and its robust pipeline of new products.

The firm has submitted its donanemab antibody therapy to the US Food and Drug Administration (FDA) and received accelerated approval for use in early Alzheimer’s disease. Lilly said third-quarter sales from Trulicity, a diabetes treatment, were $1.6 billion, 45% higher than the year-before period, exceeding Wall Street projections. In late 2020, the FDA granted emergency use authorization for its antibody medicine to treat COVID-19 in adults and children 12 and over. Increasing at least 30% in the past quarter were Taltz, for an autoimmune disease; breast cancer drug Verzenio; and migraine treatment Emgality.

With a P/E of 32, Lilly doesn’t fit into the thrifty mold of most value stocks, although it is less than that of the Nasdaq 100, the biggest growth-oriented stocks. Here, too, the shares have romped, rising almost 59% in 2021. Debt to equity: a mere 0.7.

Williams-Sonoma. Boasting impressive revenue and earnings growth, the upscale home goods merchant has weathered the retail nuclear winter well. Unlike many of its retail brethren, the chain didn’t suffer as much in 2020, and it engendered good will with its staff by continuing to pay them during the lockdowns. When its stores closed, it deftly shifted to e-commerce. Even though Williams-Sonoma has encountered higher raw materials and freight expenses, the company was able to expand its operating margins. A booming housing market has helped. Its Pottery Barn and West Elm subsidiaries cover other parts of this market well.

Carrying an affordable P/E of 16 and a stock that has doubled this year, the company has a lot going for it. Debt to equity is just 0.9, thanks to its campaign to pare borrowings. In other shareholder-pleasing moves, it recently increased its dividend by 20%, following a payout boost earlier this year, and has embarked on a stock buyback. Over the past pandemic-ridden two years, Northern Trust’s Hunstad pointed out, revenue vaulted almost 20% and earnings doubled. “Total assets are up,” he said.

Laggard Value Stocks

These names are hardly destined for history’s ash heap. In Northern Trust’s eyes, though, they have flaws that will hinder their futures.

Bristol-Myers Squibb. The company will soon face generic competition for its top-selling Revlimid, a treatment for multiple myeloma (white blood cell cancer). A number of analysts fret about its pipeline, even though the business still has some other bestselling drugs.

The company missed analysts’ estimates in the first quarter, but returned to beating them for the next two, as sales of a key product, the cancer immunotherapy Opdivo, reversed a skid. The drugmaker is continuing to look at expanding its roster of medicines in development through deals, mostly involving smaller, early-stage biotech outfits in areas such as cancer, immunology, and cardiovascular health. In 2019, it bought Celgene, holder of several cancer drugs, for $74 billion.

The stock is down 2% for the year, and the debt ratio is 0.36, hardly onerous, yet not as small as the trio in Northern Trust’s top category. A debt-equity ratio of 2.0 and above is widely considered to be too much. BMS has an A+ rating from Standard & Poor’s. With a P/E of 19, it is not expensive, at least. The company wouldn’t comment.

Cleveland-Cliffs. Steelmakers once were in the doldrums, but Cliffs lately booked record earnings. The company has moved big-time into steel production after years as an iron ore provider. And its CEO has pledged to reduce the company’s debt to zero. What’s not to like?

The P/E looks like a bargain, at 6. The debt-to-equity multiple is 0.42, again not betokening a debt problem, but a higher load than the top fliers listed above. The stock is up a handsome 62% this year because steel prices have soared. Nonetheless, it sits at around a fourth of its level from 10 years before. This is, of course, a very cyclical business. And Cliffs’ bonds are junk rated, a bottom-dwelling CCC from S&P.

Investors worry that steel prices will collapse in 2022 as new supply enters the market. Concerns flare about the slowdown in auto manufacturing courtesy of a chip shortage—steel is a car’s biggest ingredient. Autos are about 20% of Cliff’s revenue. Moody’s Investors Service stated that its bonds belong in junk status because of “its inconsistent historical operating performance and free cash flow generation due to its exposure to cyclical end markets and volatile iron ore and steel prices.” In April, Cliffs CEO Lourenco Goncalves berated S&P for the agency’s low rating of his company, saying, “They are blind, and they don’t get it.” The steel company didn’t return a request for comment.

FedEx. Supply chain disruptions, labor shortages, and all the other troubles of the pandemic economy circa 2021 have taken a toll on FedEx, the nation’s second biggest delivery service behind UPS.

The shipper reported disappointing profits for the first fiscal quarter, ending Aug. 31: $4.37 per share, well below analysts’ estimates. FedEx blamed the punk profits on a $450 million jump in operating costs “due to a constrained labor market.” Profit margins have shrunk. “Costs are way up and net income is up a little since 2018, even though revenue rose 28%,” Northern Trust’s Hunstad said.

At a below-market P/E of 14, it certainly is not expensive. The debt ratio is 0.58, not awful. S&P gives it a BBB rating, the last investment-grade tier. The stock had a nice runup in 2020, amid the spurt of goods orders from locked-down folks, although that has stalled out this year. Wall Street estimates are on the downside. The shares have dipped around 6% in 2021. The company said it wouldn’t comment.

For Benjamin Graham, writing in his classic book The Intelligent Investor (1949), a true value devotee is eternally vigilant for the bargains that will someday touch the firmament. His timeless advice: “Buy cheap and sell dear.” Provided that the stocks get to be dear, that is.