S&P 500 single stock valuations have the tightest spread in 25 years, with eight out of ten sectors below their long-term averages, according to a note from Goldman Sachs Group, Inc. (NYSE:GS). “The distribution of S&P 500 stock P/E multiples has been tightening since mid-2012 and is well below the average of 55% since 1990,” says the note.
The current dispersion of price/earnings is 1.5 standard deviations below the 30 year average, and the only sector that is significantly above its 30 year average is Financials where rising interest rates and other effects are benefiting some players and hurting others, increasing the spread in that sector. Utilities, on the other hand, are three standard deviations below the 30 year average, giving investors a rare opportunity to take on risk that isn’t being priced in by the market.
Also see: A Look at Current S&P 500 Valuation By Sector
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
Strategy suggestion: buy faster growth
“With stocks trading in tight P/E multiple bands within a sector, the logical strategy is to buy faster growth at little or no premium,” the note explains. “For example, within Industrials, Eaton and Rockwell Collins, Inc. (NYSE:COL) trade at forward p/e’s of 15.2x and 15.0x… however, the expected sales and EPS growth are much higher for ETN.”
“Similar situations exist in Utilities and Consumer Discretionary sectors,” says Goldman Sachs Group, Inc. (NYSE:GS). “NRG Energy Inc (NYSE:NRG) and SCANA Corporation (NYSE:SCG) (NYSE:SCU) trade at p/e multiples of 15.3x and 15.4x… but earnings growth and momentum differ sharply and the returns to our analyst price targets are 30 percentage points apart. In Consumer Discretionary, Viacom, Inc. (NASDAQ:VIA), AutoZone, Inc. (NYSE:AZO), International Game Technology (NYSE:IGT) and Coach, Inc. (NYSE:COH) trade at similar multiples but have different growth prospects and potential returns.”
S&P 500: Optimism might be overtaking hard evaluation
Even though valuation dispersion is incredibly low, as a measurement it is fairly spiky, and one only has to go back to 2007 to find spreads that were nearly as tight as today. There’s no reason to expect this scenario to last for a long time, especially if it influences multiple investors’ decision in the same way, and while Utilities are the best sector for factoring in the tight p/e spread, that doesn’t mean it’s right for every portfolio.
There is also concern that this tight spread might be due to some stocks being overvalued. The S&P 500 hit 1700, close to an all-time high, and plenty of investors are wondering if it’s currently overvalued. The flat p/e could be seen as optimism replacing a hard look at different companies’ fundamentals, something that would eventually require a correction.