5 Stocks That Are Priced for High Returns

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Step away from the Bloomberg machine. Put down the bottle of scotch. Yes, I know the market has been down day after day after day, challenging the resolve of even hardy investors. And I haven't missed the big news about Standard & Poor's downgrade. But I don't want to talk about the past seven days. I want to take a moment to step back and look at the big picture.

Is it simply crazy to be wading against the tide and buying stocks right now?

Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) Vice Chairman Charlie Munger likes to repeat the wise advice from German mathematician Carl Gustav Jacobi, "Man muss immer umkehren." Or for the non-German-speakers out there, "Invert, always invert."

So if we're wondering whether today is a good time to buy, we should take a look back at what was a bad time to buy. In late 2004, Oaktree Capital's Howard Marks wrote a memo in which he said that most assets weren't "priced to give high returns or adequate risk compensation." Obviously, this came well ahead of the crash, but it could be instructive to look at what the market looks like today versus what it looked like back then.

Low-return environment?
In his book The Most Important Thing, Marks differentiates between low-return and high-return environments. In short, the idea is that at times asset prices are low enough that it's reasonable to expect high future returns, while at other times prices are high enough that the only way to reach for high returns is by climbing way up the risk ladder.

If we were to consider 2004 -- as tagged by Marks -- as a low-return environment and 2007 -- as identified by painful experience -- as a low-return environment, what does that say about today?

Year

S&P 500 1-Year Trailing Price-to-Earnings Ratio

S&P 500 10-Year Cyclically Adjusted Price-to-Earnings Ratio*

200420.727.1
200722.226
2011**13.920.3

Source: Standard & Poor's and IrrationalExuberance.com.
*S&P 500 price divided by average S&P 500 earnings over prior 10 years.
**Earnings for multiples as of June 30, 2011, and March 31, 2011, respectively.

If 2004 and 2007 were low-return environments, then the current environment is obviously a good deal better by comparison. The current single-year P/E is 33% lower than 2004's and 37% lower than 2007's. The 10-year P/E hasn't adjusted down quite as much, but it's down 25% and 22% for the respective periods. So on a relative basis, the market definitely looks better today.

On an absolute basis though, it's not quite as clear that today is a great time to buy. The long-term average for the 10-year multiple is 16.4, so the multiple today is significantly above that. On the other hand, the one-year multiple is below the long-term average of 15.5.

This ain't 2008
It's not too surprising that some investors are ready to jump to the conclusion that what we're going through right now is 2008/2009 all over again. Even three years out, the experience was painful enough that it's still very fresh for most investors.

However, as we can see from the table above, prior to that plunge investors were paying much higher prices for stocks. By doing that, they gave themselves very little room for error or change in economic circumstances. So when the financial crisis came along, it was like hitting a pile of dry tinder with napalm.

Today the economic picture may not be overly rosy, but investors are paying significantly lower prices for stocks. Corporate profits could be challenged if the economy continues to sputter, but investors have more cushion in valuations today than they did three years ago.

Mr. Market throws a sale
While the recent sell-off may have made the broad-market valuation even more attractive as compared to the pre-crisis years, I'm not convinced that we're what Howard Marks would call an overall "high returns" environment.

However, when I look at the valuations of many individual stocks, I remain confident that there are some very good investment opportunities even if the overall market's return isn't fantastic.

Here are just a few examples of what I'm talking about.

Company

Trailing 2004 P/E

Trailing 2007 P/E

Current Trailing P/E

Current Forward P/E

Apple (NAS: AAPL) 116.736.914.812.1
Microsoft (NAS: MSFT) 29.023.79.69.0
Wal-Mart (NYS: WMT) 25.917.011.811.1
GE (NYS: GE) 22.520.212.811.1
Oracle (NAS: ORCL) 28.825.017.011.7

Source: Capital IQ, a Standard & Poor's company.

When it comes to trying to make money on anything -- whether we're talking stocks, bonds, livestock, or vintage 1980s jean jackets -- the lower the price you pay for a given asset, the better your chances are to make money on it. The profits from the stocks above may not come tomorrow or even next year, but by buying at these kinds of prices, I'm confident there will be good money to be made over the next five to 10 years.

Of course even if these valuations look great to you, it's rarely a good idea to rush to buy without doing your homework. So go ahead and add the stocks above to your watchlist by clicking the "+" next to the tickers. And if you don't have a watchlist yet, go ahead and set one up for free.



At the time this article was published The Motley Fool owns shares of Berkshire Hathaway, Oracle, Apple, Microsoft, and Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway, Microsoft, Wal-Mart Stores, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of Microsoft, Berkshire Hathaway, and Wal-Mart, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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