3 ways to find value in a pricey market

By Carla Fried, Money Magazine contributing writer


(Money Magazine) -- A year ago, when all sorts of investments -- stocks, bonds, commodities -- were being tossed on the scrap heap, dyed-in-the-wool bargain hunters who had the courage to sift through the market's ruins were richly rewarded.

U.S. blue-chip stocks, for instance, rebounded 59% from March to January. Bonds issued by companies with poor credit ratings rocketed nearly 60%. And shares of fast-growing firms based in emerging economies, like China and India, nearly doubled.

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"You could throw darts and do well," says Forester Value manager Tom Forester, whose stock mutual fund was the only one to have made money in 2008, and has gained 8% a year since the financial crisis began.

While the across-the-board rebound served as vindication for those who took Warren Buffett's advice to be "greedy when others were fearful," it poses a major challenge today.

If a value investor is someone who bets on stocks that his peers are ignoring, can you still be one after so many have piggybacked on your bets? And with almost everything well above its March 2009 low, is there such a thing as an undervalued asset anymore?

Obviously the pickings are a lot slimmer for buy-low devotees. But it's not impossible to find attractive opportunities. "There is still value out there," says Forester. "It's just harder to come by."

The trick is to know where to look. Start in the most obvious place: among those investments that didn't fully participate in last year's rally -- and are therefore cheap by anyone's standards. Granted, it isn't a terribly long list, as the numbers at left indicate.

Another strategy is to look for stocks that have shot up alongside the broad market -- but whose fundamentals have improved even more. As a result, these shares can be regarded as real bargains in both relative and absolute terms.

Finally, at a time when the market is turning greedy for growth, the ultimate contrarian move may be to shift your portfolio into a defensive, income-minded mode. But it's imperative you do so in a cheap way.

Below, find out how to execute these three strategies -- either through individual stocks or exchange-traded funds that allow you to spread your bets across various asset classes or particular sectors. Playing the bargain hunter's game in a market where few deals jump out isn't easy, but it's the only prudent way to invest.

Strategy No. 1: Focus on the laggards that remain undervalued.

Though most equities gained ground last year, not every stock was a Ferrari whizzing by in the fast lane. In fact, one group -- health care -- lagged, largely because of fears about potential government policy changes.

The bargain: Big pharma. Blue-chip drugmakers were the wallflowers of last year's recovery party. While the S&P 500 soared 24% in 2009, Johnson & Johnson (JNJ, Fortune 500) and Pfizer (PFE, Fortune 500) gained less than 8%. Eli Lilly (LLY, Fortune 500) actually fell.

A big force that held this group back was the uncertainty swirling around health-care reform. But with fears of any profit-threatening reforms abating after the loss of the Democratic super-majority in the U.S. Senate, it's time to give this sector another look. When you do, you'll find compelling values rare in stocks with solid balance sheets.

Indeed, because of their high levels of profitability combined with low debt, drug stocks have typically traded at a slight premium to the S&P. But due to reform concerns, these shares are trading at a 40% discount to the market.

In other words, investors are paying considerably less per dollar of health-care earnings than for other corporate profits -- a discrepancy that won't last forever. Johnson & Johnson, for example, trades at a P/E of 13, compared with around 19 for the S&P, says Bill Nygren, co-manager of the Oakmark Fund. What's more, JNJ's 3.1% dividend is more than the yield on five-year Treasuries.

For ETF investors: Johnson & Johnson, Pfizer, and Merck (MRK, Fortune 500) are the three largest holdings of Health Care Select SPDR (XLV), accounting for more than 30% of its assets.

Strategy No. 2: Go with stocks that have risen - but are still cheap.

Looking for a bargain means seeking stocks that are undervalued. But stocks don't have to be beaten down to be a good deal.

The bargain: Tech stocks. Yes, tech was among the market's big winners in the recent rebound. But because earnings for information technology companies actually grew during the financial crisis, tech has seen its price/earnings ratio fall since the credit crunch began in 2007, while the S&P 500's P/E has risen.

Imagine how this group will perform once sales, which fell for a brief period in 2009, improve as the economy heals? Forrester Research forecasts that global spending on IT products and services should jump 8.1% this year to $1.6 trillion.

James Barrow, who runs a portion of the value-minded Vanguard Windsor II fund, says two of the cheapest -- and most attractive -- stocks in the group are IBM (IBM, Fortune 500) and Hewlett-Packard (HPQ, Fortune 500). Both firms trade at just 11 times projected earnings, though their shares soared 56% and 42%, respectively, last year. Both managed to boost or maintain profit margins during the downturn by aggressively slashing costs.

And the companies have ample cash on their balance sheets -- HP, for instance, sits on more than $10 billion -- to invest in future growth.

For ETF investors: If you want exposure not just to IBM and HP but also to a variety of other tech companies, check out Vanguard Information Technology (VGT), an exchange-traded fund that counts HP and Big Blue among its top six holdings.

Strategy No. 3: Seek income -- but don't pay exorbitant prices for it.

At a time when many investors are trying to jump on last year's bandwagon, playing it safe may make sense. But bonds -- the traditional conservative refuge -- are in fact risky now. Here's a better way to get income.

The bargain: Dividend-paying stocks. After last year's rally sent domestic and foreign bonds soaring, you can't say that fixed-income investments are cheap anymore. But with an average P/E of just 15, dividend-paying stocks are -- relative to the broad market, to their historical average, and to bonds.

True, stocks are on average yielding just 2%, but some sectors are paying out considerably more. Shares of large telecommunications companies, for instance, are yielding more than 5%.

Dan Chamby, associate portfolio manager for the BlackRock Global Allocation fund, says the Treasury-beating payouts of dividend stocks, particularly in the telecom sector, make them "fixed-income surrogates." Chamby recommends Verizon (VZ, Fortune 500) (yield 6.6%) and AT&T (T, Fortune 500) (6.8%). He's not alone. Pimco bond chief Bill Gross has also been beating the drum for dividend payers.

But aren't stocks inherently more volatile than bonds? Absolutely. Yet bonds aren't as safe as you might think. Interest rates are at record lows; when the trend reverses, bond prices -- which move in the opposite direction of rates -- could get pummeled.

For ETF investors: iShares S&P Global Telecommunications (IXP) sports a 4.3% dividend yield.  To top of page

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