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It’s been more than a decade since investors have felt this confident. The Wells Fargo/Gallup U.S. Investor and Retirement Optimism Index hit 96 at the end of the fourth quarter, its highest level since January of 2007.
But this wave of confidence shouldn’t come as a surprise — U.S. stocks are on a roll.
The S&P 500 delivered a total return of 13% in 2016. That was the eighth consecutive year that the S&P 500 has closed in the green, its second longest annual win streak ever.
This impressive win streak has been great for returns and confidence. However, it has also created a problem. The S&P 500 is expensive. Its P/E ratio of 25 is the highest level since the financial crisis in 2009. Take a look below.
This high P/E ratio is creating some uncertainty that is lurking below the high investor confidence reading. Not only can it be intimidating for investors to buy stocks trading at an all-time high, but this makes it difficult to find value stocks.
A recent study by Bank of America/Merrill Lynch highlights the strong performance history of value stocks. The study tracked the performance of value stocks and growth stocks over a 90-year period from 1926 to 2016.
Over that time growth stocks generated an average annual return of 12.6%, while value stocks delivered an average annual return of 17.0%. The study also found that value also outperformed growth in three out of every five years.
On the surface, it would be easy to look at the S&P 500’s high P/E ratio as an obstacle. However it’s actually an opportunity. There are still many stocks in the S&P that are trading with P/E ratios well below their five-year average.
I would expect these stocks to be in favor with investors in any market, but in light of the current state of the market, I expect them to get even more attention from investors in 2017. Below is a list of 10 of the most undervalued S&P 500 stocks with P/E ratios well below the five-year average. Take a look.
|Company||Ticker||P/E Ratio||5-Year Avg. P/E|
From the group, I have chosen to profile two stocks that I believe have the most upside potential in 2017.
Gilead Sciences (Nasdaq: GILD) is one of the largest pharmaceutical companies in the world. Gilead had a challenging year in 2016 as shares fell from above $100 in April to below $70 at the end of the year.
That weakness was driven by generic competition for Gilead’s popular Hepatitis C drugs. Despite the tough year, I believe the selloff has created a great opportunity.
Gilead has a robust pipeline of future drugs, with 180 trials currently underway. More than 60 of those are in Phase 3, meaning they could be on the market soon. Gilead’s current pipeline is projected to bring in around $32 billion in annual sales when fully developed.
Gilead’s pipeline has the company on pace to begin growing earnings again in 2018. In the meantime, Gilead is one of the most undervalued stocks in the S&P 500. Its P/E ratio of 6.7 is a huge discount to the S&P 500’s 25 and Gilead’s 5-year average of 48.
Valero Energy (NYSE: VLO) is one of the largest petroleum refiners in the world. Valero’s earnings were down about 60% in fiscal 2016. However, that decline was not driven by bad management or performance. The entire refining industry’s earnings were down in 2016 as rising crude prices tightened margins.
Looking forward, the crack spread (the difference between the prices of crude and refined oil products) is rebounding, a trend I expect to continue in 2017. That should be good for the entire refining industry, but particularly for Valero.
Valero’s earnings are expected to rebound 44% in fiscal 2017 to $5.48 per share. In the meantime, Valero is paying one of the best dividends in the S&P 500. Its current yield of 4.3% is an 115% premium to the S&P 500’s 2.0% yield.
Despite the promising outlook and outsized yield, Valero is one of the most undervalued stocks in the S&P 500. Its current P/E ratio of 13.7 is more than a 55% discount to the S&P 500 and a 63% discount to Valero’s 5-year average of 37.
Risks To Consider: When looking for undervalued stocks, it’s important to distinguish between undervalued and distressed. Distressed stocks have a low P/E ratio because of unexpected bad news such as missed earnings targets, a weak forecast or new competition.
Action To Take: The S&P 500 is trading with its highest P/E ratio in more than five years. Despite the high valuation, there are still pockets of value. The list above is loaded with industry and global leaders that I believe have a strong long-term outlook. Buy them now while they are out of favor and look for P/E ratios to revert to long-term averages and shares to rally.