Most investors focus primarily on the growth prospects of stocks in order to identify the most attractive holdings for their portfolios. However, valuation is equally important. When market sentiment turns negative for a stock due to a temporary headwind, its valuation may become too cheap.
When the headwind subsides, the valuation of the stock is likely to revert to normal levels as Paul Price frequently talks about on Real Money Pro. In this way, a company can offer excessive returns even without growing its earnings significantly.
Below, we will discuss the prospects of three stocks that are exceptionally cheap on a valuation basis right now.
Cook Up Excellent Returns at a Cheap Price
Williams-Sonoma (WSM) is a specialty retailer that operates home furnishing and houseware brands, such as Williams-Sonoma, Pottery Barn, West Elm, Rejuvenation, Mark and Graham and others. The company operates traditional retail locations but also sells its products through e-commerce and direct-mail catalogs.
Most retailers were hurt by the Covid-19 pandemic but Williams-Sonoma actually benefited from this crisis. Thanks to the shift in focus of consumers from other goods to their homes, the demand for the company’s products skyrocketed. As a result, Williams-Sonoma grew its earnings per share by 92% in 2020 and by another 72% in 2021, to an unprecedented level.
It is also remarkable that Williams-Sonoma has an exceptional performance record, as it has grown its EPS every single year over the last nine years. During this period, the company has grown its EPS more than five-fold, from $2.54 in 2012 to $14.85 in 2021. The impressive growth combined with the consistency in business performance are testaments to the strength of the business model of this high-quality retailer.
Notably, Williams-Sonoma is currently trading at a nearly 10-year low price-to-earnings ratio of 9.2, which is much lower than the stock’s historical average of 14.0. The depressed valuation has resulted primarily from a deceleration in the business momentum of the company.
Inflation has surged close to a 40-year high since last year, thus increasing the costs of retailers. In addition, sky-high inflation has greatly reduced the real purchasing power of consumers, thus taking its toll on their spending habits. Moreover, high inflation reduces the present value of future earnings and thus exerts pressure on the valuation of stocks.
However, the Fed has clearly prioritized restoring inflation to its long-term target of 2%. Thanks to its aggressive interest-rate hikes, inflation has declined every single month since it peaked last summer.
Whenever inflation reverts to its normal range, the valuation of Williams-Sonoma is likely to revert towards its historical average. If this occurs within the next five years, the stock will enjoy an 8.8% annualized valuation tailwind. If the 2.4% dividend is added, the stock can offer double-digit annual returns even without growing its earnings.
Overall, thanks to its reliable business performance, its exceptional growth record and its markedly cheap valuation, Williams-Sonoma is likely to highly reward patient investors.
Livin’ on Tulsa Time
Helmerich & Payne (HP) provides contract drilling services primarily to inland oil and gas producers in the U.S. It is the market leader in the U.S., with a market cap of $4.8 billion.
Just like all the other oil services providers, Helmerich & Payne incurred a fierce downturn in 2020 due to the impact of the pandemic on global oil consumption. Due to that downturn, the Tulsa-based company cut its dividend by 65% and thus it ended its 47-year dividend growth streak. Nevertheless, the stock is still offering a decent dividend yield of 2.2%, with a solid payout ratio of 22%.
Moreover, global oil consumption has recovered to pre-pandemic levels and is on track to climb to new all-time highs this year. Even better for Helmerich & Payne, western countries have imposed strict sanctions on Russia, which was producing about 10% of global oil output before the sanctions. Furthermore, OPEC members have remarkably reduced their production quotas in order to support the price of oil. The U.S. is the only oil producer in the world which can cover all these lost barrels and help global oil supply meet demand. As Helmerich & Payne is focused on the U.S. oil market, it has greatly benefited from all these factors.
The above tailwinds are clearly reflected in the latest earnings report of Helmerich & Payne. The company exited fiscal first quarter 2023 with 184 active rigs, eight rigs higher sequentially, and improved its revenue per day 12% thanks to strong demand for its rigs.
U.S. drilling activity has recovered from the pandemic and currently stands above pre-Covid levels. As a result, Helmerich & Payne more than doubled its EPS sequentially, from $0.45 to $1.11, and exceeded the analysts’ consensus by $0.30.
It was the third profitable quarter for the company after nine consecutive quarters of losses due to the pandemic. Thanks to sustained business momentum, Helmerich & Payne is on track to post 9-year high earnings per share of about $4.60 this year.
Based on these earnings, the stock is currently trading at a nearly 10-year low price-to-earnings ratio of 9.7, which is much lower than the 10-year average of 16.0 for the stock. As long as the aforementioned sanctions remain in place, U.S. drilling activity is likely to remain in an uptrend, in the absence of a severe recession. Therefore, Helmerich & Payne has significant potential for valuation upside.
On the other hand, investors should always be aware of the highly cyclical nature of the oil industry and the secular shift of most countries from fossil fuels to renewable energy sources. Nevertheless, the Ukrainian crisis has proved that this secular transition will take much longer to materialize than previously expected.
A Stock for the Long Run
Marathon Petroleum (MPC) was spun off from Marathon Oil (MRO) in 2011. After the acquisition of Andeavor Logistics in October of 2018, Marathon Petroleum has become the largest U.S. refiner, with 16 refineries and a refining capacity of 3.1 million barrels per day. It also has a marketing system that includes approximately 7,100 branded locations.
Just like almost all the other refiners in the world, Marathon Petroleum currently thrives thanks to the sanctions of the U.S. and Europe on Russia for its invasion in Ukraine. As Russia provides a great amount of refined products to the global market of refined products, the latter has become extremely tight. As a result, refining margins have skyrocketed to unprecedented levels.
The benefit from this tailwind is evident in the business performance of Marathon Petroleum. In 2022, the refiner grew its EPS more than 10-fold, from $2.45 in 2021 to an all-time high of $26.16. This level of earnings per share is more than triple the previous all-time high of $6.78, which was achieved in 2018. It is also remarkable that the company recently raised its dividend by 30% and thus it is now offering a 2.3% dividend yield.
Due to its blowout earnings, which are unsustainable in the long run, Marathon Petroleum is currently trading at a forward price-to-earnings ratio of 7.5, which is much lower than the 10-year average of 11.9. The stock is likely to revert towards its average valuation level in the upcoming years and thus it has a significant valuation tailwind ahead. On the other hand, the refining business is characterized by dramatic boom-and-bust cycles and hence investors should expect the earnings of Marathon Petroleum to deflate in the upcoming years.
Nevertheless, if earnings remain excessive for a few years, the benefit for Marathon Petroleum may be enormous. Thanks to its cheap valuation and the divestment of Speedway, the company reduced its share count by a massive 24% in 2022.
As long as the P/E ratio of the stock remains depressed, the company can continue reducing its share count at a fast pace. Marathon Petroleum currently has $7.6 billion for share repurchases, enough to reduce the share count by another 13%.
Overall, as long as the current boom phase of the cycle remains in place, the cheap valuation of Marathon Petroleum can prove highly beneficial for the shareholders.
Final Thoughts
The above three stocks are currently trading at nearly 10-year low P/E ratios, primarily due to their blowout earnings, which are viewed by the market as unsustainable in the long run, especially in the event of a severe recession. However, Williams-Sonoma has an impressive performance record and thus it is likely to highly reward investors in the upcoming years.
Helmerich & Payne and Marathon Petroleum are exceptionally cheaply valued but investors should always be aware of the high cyclicality of the oil industry and the refining business. Nevertheless, if the current boom phase extends beyond this year, these stocks are likely to offer significant valuation upside potential to their shareholders.