Think Big to Track Down Value

At the end of 2004, I wrote a column that used Morningstar's fair value estimates to find an intrinsic value for the S&P 500 and a few other major market indices. At the time, the S&P 500 looked like it was a bit overvalued, the Nasdaq 100 looked pretty pricey, and the Dow looked fairly valued. Now that we're five months into 2005, let's revisit the topic to see what our fair value estimates are saying about the market.

Just a reminder: We use the discounted cash-flow method to value stocks, and, because we cover such a wide swath of the market, I can simply add up our fair value estimates to arrive at a bottom-up intrinsic value for a number of major indices. We favor the discounted cash-flow approach because it accounts for companies' cost of capital and capital-spending needs, and we think that cash flow is less subject to distortion than accounting earnings. As I've written before, it's not a perfect tool for valuing stocks, but we think it's the best one available.

Where Are We Now?
Morningstar covers 480 of the 500 stocks in the S&P 500, which accounts for just more than 99% of its market capitalization. Late last year, our bottom-up estimate for the index was 1,160--about 4% below where it was trading at the time. Now the S&P 500 sits at 1,170, down about 3%, while our aggregate fair value estimate for the index has increased by a little more than 4% to 1,212. So, according to our fair value estimates, the S&P 500 is undervalued by around 3% at the moment, weighted by market capitalization. (Mega-cap stocks have a big impact on the S&P 500--for example, the largest 10 companies account for about 22% of the index.)

That's a bit of a change, but not a gigantic one. Valuation is fraught with uncertainty, and in the same way that a 4% overvaluation didn't cause me to hit the panic button late last year, a 3% undervaluation doesn't make my mouth water. On a cap-weighted basis, we thought the market was essentially fairly valued in late 2004, and that's pretty much where things still stand.

What's interesting is that, on an equal-weighted basis--which does not give more emphasis to larger companies--our fair value estimates indicate that the S&P 500 is overvalued by about 4%. That's a meaningful difference from an estimate of 3% undervalued, and therein lies the rest of the story, as Paul Harvey would say. (You can track the median price/fair value ratio--which is close to an equal-weighted measure--of the stocks that we cover with our market valuation graph.)

The Bigger the Better
Here's some data that digs into why the cap-weighted and equal-weighted estimates yield different results:

Large-Cap Values
Stocks	Percentage of S&P 500 Index	Average (under)/ overvaluation, 12/2004	Average (under)/ overvaluation, 5/2005
Largest 10	22%	(5.5%)	(8.4%)
Largest 25	36%	(3.2%)	(10.9%)
Largest 100	66%	6.6%	(2.1%)
Largest 250	88%	10.7%	2.5%
Smallest 250	12%	19%	5.3%

This is an updated version of a table that was put together the last time that I used our fair value estimates to look at the market as a whole. The pattern today is the same as it was in late 2004:  Mega-caps are somewhat undervalued, and the smaller firms in the S&P 500 are still a bit pricey. While the entire market is soft, large-cap stocks have held up a lot better than small caps, at least within the S&P 500. The largest 25 companies in the index went from being 3% undervalued to an almost-tempting 11% undervaluation, while the smallest 250 companies in the index really cratered, correcting sharply from 19% overvaluation to about 5% overvaluation. You can see the same trend in other indices as well--the Morningstar Large-Cap Index is down about 3% year to date, while the Morningstar Small-Cap Index is down about 7.5%

The bottom line is that after screaming to insane heights during the "Great Bubble," we think many mega-caps are attractively priced. About one third of the S&P 500's top 25 stocks are trading at discounts of 15% or more to our fair value estimates, and six have 5-star ratings. Assuming that we're right, it looks like a good time to start building a portfolio of core blue-chip names that have not been attractively priced in quite some time.

For the curious, those six stocks with 5-star ratings are  Microsoft (MSFT),  Wal-Mart (WMT),  AIG (AIG),  Coca-Cola (KO),  UPS (UPS), and  Home Depot (HD). We also have a 5-star rating for  Berkshire Hathaway (BRK.B), which would be about the 12th-largest company in the S&P 500 if it were included in the index.

Uncovering the Value
So that's what the market looks like broken down by size. But what about sectors? Let's take a look, showing both capitalization-weighted and equal-weighted data.

Valuation by Sector
Sector	Average (under)/ overvaluation, cap-weighted	Average (under)/ overvaluation, equal-weighted
Software	(13.6%)	(2.2%)
Financial Services	(11.1%)	(6.5%)
Consumer Services	(10.3%)	(3.9%)
Consumer Goods	(9.1%)	(4.6%)
Business Services	(6.7%)	(0.8%)
Telecommunications	(4.8%)	(2.4%)
Health Care	(4.5%)	0.2%
Hardware	(2%)	(0.8%)
Media	1.2%	(5.4%)
Industrial Materials	4.1%	2.4%
Utilities	6.9%	7.3%
Energy	9%	17.6%
Data as of 04-29-05

In the big-picture, the financial and consumer goods sectors look the most attractive, with energy and utilities on the pricey side. (I'm not including software as a whole in the "most attractive" camp because that giant 13.6% cap-weighted undervaluation is driven almost entirely by Microsoft, which makes up 60% of software stocks' total market capitalization in the S&P 500.) Again, you can see the difference between the big companies and the small fry--in almost every sector, the equal-weighted numbers indicate less-attractive aggregate valuations than the cap-weighted numbers.

Some Stocks Are Cheap, but the Market's Not
The bottom line is the same as it has been for a while: In aggregate, the market's neither terribly pricey nor terribly cheap. The huge divergence that existed a few years ago between insanely priced and dirt-cheap has disappeared, and bargains are now relatively hard to find. However, there are still attractive stocks out there, and the good news is that many of them are high-quality blue chips that could easily form the core of a solid long-term portfolio.

Etc.
As before, I also applied our discounted-cash-flow-based fair value estimates to the Dow and the Nasdaq 100. Our bottom-up fair value estimate for the Dow is about 10,860, which is almost exactly the same as it was late last year. With the Dow at 10,300, the index looks mildly undervalued, but nothing to write home about in aggregate--though AIG, Microsoft, Home Depot, and Wal-Mart look pretty attractive. As for the Nasdaq 100, our bottom-up fair value estimate was about 1,380 at the end of 2004, and the index was around 1,600, so we thought it was overvalued by a solid margin. Since then, the index has fallen about 10%, while our fair value estimate has risen about 5% to 1,450--which means that, by our estimates, the Nasdaq 100 is fairly valued.