Fewer Cheap Stocks: A Warning Sign? Investors should take note as cash builds up in ‘value’ funds

Fewer Cheap Stocks: A Warning Sign?

Investors should take note as cash builds up in ‘value’ funds

TOM LAURICELLA

Updated Jan. 5, 2014 4:22 p.m. ET

The huge rally in U.S. stocks in 2013 had a downside for fund managers whose job it is to hunt for bargains: It has gotten harder to find undervalued names for their portfolios.Value managers stress that they aren’t saying the stock market can’t continue its record-breaking rise just because there are fewer stocks they think are cheap. But cash is building up in their portfolios. The $1.5 billion Artisan Value fund, for example, was holding 9.1% of assets in cash at the end of November, up from 1% at the start of the year.

“It’s getting harder to find new names,” says George Sertle, a portfolio manager on the U.S. value team at Artisan Partners. APAM +0.99% “Cash is going up as you’re selling more than you’re buying.”

For investors, it can pay to think of value managers as a kind of very early warning system for their portfolios.

In one unusual example, the managers of the $4.2 billion Longleaf Partners Small-Cap Fund, which held 45% in cash at the end September, recommended in their third-quarter shareholder letter that some investors consider selling. “With the fund’s high cash level and slim opportunity set…it would seem a good time to take money out of the Small-Cap Fund,” they said.

Of course, history shows stocks can be on the expensive side of the ledger for years before suffering a bear market. And with interest rates at extremely low levels and the chance of a recession in the U.S. seen as slim, some argue that valuations can be—or even should be—higher than might otherwise be the case.

But while stocks have been in a bull market since March 2009, the rally of the past year had a different dynamic. As price gains far outstripped earnings growth, valuations jumped. In 2013, the price/earnings ratio on the S&P 500 rose to 15.4 times estimated earnings for the next 12 months, according to FactSet. That compares with 12.7 at the start of the year and a 10-year average of 14.

“It’s nowhere near crazy like it was in the late 1990s,” says Artisan’s Mr. Sertle. (Back then, the S&P 500 traded as high as 25 times expected earnings.) Broadly, he says, valuations might be considered “fair.”

“A lot of stocks around fair doesn’t mean the market needs to correct” in a big selloff, he says. “The problem for value managers is that we’re looking for cheap, not fair.”

But Jason Subotky, portfolio manager of Yacktman Asset Management, says some concern is warranted.

Extremely high profit margins by historical standards may indicate the profit outlook isn’t as sustainable as some might think, meaning earnings estimates may be too bullish and therefore valuation multiples “for many companies may be higher than they appear,” he says.

“Valuations have been driven by a lot of multiple expansion…so you have to be careful about what you own,” he says.

In this environment, cash levels on the $13.9 billion Yacktman Fund have been rising, and stood at 21.6% at the end of September. The firm has focused on companies that the managers and analysts feel have “consistency and predictability” such as PepsiCo Inc.PEP +0.11% and Procter & Gamble Co. PG +0.01% , says Mr. Subotky.

Oracle Corp. ORCL 0.00% is one stock the managers added to the portfolio at midyear. “Old technology is a good area [in which] to be looking,” he says. “Even when lots of things have gone up, Oracle was left out of the rally.” But, he says, “overall, it has been more challenging given where valuations are to find new ideas.”