The S&P 500 Index may be up 6.9% this year on a total return basis, but the average Index member is only up 4.0%. Surprisingly, 174 of the 500 stocks are actually down for the year, and 31 stocks are down by double-digit percentages. This goes to show how selecting the wrong stocks could dramatically affect portfolio performance. But these figures could get even uglier…
If the S&P 500 were to suffer a correction of 10% (which many investors think is beyond the realm of possibilities), then I would expect a significant amount of stocks to be down 30% or more. With this in mind, what’s the best way to prepare for the unexpected and avoid these portfolio bombs?
Expensive Yield
Currently, the most dangerous stocks may very well be the ones that have benefited the most from the search for yield. You see, investors are attempting to make up for plummeting global interest rates by taking on more risk. Essentially, they’re reaching for a higher yield wherever they can find it.
As a result, many stocks that look attractive based on dividend yield are actually dangerously expensive. To see what I mean, let’s put four stocks to the test using the enterprise value-to-EBITDA ratio. I consider it to be one of the best valuation metrics around because it adjusts for cash and penalizes highly-levered companies.
All of the companies in the list have EV/EBITDA ratios above that of the median S&P 500 constituent. It just doesn’t make sense, considering that these firms are struggling with growth in one way or another.
Pharmaceutical giant Bristol-Myers Squibb (NYSE:BMY) has experienced a 20% decline in revenue since 2011. Sales at Iron Mountain (NYSE:IRM), a provider of information management services, have stagnated for the past five years. And revenue at tax preparation services provider H&R Block (NYSE:HRB) peaked nearly a decade ago. As for Campbell Soup (NYSE:CPB), it's growing revenue, albeit very slowly. Yet this consumer staple company has a valuation more suitable for a high-growth tech stock.
With such dismal growth metrics, you’d think the yields at these companies would actually be higher, since investors would be running away from shares. But the relentless search for yield has bid up their share prices instead – pushing down yields for all four companies.
What’s more, all of these stocks have uninspiring total yields. None of these companies have reduced their share counts in the past year.
Perhaps the managements at these companies don’t think their stocks are cheap enough to warrant stock buybacks. Or maybe the firms have insufficient free cash flow to implement a buyback.
Either way, this is not a good sign.
Bottom line: Stocks with high EV/EBITDA ratios and low total yields should be avoided – even if they have high dividend yields. Remove these stocks from your holdings, as they’ll act as a drag on performance in an up market and blow a hole in your portfolio during a market correction.