Wall Street's Clearance Sale Leaves Few Bargains

It's the Great Garbage Market all over again. That's how investment banker Richard Jenrette described a hot stock market in the late 1960s that was led by such junky companies as AAA Enterprises and Minnie Pearl's Chicken Systems. Many of these firms eventually ended up in the landfill. This year, since the market struck bottom on March 9, it has again been the cruddiest stocks that have covered investors with glory. Autos, miscellaneous finance, insurance and banks each lost an average of more than 80% from the market's peak in 2007 to the trough this March. Since then, these industries have shot out of the rubbish pile. Money manager Ted Aronson of Aronson+Johnson +Ortiz in Philadelphia calculates insurance stocks are up 78%, banks 104%, miscellaneous finance 111% and autos 158%. In fact, whatever's garbage has been good. According to Strategas Research Partners, stocks in the S&P 500 with positive earnings have underperformed those with losses (or no profits) by a 24% margin since March 9. Stocks that pay dividends have been dragging behind those that don't. The smaller a company, the more money it is losing and the deeper in debt it is, the hotter its stock has been over the past three months. Investors are betting that when the economy finally rebounds from this recession, what went down the most will go up the most. In the past, the junkiest companies have often bounced the highest early in a recovery. But after this big and fast a bounce, how much upside can be left? After all, once any kind of garbage gets hot, it's only a matter of time before it begins to stink. "The junky companies may be diluted to hell just to keep them alive," says money manager Jeremy Grantham of Grantham, Mayo, Van Otterloo in Boston. For companies too weak to generate surplus cash, a big rally in their shares will enable them to sell more stock. And that will dilute investors' returns by spreading future earnings more thinly across a greater number of shares. Furthermore, the market has come so far so swiftly that bargains have suddenly gotten much harder to find. In the 62 trading days since March 9, the Dow is up 34%, the fifth-fastest recovery from a bear-market low in the history of the index. On March 9, 600 stocks on the New York Stock Exchange hit a new 52-week low; on June 3, two did. In early March, James Montier, an investment strategist at Société Générale in London, identified more than 550 stocks world-wide selling for no more than two-thirds the value of their net working capital per share (current assets minus total liabilities). By the second half of May, one in three of those companies no longer made the cut. So where can a value-conscious investor turn? Mr. Grantham regards "high-quality blue chips" as the only bastion of value in today's market. He cites companies like Coca-Cola, Johnson & Johnson, Procter & Gamble, Wal-Mart Stores and Microsoft as offering "high, stable returns with very little debt." Dividends average better than 3% for this group; if "everything merely returns to normal" over the next few years, Mr. Grantham expects these blue chips to be able to return 11% to 12% annually after inflation. As a group, the royal blue chips trade for less than 13 times their earnings over the past year -- no higher than the S&P 500 overall -- even though their return on equity averaged 27% over the past five years, much better than the average big company. A cheap and simple way to mimic Mr. Grantham's GMO U.S. Quality Equity III fund (which has an investment minimum of $10 million) is iShares Morningstar Large Growth Index, an exchange-traded fund with similar holdings but annual expenses of only 0.25%. Mr. Montier of Société Générale sees value in another arena: small companies in Japan, the home of roughly two-thirds of all the world's stocks selling for less than net working capital. Unfortunately, it isn't feasible for an individual to assemble a portfolio of these dirt-cheap small-fry one by one, since many have total stock-market values of less than $100 million apiece and the trading costs alone would eat you alive. You can pick up a smattering of them in either of two ETFs: SPDR Russell/Nomura Small Cap Japan or iShares MSCI Japan Small Cap Index. But neither fund is a pure play on working-capital bargains, and in any case this kind of bet is purely for someone who wants to put a smidgen of money into an unusual risk. Otherwise, at least for now, the bargain racks have gotten pretty bare.