Stocks too expensive for your taste? This bargain-hunting strategy can yield big returns with less risk.

By Joseph Adinolfi

If you're experiencing Wall Street sticker shock, try looking past the biggest names in the S&P 500 - there's still value to be found deeper in the index

Investors who are being put off by stocks' lofty valuations can still find bargains in the S&P 500. They just need to know where to look.

History has shown that valuation metrics like price-to-earnings ratio aren't all that useful when it comes to timing stock-market tops.

Just because stocks look expensive doesn't mean they can't get more expensive. To wit, bearish investors have been sounding the alarm about stock-market valuations since at least the summer of 2023 - but their warnings have largely fallen on deaf ears.

Still, as the S&P 500 SPX tallied another record closing high on Tuesday, concerns about nosebleed valuations for the largest U.S. stocks are starting to creep back into the discourse on Wall Street.

The latest reading from BofA Global Research's global fund-managers survey, published earlier this week, found that a record share of respondents said U.S. stocks were overvalued.

See: Almost every investor in this survey says U.S. stocks are overvalued as 70% expect stagflation

The forward price-to-earnings (P/E) ratio for the S&P 500 has been stuck north of 22 since late June - putting the valuation metric well above its five-year average, and right around levels last seen during the early-2022 market peak.

Brian Belski, chief investment strategist at BMO Capital Markets, pushed back on the idea that high valuations mean a severe downturn is preordained.

In a report shared with MarketWatch on Tuesday, the BMO team said they could empathize with anybody grappling with Wall Street sticker shock. But they also said there is a simple solution: Look past shares of the 10 largest stocks in the index, which have skewed its P/E, and focus instead on the myriad bargains that can still be found among out-of-favor names.

That might involve cozying up to stocks in the unpopular healthcare and energy sectors, both of which have struggled lately. But a historical analysis by BMO shows that investors with the temerity and patience to take a chance on these market laggards have been well-compensated in the past.

Since 1990, stocks with lower P/E ratios have actually outperformed the S&P 500 on a rolling one-month and one-year time frame. And they have done so with less volatility, the BMO team found.

While predicting how market trends might evolve over the coming year is extremely difficult, Belski highlighted one reason investors might want to be bullish on these cheaper names.

After driving much of the earnings growth for the index over the past two years, profits for the biggest firms in the S&P 500 are expected to slow. Meanwhile, profit growth for the rest of the index is just starting to pick up.

Furthermore, low P/E stocks have performed particularly well when valuations at the index level were already stretched relative to history.

The opportunity set for this strategy is smaller today than it has been in the past. The number of stocks in the S&P 500 with a P/E ratio below 15 currently stands at 157, by Belski's count, compared with an average of 218 in the past.

"We would argue that this is precisely the type of environment that should benefit a value-focused investment strategy because when most stocks are expensive, investors should be seeking lower-cost alternatives," Belski said.

Toward the end of the report, the BMO team included a list of S&P 500 stocks that fit the low P/E theme, and were also rated "outperform" by BMO analysts.

Pharmaceutical giant AbbVie Inc. (ABBV), insurer Allstate Corp. (ALL), gold miner Newmont Corp. (NEM) and fertilizer producer Mosaic Co. (MOS) were just some of the examples.

U.S. stocks finished higher on Tuesday, with the S&P 500 finishing north of 6,400 for the first time ever, FactSet data showed. The Nasdaq Composite COMP finished at 21681.90, also a record. The Dow Jones Industrial Average DJIA closed within 1.5 percentage points of its latest record from December.

-Joseph Adinolfi

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