It's hard to talk about cheap ASX stocks when experts are warning that the market is overstretched and is facing judgement day next month.
But as it turns out, ASX shares may actually be cheap after all, if UBS' analysis on the true market valuation is on the money.
The pessimists have been beating the warning drums on lofty share prices after the S&P/ASX 200 Index (Index:^AXJO) rallied 33% in four short months.
There's a growing sense of foreboding. Many are expecting a day of reckoning in August when companies unveil their profit results, which are unlikely to justify the big jump in ASX shares.
When reality clashes with valuation
Next month's reporting season is tipped to be a pretty sombre affair as the COVID-19 pandemic wreaks havoc on profits.
Brokers are forecasting earnings to tumble by around 15%-20% at a time when the ASX 200 is trading on a lofty one-year forward price-earnings (P/E) multiple of nearly 20 times.
However, UBS believes that the overall market may still be inexpensive after it took a closer look at the impact of interest rates on valuations.
Impact of record low interest rates on ASX shares
Record low rates around the world have been credited for the larger than expected jump in equities. What the broker found was that there could be another circa 35% upside for ASX stocks, although this comes with a few caveats.
Firstly, the impact of rates on valuations differ between sectors. For instance, there's little correlation between resource stocks and interest rates. This is likely because of the positive correlation between rates and commodity prices.
"For Financials, the negative effect of lower interest rates on earnings partially offsets lower interest rates, with a linear negative relationship between yields and Pes," said UBS.
"However, for the Industrials ex-Financials, there is significant convexity in the relationship between bond yields and P/Es."
The real P/E looks cheap
Based on its estimates for the current rate environment, fair value for ASX industrial stocks is 25 times P/E.
This is roughly what industrial stocks (excluding financials) are already trading at, but this P/E is distorted by two factors.
First is the exaggerated impact of technology and health care stocks. These stocks are on multiples that are well ahead of the group.
Second is the one-off hit from COVID-19 on FY21 earnings. To adjust for these distortions, one should be looking at FY22 and FY23 estimates instead and exclude tech and healthcare stocks.
This puts the "adjusted" P/E for industrials at around 19.8 times for the next financial year and 18.5 times for the following year.
Cheap ASX stocks to buy
"To screen for stocks that are potentially cheap, we compare the current P/E of stocks relative to their sector with their typical relative P/Es," added UBS.
There are five ASX stocks that stand out as cheap buys, according to the broker.
These are the Aristocrat Leisure Limited (ASX: ALL) share price, Aurizon Holdings Ltd (ASX: AZJ) share price, Worley Ltd (ASX: WOR) share price, Crown Resorts Ltd (ASX: CWN) share price and Reliance Worldwide Corporation Ltd (ASX: RWC) share price.
