Ugly Sell-Off Makes Attractive Bargains

In light of today's market dip--in case you missed it, the Dow Industrials fell more than 300 points--and a myriad of uncertainties surrounding the current market environment, it's only natural that some would consider cutting their losses and taking their chips off the table. It can take nerves of steel to go bargain-hunting amid a homebuilding swoon, tightening credit markets, and soaring oil prices (to name a few), but we contend that times like these allow a disciplined investor to buck the "herding" trend and capitalize on the opportunities a market correction presents. All it takes is an unerring focus on company fundamentals, a willingness to turn a deaf ear to negative "noise," and a suitably long investment horizon.

It's no coincidence that those very qualities define our approach to valuing stocks. In our mind, the market's daily sentiment and gyrations have very little to do with a particular firm's worth. Our discounted cash-flow valuation method looks past market noise and focuses on the underlying fundamentals that determine a stock's fair value, which allows us to unearth many mispriced gems. Today's market retreat put several securities in our bargain bin, including industrial behemoth 3M.

3M
Moat: Wide | Risk: Below Avg | Price/Fair Value Ratio*: 0.84 | Three-Year Expected Annual Return*: 14.9%

What It Does:  3M (MMM) manufactures adhesive, coating, electronic, and health-care products. The firm operates in more than 200 countries (more than half of its sales come from outside the United States) and makes more than 55,000 products. Best known for its Post-it and Scotch brands, 3M offers a diverse array of items, ranging from dental products to brightness-enhancement films for electronic displays to reflective sheeting used on highway signs.

What Gives It an Edge: Morningstar analyst Scott Burns assigns 3M a wide moat. The firm boasts top-of-the-line research-and-development capabilities, the ability to leverage technology across different platforms, and a fierce dedication to production excellence. The company has some of the highest profit margins in the industrial space and is on track to generate over $2.2 billion of free cash flow this year.

What the Risks Are: Burns' projections assume 3M will continue creating new and profitable products. Should 3M's laboratories stall for an extended period, Burns doubts that the company would be able to maintain its high margins and returns.

What the Market Is Missing: Today's market reaction to the company's earnings release was definitely a bit of a head-scratcher, Burns says. Despite anemic sales growth in the U.S., the company still beat estimates--Morningstar's and Wall Street's--and even raised its earnings guidance for 2007. Burns speculates that in addition to the weak U.S. growth, investors were spooked by the company's comments about the need to sell lower-priced LCD film. The move is to keep competitors at bay in one of its highest-margin and highest-growth product lines. Although this will grow 3M's top line, the move is expected to have a negative impact on the margins in the company's Display and Graphics group. However, the news did not have as much of an impact on Burns' projections, as he lost a lot of confidence in the LCD film business last year following its last blowup; the business proved too volatile to be trusted, thus he modeled very conservatively.

Burns asserts that while some investors could dwell on an underperforming but relatively small portion of 3M's total business, the savvy investor can pick up the whole company for a nice discount.

PetSmart
Moat: Narrow | Risk: Avg  |  Price/Fair Value Ratio*: 0.75  |  Three-Year Expected Annual Return*: 21.5%

What It Does:  PetSmart  sells pet food, supplies, and professional services. It operates 966 North American stores, which range in size from 19,000 to 27,000 square feet and are generally near major shopping centers. It also reaches customers through mail-order catalogs and its Web site. PetSmart is the largest provider of grooming and pet-training services in the U.S. Vet care is available in about two thirds of its stores, mostly through a strategic relationship with Banfield.

What Gives It an Edge: Morningstar analyst John Owens assigns PetSmart a narrow moat. Owens emphasizes PetSmart's superstore format that allows the company to stock more than 13,400 distinct items and to provide grooming, training, boarding and day camps, all of which help to drive customer traffic. Smaller pet stores, including privately held rival Petco, cannot match the breadth of PetSmart's offerings. Likewise, many of the firm's products, including its premium pet food brands and services, are not available at supermarkets or mass merchants like  Wal-Mart (WMT) and  Target (TGT).

What the Risks Are: PetSmart plans to expand to 1,400 stores, including 100 net new stores in fiscal 2007. This aggressive rollout could lead to cannibalization and increased industry rivalry. The company could also reach saturation sooner than expected. The challenging consumer environment could lead some of PetSmart's customers to scale back spending at its superstores. Higher labor and occupancy costs could weigh on profits.

What the Market Is Missing: The stock sold off last week after the company trimmed its outlook, citing an uncertain economic environment and warmer-than-usual weather (which has damped sales in key cold-weather categories). Owens believes that the near-term headwinds the company is facing will eventually pass and that its long-term prospects remain strong. Pet ownership is increasing, driven by empty-nesters and young professionals delaying starting their families. These owners are pampering their pets; spending over the past decade nearly doubled to $41 billion. Owens sees more growth ahead and believes that PetSmart is best positioned to capitalize on this secular trend.

SanDisk Corporation
Moat: Narrow |  Risk: Above Avg  |  Price/Fair Value Ratio*: 0.71  |  Three-Year Expected Annual Return*: 24.3%

What It Does:  SanDisk  is the global leader in flash memory cards. Its products are used in a number of consumer electronic devices including digital cameras, mobile phones, and USB flash drives. SanDisk generates roughly 60% of its revenues through retail sales and 30% through sales to OEM customers (mainly mobile phones). SanDisk also develops flash memory standards internally, and it consistently earns the remaining 10% of its sales from royalty revenue on its patented technologies.

What Gives It an Edge: Morningstar analyst Erik Kobayashi-Solomon considers SanDisk a leader in the NAND flash space, primarily due to a number of patents the company holds. Thanks to its patent portfolio, the firm enjoys dependable licensing revenues that cushion it from the vicissitudes of the commodified NAND market that plague its competitors. It is not an exaggeration to say that SanDisk receives a percentage of the revenue of virtually every flash device sold on the planet, and considering the explosion of digital content, represented by products like  Apple's (AAPL) iPod and iPhone, Kobayashi-Solomon considers it to be a very attractive position.

What the Risks Are: SanDisk, as a producer and retailer of NAND flash, operates in a highly price-competitive and volatile market where average selling prices decrease at an average rate of 43% per year. It may not be successful in developing new production technologies that will allow it to cut manufacturing costs faster than the decline in average selling prices.

What the Market Is Missing: SanDisk shares took what Kobayashi-Solomon believes to be an undeserved hit after reporting its third-quarter earnings. The market's negative short-term perspective on NAND pricing was the key driver behind the stock drop. However, SanDisk has consistently proved it can create value for its shareholders regardless of the pricing environment. Kobayashi-Solomon believes SanDisk is a well-managed company that has a unique portfolio of intellectual property, manufacturing skill, and retail savvy, and he encourages long-term investors to consider it for their portfolios.

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