Cheaper Stocks to Check Out
These stocks have low price tags based on a variety of value metrics.
These stocks have low price tags based on a variety of value metrics.
Now that the market has emerged from its prolonged slump, it's getting tougher to find cheap stocks. Fewer than 3% of the stocks covered by Morningstar's analysts currently earn a Morningstar Rating of 5 stars--down from 20% a year ago. Internet and biotech stocks are once again burning up the charts, and the old bull-market habit of turning a blind eye to valuation seems back in force again.
But there are still some stocks out there that pass muster for value-oriented investors. For this week's Five-Star Investor, we used Morningstar's Premium Stock Screener to identify stocks with lower-than-average valuations based on a variety of metrics. (Premium Stock Screener is a feature of Morningstar.com Premium Membership. If you're not a Premium Member, you can sign up for a free trial by clicking here.) We started out with traditional value screens like low price/earnings, price/book, price/sales, and price/cash flow ratios. Looking at all of these measures together lessens the chance of an odd data point or two throwing off the results. The stock of a company like footwear maker K-Swiss , for example, might look cheap based on its projected P/E, but it looks pretty pricey based on price/book, price/sales, and price/cash flow. Roughly 10% of the 7,127 stocks in Morningstar's database made it past all four of these hurdles.
We narrowed down the list by focusing on stocks with PEG ratios (P/E relative to projected earnings growth) lower than the average for the S&P 500. We're not big fans of using the PEG ratio as the sole measure of value, but it does have the merit of incorporating both value and expected growth in one number. We also required free cash flows equivalent to at least 7% of the stock's market capitalization. Because stocks that are cheap are often cheap for a reason, we also looked for a return on equity of at least 10% for the trailing 12 months. That weeded out stocks like Cadmus Communications , which may be cheap relative to the market, but has also been gushing red ink lately.
One note of caution: Make sure to do more research before stepping up to the plate on these stocks. This week's screen turned up a few stocks that don't look so attractive after a more detailed discounted cash-flow analysis, even though they made it through all the hurdles of the value screen. AutoNation (AN), Delphi , Health Net , and Tenet Healthcare (THC) are some prime examples. But we also found some that could be worthy of further investigation. Here are a few of the most interesting ideas:
General Dynamics (GD)
Economic Moat: Wide
Business Risk: Average
Morningstar Rating: 4 Stars
From the Analyst Report: "For the sake of conservatism, we valued General Dynamics solely on its internal growth, toning down annual sales growth to historical internally generated levels of 7%-8% and removing outlays for acquisitions. This shaved only a few dollars off our acquisition-based fair value estimate, and we still see the shares as undervalued. We would buy at a 20% discount to our $100 fair value estimate. Our valuation also incorporates the potential worst-case impact of a full payout of the government's claims in the A-12 cancellation case."
Barnes & Noble
Economic Moat: Narrow
Business Risk: Average
Morningstar Rating: 3 Stars
From the Analyst Report: "We recently raised our fair value estimate for Barnes & Noble to $29 from $27. We are integrating the financials of Barnes & Noble and GameStop (of which B&N owns 63%) and subtracting the minority interest in GameStop. For Barnes & Noble's book business, we assume mid-single-digit revenue growth; for GameStop, we assume low-single-digit to flat revenue growth. Combined, this gives us mid- to low-single-digit revenue growth. We don't assume much margin improvement."
Harrah's Entertainment
Economic Moat: Narrow
Business Risk: Average
Morningstar Rating: 3 Stars
From the Analyst Report: "In the long run, we think Harrah's will be a prime benefactor of liberalization of gaming laws. Not only does it have the know-how and infrastructure to optimize cross-market play, but it also has a relatively strong balance sheet, which earns it one of the highest credit ratings among its small-market competitors and puts it in position to acquire weaker rivals when times get tough....We like the leading position Harrah's holds among Joe Average casino patrons, but the risks inherent in the industry, including high debt and inconsistent regulation, cause us to look for a 40% discount to our fair value estimate before investing."
Republic Services (RSG)
Economic Moat: Narrow
Business Risk: Low
Morningstar Rating: 3 Stars
From the Analyst Report: "Republic Services is the cleanest story among the waste service companies, lacking the turnaround risk of Waste Management or the high financial leverage of Allied Waste . We'd invest in this low-risk company if the shares fell below $18."
Shell Transport & Trading
Economic Moat: Narrow
Business Risk: Below Average
Morningstar Rating: 3 Stars
From the Analyst Report: "We continue to believe that large oil is an attractive area for investment, and that Shell is one of the top-shelf companies in the industry. At $35 and below, Shell is worth considering, in our opinion."
Laboratory Corporation of America (LH)
Economic Moat: Narrow
Business Risk: Average
Morningstar Rating: 3 Stars
From the Analyst Report: "LabCorp is one of two major independent diagnostics-service providers left standing after intense industry consolidation in recent years. We think it has taken better advantage of its position than market leader Quest Diagnostics (DGX) has, and we'd consider the shares if they traded at a 40% discount to our fair value estimate."
To run this screen yourself and see all the stocks that passed, click here. (Note: You will need to be a Premium Member to view and save the complete screen.) After clicking, you can save the search to use later by using the "Save Criteria" button in the bottom right-hand corner of the screen.
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