Surveying the Rubble: Potential Buys in Tech, Retail, Industrials and Materials

Back at the beginning of September, I was working to formulate a market outlook. The more I stepped back to look at things, the more pessimistic I became – giving rise to ideas like "optimism is dangerous" at the start of September, "buying on this fear is foolish" in the middle of the month, or the "Gruesome Twosome" at the end of the month.

As it turns out, I wasn't negative enough. I was originally expecting about 100-150 points in downside judging from the S&P 500; right now we're about 200 points past that mark. Now, I quickly became more negative in a macro sense – the end of my first presentation at the BC Investment Club cemented my role as resident bear – but when I look at someone like Jeremy Grantham, who was (seemingly) so bearish for so long, say that things are worse than he expected… it's really a sign of how incomplete the macro picture is, even for the best investment managers. Interestingly, Grantham suggested that the S&P 500 is noticeably undervalued relative to his estimates, and there are plenty of people suggesting there are bargains to be found, but before moving to that, I think a survey of the damage is in order first. The selling has been so widespread (every single SPDR sector down more than 15% in the last month) that it's led some to conclude everything in the market is undervalued.

I'm not ready to make that kind of sweeping statement, but things are certainly cheap relative to just about any price I've seen going back years. Valuation alone is not enough to set a market bottom (or top, for that matter) – in 2006 and 2007, there were many stocks that I believed to be absurdly overvalued, but this didn't stop them from going higher. In Fall 2007, Tom Lyons and I became extremely bearish on a number of large-caps that were momentum favorites, particularly tech names like Apple (AAPL), Google (GOOG), and Research in Motion (RIMM). It took time, but all of those have been caught up in this selloff and have fallen to or below our valuation estimates while continuing to build up cash on their balance sheets – prices that, in all honesty, I originally found it hard to believe the stocks would eventually trade at, much less below.

The point? Prices don't have to stop going up or down as a simple reflection of business fundamentals. A number of items I've caught from Bloomberg suggest that big-name hedge funds were caught with exposures that turned into large losses and are being forced to liquidate holdings in the face of redemptions. (A worthwhile sidenote: Nassim Taleb seems to be a notable, if unsurprising, exception). The enormous intra-day volatility suggests that technical trading, rather than fundamental performance, is predominately driving stock prices. This isn't my way of pulling a Kudlow and pretending the economy is fine – there are serious problems, and I've acknowledged them before – but that certain selling may be overdone.

In that vein, there are plenty of good firms with cash-rich balance sheets that will survive to operate in a better economy. Tontine Associates' Jeff Gendell is supposedly hurting, and may have had to liquidate his holdings in stocks like Kellogg Brown Root (KBR), an engineering and construction company that trades at $16/share with over $9 of that in cash, or about 4x this year's earnings after backing that out. KBR might not even be hurt by the credit contraction because so much of their work is on behalf of governments, which are generally the only entities that can still borrow at reasonable terms.

Consumer skittishness is going to translate to weak apparel sales, but plenty of companies in this space built up cash during the good years and will be able to weather a spending downturn. Coach (COH) has more than 10% of its share price in cash, and trades at less than half its trough book multiple from the 2002-2003 bear market. American Eagle (AEO) has over 30% of its stock price in cash, and I'll argue that the 1.4x book multiple being assigned here is lower than what it should be for a company whose primary asset is a brand name with zero carrying value. The sector fundamentals here are going to be shaky, so there's bound to be some rough news coming out… but ultimately that will be good news for the well-capitalized players like Bed Bath & Beyond (BBBY), which stands to benefit from the liquidation of bankrupt competitor Linens n' Things.

Industrials and materials companies represent some big question marks in the outlook; Ingersoll-Rand (IR) is a personal favorite, and they made a slight downward revision to earnings guidance the other day. Ingersoll joins Ford (F) CEO Alan Mulally in saying that their outlook has significantly deteriorated in the last few weeks, and signs of a recovery have moved out several months beyond where anyone thought they would be several months back. Industrials generally have attractive valuations, but the lag that has occurred in pricing in a slowing global economy means they could be vulnerable to further selling.

Likewise, the materials stocks - such as hedge fund favorite Freeport McMoRan (FCX) - have gotten slaughtered, even as the earnings estimate suggest these stocks are single-digit-multiple bargains. I'm not trusting this either, as most of them relied on debt financing for acquisitions during the boom, and even a small dropoff in global demand for commodities can be enough to send prices off a cliff.

Stock position: None.