2 Undervalued Ideas For This Bull Market

Includes: HFC, RBC
by: Value Trap Blog

As the market climbs higher and higher, you have to turn over more rocks to find undervalued stocks. For this article, I introduce a small cap company and a mid cap company that still have attractive valuations at this time.

For the analysis of these stocks, I examine 7 categories which all must reinforce the strength of each company. All the financial data was pulled from each company's most recent annual report (2012, SEC Filings) except for dividend information and share price, both of which are most recently updated (Stock Screener).

Running a Screen to Find Undervalued Ideas

To find the type of value that I am looking for, I ran a screen with the following parameters: P/C < 10, P/E < 30, P/S < 2, and P/B < 2. This part of the screen shows undervalued equities at a time when many are expensive. A general screen like this one returns 535 eligible stocks, and so of course we need more parameters to filter out the bad stocks.

Next, it's important to weed out the companies that may be overvalued but are in a state of a bad financial condition. To do this, I set Current Ratio > 2 and Debt to Equity < 1. Like Warren Buffett, I also look to invest in American companies. To compound returns on my investment, I set another parameter that the company must be paying a dividend. This cuts the list to 55 stocks.

Because micro cap and small cap stocks tend to be more volatile, I prefer stocks with at least $2 billion in market capitalization. The greater risk can lead to greater reward, but I prefer to have more peace of mind with my investments. To me, stocks over $2 billion in market capitalization give me the right balance of risk and reward. In this case, I set the screen to show me companies over $3 billion due to the high valuations in the market today.

Now that the list is down to a manageable 8 companies, there's just one last filter to apply. We want companies who are cheap because they are a bargain, not because their business is deteriorating. In order to ensure this is true, I screen out any stocks that have negative EPS growth in the past year.

With a list now of just 4, I can dig into the stories of these stocks and determine which have the best growth prospects and overall financial picture.

The results of the screen left 4 companies on the list. After examining all 4 and comparing both their financial numbers and potential for growth, I decided on two stocks as my favorites: HollyFrontier Corporation (NYSE:HFC) and Regal Beloit Corporation (NYSE:RBC). Both of these stocks have bright possibilities in their future, highlighted by strong balance sheets and evident plans for growth. Both companies reflected high optimism from management, as well as a strong and steady track record.

The first company I like is HollyFrontier Corporation, trading at $47.85, and let me explain why.

HollyFrontier Corporation
This mid cap company deals in the Oil & Gas industry and has seen their stock price fall since its peak in March of this year. With the recent pullback, there is an opportunity to get this great company at a cheap price.

Growth Outlook: As can be found from the annual report, the company's primary growth strategy comes from new refining processing units. The success of the strategy depends on the company having enough cash liquidity to build the new units. From what I can determine relating to the analysis done below, the company has a healthy cash flow to not only build new plants but expand on current refineries.

With cash equivalents totaling $2.4 billion, the company feels strongly that their strategy for growth can be maintained. For a company who has a market cap of only $9.72 billion, the shareholders are essentially getting 25 cents of cash for every $1 of a share. With that kind of value there is really minimal upside.

The future looks bright in more ways than one, due to planned share buybacks outlined in the annual report. A stock repurchase plan was approved by the board of directors for $700 million in early 2012. Only $205.6 million of this plan has been spent already, meaning that shareholders will see the positive effects of $494.4 million guaranteed for stock repurchase.

1. P/E Ratio
The company had record earnings in 2012, which has helped result in its really low P/E. At the current price, the company has a tempting P/E of 5.7. This P/E is ranked #3 out of 32 companies in the Oil & Gas Refining & Marketing Industry.

2. P/B Ratio
I like to see stocks with a P/B ratio close to 1.5, as encouraged by Ben Graham's The Intelligent Investor. At this time, HFC has a P/B of exactly 1.5. This is ranked #10 out of 32.

3. P/S Ratio
Anything under 1 is a great ratio for P/S. While this ratio is commonly overlooked, it is a crucial part of valuation analysis, as revenue numbers can't be manipulated as easily as earnings. The company's P/S is 0.49, ranked #20 out of 32. While most companies in this industry boast of good P/S ratios, we see 8 out of 32 having unfavorable P/S ratios over 1. It's a great sign that HFC isn't one of those 8.

4. P/C Ratio
The cash flow situation is more than healthy with a P/C ratio of 5.6. Again HFC ranks strongly in its industry, #7 out of 32.

5. Debt to Equity
This ratio is so critical to ensure we are selecting a company with a solid balance sheet. All the valuations above are useless if the company is a risky play. With a Debt to Equity ratio of 0.55, the company is on solid ground. I calculate Debt to Equity with total liabilities, which is different than the way most screens calculate the ratio, therefore there are no ranking numbers for this category.

6. Earnings Growth
As a mostly value oriented guy, I need to make sure I'm calculating at least one aspect of growth when analyzing stocks to keep my picks balanced. Both #5 Debt to Equity and #6 Earnings Growth keep me from choosing value traps. The 3 year growth average for HFC was 16.5%, which is more than double the S&P 500 average since 1972.

7. Dividend Yield and Payout Ratio
The yield for this stock is 2.42%, which is a little low but definitely nothing to sneeze at. The story gets better when looking at payout ratio, which is at a very healthy 22.38%, #12 out of 32 in the industry. With such a low payout ratio, the dividend is definitely sustainable and has great potential to grow.

Conclusion: The HollyFrontier Corporation company looks superb in all 7 categories, which isn't easy to do at this time. A play in this company can add value to an already diversified portfolio. My Value Trap Indicator, which indicates a buy signal below 125 and a sell above 800, sees HFC as a buy.

Value Trap Indicator = 69.58.

The other company that stands out to me from the final list of 4 is Regal Beloit Corporation at $67.66.

Regal Beloit Corporation
This small cap company sells industrial and electrical equipment that provide a broad range of functions. The company also has a similar recent story to HFC, being -23.33% off of its 52 week high.

Growth Outlook: Reading through the latest annual report reveals that the company's growth strategy depends on making industry relevant acquisitions to increase revenues and earnings. Through a combination of acquisitions and patents, the company expands their product base and has been successful with this strategy since 1955.

The company's long success with this strategy gives them a competitive edge over their market, as their ability to optimize profits through cost reduction and efficient manufacturing processes has been showcased through the years. The management's extensive experience with these techniques is a substantial asset to investors that can't be quantified with numbers or a dollar value.

Additionally, the company has consistently been growing their expenditures on research and development, showing solid financial ability to maintain and grow these costs. As a result of these added costs, RBC filed 88 patents in 2012 emphasizing product development. The effects of these patents will positively influence earnings and revenue numbers in the future, for this year and the years to come.

Also, the company has secured a number of custom machinery, equipment, and problem specific products. The fact that these products and machinery are unique gives RBC another clear competitive advantage over its peers. With both the numbers analyzed below and intangibles mentioned above reinforcing the fact that the company is undervalued, this stock has plenty of potential to grow in the future and reward shareholders.

1. P/E Ratio
I always want a P/E ratio around 15, give or take a little bit. With last year's trailing earnings, RBC has a P/E of 14.6. This is #10 out of 44 in the Industrial/Electrical Equipment Industry.

2. P/B Ratio
This ratio is also favorable at 1.4. This is #21 out of 44.

3. P/S Ratio
Again the company meets the standard for this valuation, just under 1 at 0.9. This is 23rd out of 44.

4. P/C Ratio
The company boasts a strong P/C ratio of 7.6. A ratio of 10 is acceptable, and the more under that is added just gravy. With a rank of #21 out of 44, the company is proving to be above average in every category so far.

5. Debt to Equity
A strong debt to equity ratio is especially crucial when looking at small cap stocks, which can be more volatile than its bigger market cap counterparts. So when I see a debt to equity ratio of 0.79, I can feel confident in its balance sheet. Keep in mind that I make these calculations with total liabilities, which makes the low number even more impressive.

6. Earnings Growth
The stock market is a sucker for consistent earnings growth, and this company has shown strong growth over the past couple of years. The 3 year average for RBC is 13.9%, almost double the S&P 500 average since 1972.

7. Dividend Yield and Payout Ratio
The dividend yield is low for the company at 1.19%. However, it is rare for a company with such growth and small market capitalization to even pay a dividend, so I appreciate the opportunity to compound my returns with dividends. The dividend is primed to grow with the current payout ratio of 16.76%, and this is ranked #13 out of 44.

Conclusion: To see the company ranking so high in so many categories right now is a great sign. RBC has a buy signal from the Value Trap Indicator as well. My Value Trap Indicator, which indicates a buy signal below 125 and a sell above 800, sees RBC as a buy.

Value Trap Indicator = 107.49.

While RBC is not as strong as HFC in the valuation numbers, you can't compare apples to oranges. If both companies are dominating compared to their industry (which they are), then you can say they both look good. The low valuations increase their attractiveness and limit the downside risk.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HFC, RBC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.