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As the market continues to soar, it becomes more and more difficult to buy high quality businesses at a cheap price. While the opportunity set has certainly narrowed, there remain a few bargains. Here I will highlight three stocks which I expect to outperform the S&P 500 over the next three years. My selection criteria are as follows:

  1. leading market position
  2. P/E ratio below 13x
  3. net debt < 1.5x EBITDA
  4. 5-year historical EPS CAGR of at least 5%.

I believe that this combination of factors will ensure significant upside potential but also downside protection given the low valuation and strong balance sheets of these companies.

Oracle (ORCL) is the world's leading provider of database software with over 40% market share. In addition, Oracle has a strong position in Enterprise Resource Planning (ERP) software where it is a strong number two behind SAP (SAP). Oracle shares have been in the doghouse as it has missed earnings expectations several times in the last two years.

While this has been frustrating for shareholders, it has also created an opportunity for long-term investors to buy into a top-notch franchise at just 12x current year estimated earnings (+$4/share in cash on the balance sheet - ex-cash P/E is below 11x). While the market has been worried about the impact of cloud computing players on the business, I believe this concern is overdone as 1) Oracle has built a strong cloud offering through a series of acquisitions and 2) the software sold by Oracle is very, very sticky. Oracle has a long list of thousands clients who have spent many years and tens of millions of dollars to buy and implement Oracle software in their organizations. Almost no IT director wants to rip out mission critical software as this process takes several years, exposes the organization to significant operational risks, and can cost tens of millions of dollars (if not more). Because of this, few customers ever leave Oracle and the company derives over ½ of its revenue (and an estimated ¾ of profit) from recurring maintenance revenue.

While the market is very focused on what can go wrong for Oracle, it is completely ignoring what can go right - a major database upgrade cycle providing companies with real-time analytics (it can take hours, if not days to run a query today). This was the focus of Oracle's most recent Open World conference. This could drive 7-12% top line organic growth for 3-5 years.

Coupled with a shrinking share count (Oracle buys back 2% of outstanding shares per quarter), Oracle could be earning almost $4/share looking out 2-3 years. If the market re-appraises Oracle as business with strong recurring cash flows growing at a double digit rate, it could put a 15-16x P/E multiple on the shares. Assuming the company could earn just $3.50 a share and the market valued these earnings at 16x, Oracle would be worth $56/share.

Valmont Industries (VMI) is an amalgamation capital goods company, the most interesting parts of which are: leading position in irrigation systems (a duopoly with Lindsay) as well as its engineered infrastructure business. Irrigation systems is a terrific business (favorable industry structure, high barriers to entry, high operating margins, and large returns on capital) with strong underlying growth prospects both domestically and internationally.

The engineered infrastructure business has many of the same characteristics - it provides roadway and electricity infrastructure both in the US and abroad. While investors taking a cursory glance at Valmont sometimes mistake the infrastructure business for selling commodity products, this couldn't be further from the truth - these products need to have passed safety inspections (wind resistance, crash durability, etc.) with a myriad of local regulators - it is very difficult to compete on a global scale with Valmont.

The infrastructure business should also have very strong growth trajectory for the next 10-20 years as much of the infrastructure in the US is past its useful life and needs to be replaced. Similarly, increasing wealth in emerging markets is stimulating demand for road & electricity infrastructure and Valmont is well placed to deliver. At just 12.5x earnings, Valmont looks to have 40-50% upside.

UnitedHealthcare (UNH) is the leading health insurance provider in the US. In addition, the company has a small but rapidly growing Brazilian business.

UNH shares have suffered recently as the company did not increase its 2013 earnings guidance (guides to $5.40-$5.50 per share) as it had in years past. This is most likely due to the additional expense and uncertainty brought on by Obamacare. As such, UNH sells for just 12.4x EPS.

Given the company's market leading position, 17% ROE, and the growth opportunities domestically (Obamacare brings millions of new patients into the system) and in the fast growing Brazilian market, I think this multiple is way too low. Looking back in time, UNH used to trade at a 20x P/E multiple. While I think that is a bit of a stretch, given that the company believes it can grow EPS at least 10% pa going forward, I think a 15x multiple is reasonable. This gets me to a share price of $82/share.

With the market hitting new highs every day, investors need to be cautious. I believe that the stocks mentioned above will perform relatively well over a three to five year time horizon, even if we head into a bear market.

Source: 3 Cheap Stocks In A Pricey Market