While large caps have had a nice performance year-to-date, the Russell 2000 small cap index & S&P 400 mid cap index have done even better, posting gains of 30.7% and 26.6%, respectively. This makes it even tougher to find undervalued companies. However, there are a few remaining bargains. Here I'll identify 3 mid-caps which I believe will outperform their indices over a 3-5 year horizon. My criteria for selection are as follows:
- Market capitalization between $4 and $7 billion
- Market leading position
- P/E ratio < 14x.
- ROE > 13%.
Avnet (NYSE:AVT) is a well-positioned company with a strong balance sheet selling at a significant discount to our estimate of fair value. The company has two businesses: (1) it is a leading reseller of hardware/software for enterprises - including networking, PCs, servers, etc. (2) It is a leading distributor of electronic components (semiconductors are the main category) to a wide range of customer groups. The electronic distribution business represents the bulk of Avnet's business (70% of group operating profit). While operating margins in this business are low, returns on capital are high (20% after tax, excluding goodwill) as the company has numerous competitive advantages including purchasing scale, breadth of product offering (one stop shop for customers), strong infrastructure to allow for timely deliveries to customers. Further, if the company were ever to merge with competitor Arrow (NYSE:ARW), we could see an additional $250-300 million in savings (attributable to Avnet, I'd imagine the entire pot of savings would be $500+ million) which represents over 5% of Avnet's market cap (capitalizing these savings could add 40% to the share price). The company generates strong cash flow and has used it to make acquisitions and buy back stock. Recently, Avnet initiated a dividend. At 9.5x EPS, the stock looks to have 40-50% upside (even without a merger with Arrow).
Hologic (NASDAQ:HOLX) is a leader in several areas of women's health including breast health, diagnostics, GYN surgery, and skeletal health. Over ¾ of the company's revenue are derived from consumable products - ensuring a nice predictable stream of revenue irrespective of the economy. The company has been through a series of acquisitions over the past decade. Recently, there was a change in management (former CEO John Cumming has returned) and the company has pledged to cut costs, pay down debt, and return capital to shareholders. Given that prices paid for acquisitions in the past couple of years have been high, this is music to the ears of shareholders. In addition, a new product cycle (more detailed systems for the detection of breast cancer) should drive strong organic top line growth. While the stock soared initially on the announcement of Cumming's return, it has since given back most of those gains creating what I believe is an exciting opportunity for shareholders. At just 14x P/E, and with the prospect for double digit EPS growth, shares look to have 30% upside.
Joy Global (NYSE:JOY) shares have performed poorly over the past year, with shares falling 10% and now trades at just 11x earnings. Joy Global has been beaten up as lower thermal and met coal prices have caused a decline in coal production and coal mining capital expenditures. Similarly, concerns about the abundant supply of natural gas in the US have created long term fears about Joy's future. While I believe cheap gas is here to stay, I think Joy presents a great opportunity here. While the US is awash in natural gas, power demand in the rest of the world (particularly in emerging markets) continues to grow at a strong clip. These countries are still highly dependent on coal to meet their energy needs. In fact, over the long term, Joy should grow considerably faster than GDP as these countries modernize their coal mining operations. Another attractive characteristic of Joy is that it derives over 60% of it's revenue from aftermarket products (coal mining equipment has lots of wear parts which need constant replacement) which means that even in an ugly down-cycle, Joy is able to earn high levels of profitability (20% OPM). One last feature to consider is that Joy is an attractive takeover candidate to foreign mining companies like Komatsu, Sandvik, or Atlas Copco. Consider that Caterpillar (NYSE:CAT) paid 12x operating profit for Joy's duopoly competitor Bucyrus in 2010. Assuming a modest recovery in markets, such a multiple would equate to nearly a $120/share value of Joy. Even without a deal, assuming a modest recovery in markets by 2015-2016 and a P/E multiple of 15x, Joy would trade at ~$100/share.
Disclosure: I am long AVT, HOLX, JOY. 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.