Four Value Trades in Large Caps

 |  Includes: ACF, CMG, HTZ, HUM, SHLD
by: Zack Buckley

I wanted to introduce some undervalued companies that I believe will have less volatility than the previous companies I have recommended. I understand that volatility bothers many investors, which is why I am suggesting these companies. I came across these companies while looking through the top holdings of Bruce Berkowitz, the famous value investor who manages Fairholme mutual funds. Volatility does not measure risk in a company to the long term investor; the sustainability of the underlying business and what price you pay for the stock are how I measure risk. Was Yahoo (NASDAQ:YHOO) worth 300 times earnings at the height of the dotcom bubble? I don't think so, investors overpaid for a business that is not necessarily sustainable.

With these companies, the most attractive aspect is the price to owners earnings. This is essentially what cash the business is generating for its shareholders. This is how I look at all of the companies I am evaluating, and how Buffett has always evaluated companies. I determine owners earnings using net income + depreciation and amortization + changes in net working capital – capital expenditures. A price/owner’s earnings can essentially be viewed as an equity bond to shareholders. If the price/owners earnings is 5, the “equity bond” is paying out 20%, if it is 2, the “equity bond” is paying out 50%. So if I buy a local convenience store at an owners earnings of 2, I am essentially getting a 50% bond on my money, the same analysis applies to stocks.

I like thinking of equities in this way because it allows for an approximate method to compare equities and bonds. It also demonstrates to investors why paying high P/E ratios for companies is unsound investing for long run investors. While I think Chipotle (NYSE:CMG) is a fantastic company, it is trading at a price/owners earnings of 28. This means the equity bond for Chipotle is paying 3.5%. Now I believe that equity bond will grow over time because Chipotle is a fantastic business, but I think it is too high in comparison to the rates that can be found in other growing, profitable companies. Even if they triple owners earnings, which most would agree will not happen next year, the equity bond would still only pay investors 10.7%. I just think there are better buys available.

Humana (NYSE:HUM) is a health care company that operates in the government and commercial segments. I am very attracted to the low price to operating cash flow the company has reported over previous years. They are currently trading at a little over 6 times owners earnings. I believe Humana will make it through the recent Healthcare reform and still be a very profitable company. As always, I reserve the right to be wrong.

Sears Holding Corporation (NASDAQ:SHLD) is run by Eddie Lampert, who I admire greatly, and also is undervalued at its current price. It is trading at a price to owners earnings of about 11. The P/E ratio misrepresents the value of the company because they have such high annual depreciation cost. Sears may not grow at breakneck rates, but I believe it will keep generating lots of cash for its shareholders.

Americredit Corp. (ACF) is another value play for investors now, it currently is trading at a price/owners earnings of close to 3. They purchase loans directly from the dealer and then collect the receivables from the car purchasers. The net income is not a good reflection of the value of this company because their provisions for loan losses are so high. When we look at owners earnings, however, we can see this company is worth owning.

Hertz (NYSE:HTZ) generates lots of operating cash flow for its investors. I valued Hertz as trading at 10 times owners earnings. They have extremely high depreciation expenses due to their large fleet of autos. They also have a high annual cost of buying and selling the cars on an annual basis. So when I looked at the business for 2009 results, I took the 1.8 billion in operating cash flow and subtracted out the 1.3 billion cost of buying and disposing of the car fleet. This gave me an owners earnings figure of 500 million.

Disclosure: No position in any companies mentioned