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Summary

  • Market cap greater than $1 billion.
  • P/E less than 10x.
  • Expected EPS growth of at least 5%.
  • Year to date stock price decline of at least 10%.

As the market has continued to run, I am finding fewer and fewer compelling opportunities. However, even in pricey markets, there are always pockets of undervalued companies. Today I will highlight three stocks which have been beaten up, but which I believe can rise 50+% over the next year. My criteria are as follows:

  1. Market cap greater than $1 billion
  2. Year to date stock price decline of at least 10%
  3. Adjusted P/E below 10x
  4. Operate in growing industry with potential for 5-10% EPS growth

Herbalife (NYSE:HLF) is one of the most, if not the most, controversial stocks in the market today. Short sellers like Bill Ackman allege that Herbalife is a pyramid scheme which preys on low income people who simply don't know any better. Ackman has used his influence to get the FTC to investigate Herbalife. While there are certainly some questionable business practices surrounding the company (I say surrounding because many of the most blatant acts are committed by 3rd parties, i.e. internet marketing firms), I believe that Herbalife's share price more than takes this into account. While it is likely that the FTC will force Herbalife to make some adjustments to its business practices, it is important to note that the FTC only has jurisdiction over the United States, and that the US only represents 20% of Herbalife's revenue (and a similar amount of operating profit).

There are many positives to the Herbalife story. Firstly, the company has grown EPS at over 10% per year for the past five years. Secondly, shares are selling for less than 9x P/E. Third, Herbalife has a strong balance sheet with net debt less than 1x EBITDA. Fourth, the company has over $800 million (15% of today's market capitalization) authorized to buy back shares. Note that buying back stock at less than 9x P/E is highly accretive to EPS and intrinsic value per share. Further, it is likely that activist investor Carl Icahn will push the company to increase its buyback given the decline in Herbalife's share price - an accelerated buyback would further increase EPS and intrinsic value per share.

It is also worth noting that 23% of Herbalife's outstanding shares are sold short (and 31% of free float after factoring in Icahn and Stiritz's holding). This could lead to a rapid price spike once investors become less concerned about the impact of FTC intervention. With a fanatical (cult-ish?) customer base of a daily consumable, I think Herbalife could reasonably fetch a 15-18x P/E multiple. Assuming the company can earn $6.50/share in 2015, it is not difficult to get to a $105 price target or 100% upside from here.

Ocwen Financial (NYSE:OCN), the largest third party servicer of subprime loans, has seen its share price fall 33% from 2013's highs following closer regulatory scrutiny from the New York Department of Financial Services. While the regulator has temporarily frozen Ocwen's acquisition of mortgage servicing rights (MSRs) from Wells Fargo (NYSE:WFC), I believe that Ocwen will resolve these issues, and that over the medium term, Ocwen will continue to make highly accretive MSR acquisitions. In fact, the regulatory scrutiny over the handling of delinquent borrowers will likely make banks more interested in selling such rights (the banks seem to have enough regulatory issues as it is). This should allow Ocwen to continue to grow EPS at 10% or more (even taking into account the run-off of its existing book). Further, the company should have a strong tailwind if the US housing market improves (as the number of delinquent borrowers declines and the cost to service delinquencies falls). Trading at just 8.4x 2014 estimated earnings, Ocwen looks to have nearly 100% upside (assuming 15% growth in 2015 and a 15x P/E multiple).

Like Ocwen, subprime mortgage servicer Walter Investment Management Corporation (NYSE:WAC), has seen its shares decline 33% from their 2013 high. While Walter hasn't faced a direct regulatory threat, it recently missed earnings estimates, and investors are concerned about a slowdown in banks selling MSRs (as mentioned above). Walter is even cheaper than Ocwen, selling at less than 6x 2014 expected EPS. While some are concerned that the company could miss earnings again, investors are overlooking: 1) structurally attractive industry whereby 3 players Ocwen, Walter, and Nationstar (NYSE:NSM) control the vast majority of the non-bank, subprime servicing market; this should ensure that bidding for MSRs doesn't overheat, allowing Walter to continue to earn ~15% IRRs on the capital it allocates to new MSR purchases, 2) associated potential for continued growth; while Walter may see some falloff in mortgage origination earnings, this is likely to be more than offset by continued growth in the servicing business via MSR acquisition. Assuming that investors were willing to pay just 12x P/E for Walter, we could see shares double.

Source: 3 Cheap Stocks Which Could Double