10 Reliable Value Stocks and Strategies for Adding Greater Margin of Safety

by: Hedgephone

Global stock markets are volatile, if not "choppy" and directionless at the moment, even as investors shrug off the mid-March decline in equity prices as a mere overreaction to Japan's tragic events. The S&P 500 is trading for a CAPE (cyclically adjusted price to earnings ratio which averages 10 years of earnings instead of using the trailing 12 month PE) of around 24X which is well above historical norms, as well as a Tobin's Q multiple which is historically very high. In other words, this market may look reasonably valued but this value buy may instead be a value trap over the medium term. John Hussman, Seth Klarman, Robert Shiller, and Jeremy Grantham have all pointed toward valuations being somewhat lofty here, but others including Warren Buffett, Bill Miller and many more argue that stocks are 20% or so undervalued.

That being said, many of the top performers these days are growth investors who are bullish. They scoff at the "old school" Graham and Dodd methodologies of valuing equities using ten years of earnings. They point to the internet and toward innovation as being the driver of earnings growth. These growth and momentum investors have solid track records (for the time being) and argue that stocks are rising not merely because of profit margin expansion due to cyclical factors and one time stimulus measures. Rather, because of newly developed disruptive technologies and growth in emerging markets.

My guess is that the future will come in somewhere in the middle of the bull/bear extremes and that companies may need less net asset value per unit of sales to achieve growth and profitability going forward. But the risks are still palpable. Many argue that companies have "more cash on their books then ever before" (relative to net assets) but they fail to mention that corporations also have more debt on their balance sheets than ever before. That's not something the "hoarding" crowd likes to mention.

The overall stock market, however, is still somewhat overvalued if QE ends and profit margins revert to historical norms. The bottom line is that soon QE will end. It looks to me as though the Bernanke Put will be gone from the commodity and stock markets. And then the fledgling recovery will have to stand on its own two feet if the major asset classes want to move even higher from here.

Any way you slice it, equities are a bit risky today and should be viewed, in my opinion, as a market of individual stocks rather than a stock market. Such a view is not as popular today. Investors seem to flock to ETF's in droves, away from the stock pickers, and away from the all star gunslinger mutual fund and hedge fund managers. ETF investing is an increasingly popular strategy these days.

Finding the right stocks to own in the short run in today's market involves anticipating investor perception (the voting machine and momentum crowd rule the tape, for now) more than fundamental analysis. However, longer term investors tend to turn in better results over time. They buy undervalued issues either on earnings, cash flows, book value, or growth or a combination of all four, and sell when a stock's price reaches a well researched estimate of intrinsic value.

In addition to the real or perceived permanent nature of the current historically high S&P net profit margins, accommodative monetary and fiscal policies have helped to boost all asset prices to relatively high levels, regardless of intrinsic values or supply and demand considerations. Because "cash is trash," the rally in equities could continue at least until the end of Bernanke's controversial "quantitative printing". That's penned for the ultimate withdrawal and likely hangover in June.

The following 10 stocks appear to be solid values given their low price to earnings and/or price to cash flow ratios as well as low price to book value or low price relative to corporate earnings growth. Deep value investors may cringe at some of the following names when many stocks may appear to be "cheaper" on asset value or cash flows. However, after the failures in accounting controls and procedures in names such as China Media Express (OTCPK:CCME), investors have a relatively new value trap to watch out for: An outright financial fraud that is not being detected by the S.E.C. or by big four auditing firms. In an environment where the only axiom you can trust is to not trust anybody, brand identity and transparency deserve a substantial valuation premium in my opinion.

McDonald's (NYSE:MCD) seems relatively cheap on earnings and particularly reasonable on operating cash flows. Investors can add to the 3% dividend yield by selling the May $75 call options against the stock for a 1% per month yield/added margin of safety. McDiesel's may be slowly losing the Hamburgler as a marketing icon. It appears to have gone to the ghost town of slogan's past, where residents include tag lines like "where's the beef", or "It's way better then fast food, it's Wendy's." (Wendy's is a lot of things, but five star dining is not one of them.)

McDonald's may be losing some of the growth and luster that now surrounds companies like Inn and Out Burger. But the burger behemoth behind the Golden Arches has an untapped growth market ahead of it in the healthy snacks, premium beverages, and possibly the organic food markets. Just think of what the naysayer snobs will say to their friends at yoga class when Whole Foods is not the only game in town when it comes to eating organic. MCD seems to be wisely moving in a healthier direction. One day, I imagine MCD will be selling a garden burger version of the Big Mac. My suggestion-- call it the "Big Veg," and in France it could be known as "Le Big Veg." Maybe after MCD's success in the low fat and low carb markets, Wendy's will come along and start a Veggie Burger campaign of their own and ask: "Where's the Beet?"

Coca Cola (NYSE:KO) is trading for 13X trailing earnings, but investors should note that earnings for KO were boosted by a large one time gain (an investing cash inflow) which should not be valued on a recurring revenue basis. That said, KO is trading for just 15X forward earnings. Also, the company appears to have made a very bright acquisition in Vitamin Water which should help to grow the business in the future. Conservative option investors can buy the leap $57.5 calls for around $8.50 and can sell the May $65 calls for $1.7 per contract. This should yield a nice monthly yield, provided KO maintains a lower level of volatility than the overall markets and doesn't go away any time soon. Warren Buffett has a 20% or so position in this stock, so I am fairly comfortable owning the name through thick and thin. Investors in taxable accounts should consider buying this name and forgetting about the purchase for a few years.

Johnson & Johnson (NYSE:JNJ) is still mired with the fallout of recalls and the hangover from business decisions made in the recent past. However, JNJ owns some of the widest moat brands in the world and has made leaps into the healthcare and biotech industries. These should grow at a 7-10% overall rate as the baby boomer generation moves into retirement. Certainly, the company has enough Band Aids to cover the many problems surrounding its core businesses for a while. Hopefully, however, JNJ's Quality Control department will keep longer hours a bit more regularly in the coming years and weed out the root of the problem. My sincere condolences to the family of the late Casey Johnson as her passing at such a young age is a heartbreaking tragedy.

Audiovoxx (NASDAQ:VOXX) is still likely a Net Net stock. VOXX stock is trading below current assets minus all liabilities, even with the recent purchase of Kilpsch for $168MM. But the company claims that Klipsch is the #1 manufacturer of speakers in the world and that the acquisition will be accretive immediately to earnings and revenues. Personally, I get upset when managers of Cigar Butt stocks make acquisitions (it is dilutive to shareholder liquidation value) or lose money on big all-in-bet type business decisions. However, Audiovoxx has at least been break-even for the past few years and maybe the company has figured out how to run its business more successfully. That said, Buffett always said that time is the friend of the wonderful business and the enemy of businesses with poor economic fundamentals.

Pepsi (NYSE:PEP) is still relatively cheap right now and the stock has not moved very much at all since the start of the fall rally. Both Coke and Pepsi have managed to avoid the 2008 recession for their investors, and I think the out-performance of the soft drink business can continue. Pepsi stock carries a nice 3% dividend, and investors can sell the May $65 call options for $1.06, which adds an additional 1% per month in yield if the stock remains stuck in neutral. Although volatility may hurt your returns in a covered call strategy, loss mitigation makes this type of investing ideal for IRA investors who do not like the wide swings in equity markets that affect their portfolios in the short run. Covered call and call spread investing using calendar spreads can greatly reduce monthly volatility and in some cases increase risk adjusted returns.

Hastings (NASDAQ:HAST) is a good company in a bad industry. Hastings sells discount entertainment products such as video games, and used DVD's. The company is a combination of Best Buy (NYSE:BBY), Gamestop (NYSE:GME), Barnes and Noble (NYSE:BKS), and Redbox. However, it trades for an EV/EBITDA multiple of a company that is unheard of as far as cheap stocks are concerned. Investors are clearly hyper-focused on the industry trends without evaluating liquidation value, working capital, operating cash flows, or the fact that Hastings has managed to maintain a strong level of revenues and cash on cash earnings over the past five years. During this time, its competition has mostly folded in every one of its individual markets. Hastings has reduced shares outstanding from around 11,600,000 in 2005 to 8,500,000 today. Meanwhile, tangible book value has grown from $88MM to $104MM as a large portion of its long term debt has been paid down. Eventually, Hastings will be able to buy back shares from the weak hands and the price will once again rise. Much as it did last year from $4.5 to $9.3 in a little under two months.

Google (NASDAQ:GOOG) is the leader in online search and in web marketing, and until Facebook creates a viable competitor to Google.com, I expect GOOG to have a wide business moat for years to come. Google is a well managed company. I expect the firm to do well with the founders running the company directly. That's contrary to many investors who think that Eric Schmidt's departure from Google was a long term red flag for the company. Sometimes people want to retire, change jobs, or spend more time with family members. After all, it's not like the guy is hard up for money. Investors looking to increase their margin of safety or to buy GOOG at lower prices should consider selling the May $570 put options on GOOG stock.

Petrobras (NYSE:PBR) is one of the major players worldwide in oil and gas. However, the stock has not moved as much as the underlying commodity due to the government investment and joint venture to produce one of the world's largest oil deposits off the coast of Brazil. PBR is cheap on asset value and on cash flow, but the nationalization fears have kept the shares from rallying in recent months. Investors looking to buy PBR for a lower price should sell the January 2012 at the money put options instead of purchasing the shares directly.

Ja Solar Holdings (NASDAQ:JASO) has been beaten up and 'thrown out with the garbage' recently, as a Gabelli Manager wrote in a missive on his short thesis. Also, the cuts from austerity-promoting governments have crimped the outlook for the solar industry in general, and the Chinese solar firms in particular. Some analysts argue that solar companies will not be profitable without government subsidies, so be wary of governmental austerity attempts that aim to cut spending on clean energy. Solar stocks were particularly hammered by the vocal short-sellers. But they have made a small come-back recently after the nuclear disaster in Japan highlighted the need for comprehensive and sensible approaches to the world-wide energy crisis.

JASO is dirt cheap, trading at a small premium to book value and at 4.5X earnings. Investors should sell the June $7 put options instead of buying the stock directly to add an additional margin of safety to the stock. Chinese stocks scare me after watching CCME and countless others like Rino (OTC:RINO) completely implode. However, JASO is the largest company in the world--it is the Coca Cola, not the Royal Crown of solar-- which gives me some piece of mind. (That and the fact that they don't put ads on buses.)

Intel (NASDAQ:INTC) makes innumerable quality processors, but you wouldn't know it by the price of the stock over the recent month. INTC has displayed impressive growth, but skeptics on Wall Street do not believe the books due to fear of technology industry trends including tablet computing, Apple (NASDAQ:AAPL), etc... INTC January 2012 $20 put options seem like a compelling investment opportunity for adding margin of safety to the stock (which currently trades for around 9X earnings) as the contracts fetch around $2.1 in premium, or a 12% or so return on your risk between now and January 2012.

All in all, I am a skeptic of this market and especially a skeptic of the popular growth stocks that everyone and their mom continually buys on margin. I don't like a stock more because it has a high PE ratio, I usually like it less but that is because I am a Graham and Dodd curmudgeon who is looking to buy a dollar for fifty cents. The stocks above represent compelling "first glance" investment merit but readers must do their own due diligence before buying shares in any stock mentioned in these or other articles published over the internet. Happy Investing!

Disclosure: I am long KO, PEP, MCD, VOXX, HAST, JNJ, JASO, GOOG, INTC.