Undervalued Stocks: 7 Potential Buys Based on Cash Flows and Book Value

by: Hedgephone

At Hedgephone.com, we try to help individual investors create optimal long short equity portfolios so that they can dump their 2&20 managers and invest for themselves. While we are not making stock recommendations, we are trying to help investors make informed investment decisions which are based on free cash flows, discounts to tangible book value, macro economic research and above all else valuations and business moat. On the long side, we look for companies which pay dividends or are using free cash flow to repurchase stock. On the short side, we look to buy index put options on overvalued index funds or to sell bear call spreads on individual names which we think are markedly overvalued and over-hyped.

Here are 7 stocks for investors to consider buying for their long book. These stocks have optimal characteristics from either a free cash flow or net tangible book value basis. Some of the following stocks are not "cheap" from a traditional Benjamin Graham perspective (which is the strategy we like the best from the long side) but have solid business moats and/or strong competitive advantages that make them good long term investment candidates.

(NASDAQ:BAMM) -- Books A Million is clearly facing strong headwinds from the e-book market, as physical books are becoming less relevant for shoppers at brick and mortar retailers than they once were. With that said, we think BAMM suffered from bad weather in the most recent quarter as tornadoes swept through the south where their stores are located. Books A Million has been a strong competitor in their verticals in the past and we like their recent move into frozen yogurt and into additional categories besides books. As I am personally more bullish on Hastings Entertainment (NASDAQ:HAST), I have a vested interest in the failure of BAMM, but because I am an honest person and a transparent blogger I have to admit I am intrigued with BAMM's 50% discount to tangible book value and low price to free cash flow ratio. The stock has been hit over the head over and over again, but many investors are not looking closely enough at the company from a liquidation value perspective. BAMM also has a strong web presence with a website ranked $33,000 in the world. While I am more interested in HAST, BAMM is clearly undervalued and the fear is likely overblown. Insiders were buying stock at prices 100% higher than current values and I have watched as the business has paid at least $50MM in dividends over the past five years to shareholders -- the company has a market cap that places the businesses valuation at around $50MM currently!

(NYSE:TGT) -- Target has been under pressure for the past few months as investors are simply unwilling to invest in anything with a brick and mortar retail presence. Instead, investors are willing to bet their hard earned money on anything with an online story to tell. Amazon (NASDAQ:AMZN), however, is facing headwinds in that the states are becoming more and more angry regarding the company's unfair tax advantage over mom and pop local businesses who sell the same goods as Amazon but have to pay sales tax rates of 5-8% on every item they sell. Target has joined in the fight, but we wonder if the big box retailers would be better off funding the sales tax fight from behind the scenes -- nobody likes the unfair tax advantage that online monopolies have currently, but nobody likes the monopolies that exist in big box land either. In short, I agree with the concerns raised in the Amazon tax question, which I view as a free market/states rights/Tea Party issue but I also think the big box community should pay for the campaign without making it a PR event or advertisement as this could undermine the online tax fairness efforts. Target shares are cheap at 6X EV/EBITDA and 10X earnings, but again with Amazon able to charge 5-8% less than Target, the valuation likely makes Target "cheap for a reason" to some degree. Spending lobbying money on states rights issues seems like a good investment, especially since politics seem to be more or less a plutocratic exercise at present.

(NASDAQ:JASO) -- JA Solar has been punished in recent months because it's Chinese and because it's a green energy company. Investors are short this name for size and to be sure, it appears as though our leaders here in the U.S. would rather see these companies fail than succeed even though the world desperately needs clean energy as China is building dirty coal plants at something like one per day across their nation. Clean energy is likely the biggest area for growth in China, but the never-ending negative press on these names is not helping the firms to raise money or from a "Reflexivity" standpoint. I like JASO at 4X earnings and a price under tangible book value. Investors, however, should watch silver prices because silver is a main ingredient in solar panels.

(NYSE:JNJ) -- Johnson and Johnson shares appear undervalued at 12X free cash flows. We like this Buffett holding because the company's brands carry wide economic moats and strong brand identity. JNJ has made huge inroads in the drug and healthcare industries, but we don't like it when cheap companies buy overvalued competitors. Nevertheless, JNJ has one of the best acquisition track records of any large cap blue chip company and we think the valuation of JNJ is too cheap. As management puts the recall scandals behind them, the stock should have a huge tailwind for higher valuations moving forward.

(NASDAQ:KCLI) -- Kansas City Life is trading below liquidation value in my view and management should consider buying back shares of stock instead of trying to spend money to make money in my view. When companies trade below liquidation value, a share repurchase not only increases the intrinsic value per share of the business, but also shows the Street that management is working for the outside shareholders and not just for themselves and their own enrichment. We like KCLI here at 50% of book value, but watch the company closely for indications that they will be taking steps to unlock value for current and longer term stockholders.

(NYSE:KEP) -- Korea Electric Power is trading for 25% of tangible book, which makes this electric utility our favorite stock in the utility space bar none. KEP has been treading water for a few years now while intrinsic value has been increasing, which is one of the characteristics we look for in a value stock. In other words, we want to buy dollars for 50 or even 25 cents, but we also want the dollar we are buying to be appreciating in value over time. KEP meets both of these criteria for us, so we like the name and think of the stock as a good investment versus the overall market which seems speculative given current valuations.

(NYSE:ASI) -- American Safety is a lot like KCLI except the discount to book is a bit smaller while book value is growing at a bit faster clip. We like to buy stocks below book value when ROE is over 10-20% because eventually we will make money if the company executes at the same level it has in the recent past out into the future. At 60% of tangible book, we think ASI is too cheap to ignore. With ABC Funds owning a large position in the stock, ASI appears to be one of the better risk reward opportunities in the insurance sector.

Stay tuned for more long and short ideas based on the numbers, not on hype or speculation. When looking for shorter term signals, remember to buy dips and sell rips. Until next time ...

Disclosure: I am long HAST, TGT, JASO.