10 High Quality Stocks to Consider

by: Hedgephone

Joel Greenblatt's "Little Book that Beats the Market" has managed to be one of the only stock market books published that lives up to the promise made in the title. Greenblatt's latest money management venture, Formula Capital, has managed to outperform the index funds since inception.

Here are 10 names that we like from a bottoms up perspective. The high return on equity and low debt requirements weed out most of the low price to tangible book names that we tend to prefer. With that said, these stocks are higher quality businesses on average than most companies that trade for below tangible book value. Over the long run, buying good businesses at fair prices beats buying crummy businesses at cheap prices.

Almost Family Inc (NASDAQ:AFAM) -- Even though earnings at Almost Family declined on a sequential and year over year basis, I still like the name given the low price to free cash flow and given the overall growth in the home medical industry. Furthermore, the historic long term growth rate of the company is the best among its peers. AFAM's trailing PE ratio is around 8.5X but the forward PE of 9.7X is a little worrisome as we typically like to see earnings growth. With that said, this name makes sense to us and investors looking to sell covered calls should be rewarded nicely from selling rich option premiums on the stock. Investors can sell the August $27.50 call options for $1.10 or so, which is a nice maximum yield of 9.57% between now and August 20, while the $1.10 premium provides a 4.2% cushion on the downside. As far as selling puts are concerned, investors could sell the November 19th put options for $2.10 for a yield of 8.4% on your risk over the next 5 months. I like both of these trades, but I prefer the put sale versus the covered call as this provides a 17% per annum yield on your risk if the stock stays flat over that time period.

BSQUARE Corporation (NASDAQ:BSQR) -- B Square Corporation is a name we have looked at twice over the past year. The company operates in the red hot smartphone market providing testing and embedded systems, automation systems, and third party software to smartphone makers and other technology businesses. The company produces testing technologies and applications for the U.S. Military in addition to testing solutions for mobile businesses. I like this name more than many of the other 4G related names because it trades for just 6.95X trailing earnings and makes our screens. With that said, the stock has little in the way of margin of safety from a book value and free cash flow perspective, which means that it is a bit more speculative, in my opinion, than several of the more well established companies on this list.

Microsoft Corporation (NASDAQ:MSFT) -- Microsoft is a cheap stock with a high quality management team and a strong core business. We like the stock given the low valuation and incredible track record. While we think the company is somewhat late to the cloud computing party, we still believe that MSFT will come to dominate the cloud the same way that it currently dominates the software industry. With a PE ratio under 9X, we think the stock is roughly 30%-50% too cheap compared with Salesforce.com (NYSE:CRM) or compared with the PowerShares QQQ or iShares Russell 2000 Index IWM. I like the stock here, but prefer selling the January 2012 $25 put options for $1.90 or so per contract to buying the stock. If the stock sells off from these levels we would look to add to the position by purchasing stock directly.

SanDisk Corporation (SNDK) -- SanDisk has been crushed over the past few months largely because analysts have pegged the forward PE below the company's trailing PE ratio, which means they see earnings declining over the next year. SNDK trades for just 7.5X trailing earnings and for a forward PE ratio of only 8.4X. I like this stock but because I am less confident in the tech space in general I would not recommend buying a concentrated position in the stock. Instead, I think investors should consider buying this stock as a part of a larger basket of stocks and low price to book names to diversify company specific risk. SanDisk boasts an ROE of nearly 30% with an EV/EBITDA of only 4.65X, which means the stock is cheap on both cash flows and earnings. With a price to book value of only 1.5X and with an ROE this high, we think at some point in the future SanDisk will offer investors a reasonable margin of safety from a book value perspective as well.

Raytheon Company (NYSE:RTN) -- Raytheon is a cheap defense stock in a market that has priced in significant budget cuts in the defense spending area of fiscal policy. I think these fears are overblown considering the U.S. is engaged in 3 wars at present and that both Democrats and Republicans appear strongly pro-military at the moment. RTN trades at just 10.27X earnings and for only 8.72X forward earnings. I would look to sell the Feb. 2012 $48 puts for $3.8 per contract as a way to begin accumulating a position in RTN common stock. I think the discount here is unwarranted at a 6.5X EV/EBITDA because even when Congress is forced to cut overall spending I do not believe the House will be able to agree on reducing military spending given that Republicans are the driving force behind budgetary cuts and that the world is such a volatile place right now.

Dell Inc. (NASDAQ:DELL) -- Dell was listed as being undervalued with insider buying by Kapitall and since it made our screen I have decided to add it to our list of strong investment candidates even though I actually like Hewlett-Packard (NYSE:HPQ) a little bit better in the laptop category. Dell appears undervalued at first glance here at 9.5X trailing earnings and 8.35X forward earnings. The stock looks even cheaper based on cash flows with an EV/EBITDA ratio of only 4.48X. Michael Dell's large purchase of the stock back in May is also a signal that the stock is undervalued at present levels even though shares have risen around $1.60 since his recent insider buys.

Impax Labs (NASDAQ:IPXL) -- Impax Labs has given investors one heck of a roller coaster ride lately, as shares have made a round trip from $20 to $30 and back down to the $20 level in just the past four months. The company is projected to display a large drop in forward earnings, but trailing earnings and cash flows make this stock a buy for your basket of undervalued names with a 10X trailing PE and an EV/EBITDA of only 4.2X. I like this stock here, but again would want to own this as part of a large basket of undervalued stocks for proper diversification.

Deluxe Corporation (NYSE:DLX) -- Deluxe shares appear quite undervalued at the moment with a trailing PE ratio of 8.17X earnings and a forward PE of only 7.74X earnings. Deluxe has a low EV/EBITDA of only 5.2X, which makes this a cheap stock with a high quality business, given that the company has produced an impressive 78% ROE over the past year. While I don't like buying stocks at 5X book value normally, I have to recognize the overall logic of our strategy and make exceptions to my low price to book value bent given the quality of the businesses on the list and the historical returns of this investment approach over the longer term.

Teradyne Inc. (NYSE:TER) -- Teradyne shares are too cheap to ignore here and I will be adding to a small position here. Currently, I am short the January 2012 put options on this stock. The company is trading for just 7.6X earnings and for 7.4X forward earnings on an EV/EBITDA of only 3.7X. I like this name but again it's a stock to own as a part of a basket of names and not as a concentrated position. The company operates in the semiconductor and systems testing sectors and while the Micron Technologies (NASDAQ:MU) miss and other data points have turned the punditry negative for the most part on Semiconductors, I like to own stocks that trade for 3.7X EV/EBITDA as part of a large basket of cheap stocks. Teradyne looks like a winner for me. I will be selling the January 2012 $14 puts for $1.70 per contract. This "trade" will give me a nice margin of safety for my limit order on the name, as I will not be "put" the common stock until shares hit $12.30, which is a price I am comfortable buying the name outright.

Forest Laboratories Inc. (NYSE:FRX) -- Forest Labs is an interesting investment idea on this list because Carl Icahn is involved here and it makes the screen due to a low valuation and strong ROE. Shares have broken out of a longer term price channel likely because of the Icahn buy, and the stock looks cheap to me, just 11X earnings and 5.3X EV/EBITDA. I think Carl Icahn can do a better job of allocating FRX's cash flows as the company has had a tough time increasing shareholder value lately. FRX has a good deal of cash on the balance sheet so we would hope that Icahn puts that cash to work in a more profitable manner than what management has planned, as the company has a forward PE of 32.5X earnings. The high forward PE suggests that Carl could do a better job here or that shareholders would be better off if this company were sold. We wonder whether business is slowing or if management is practicing a scorched Earth tactic, which has become popular among entrenched management teams. Many times company managements view a public business as a private business that they own outright and often management teams place their own interests above the interests of the true owners of corporations, which are the shareholders.

Investors looking to diversify should buy some or all of these names for their long book while keeping an eye on the macro picture and overall valuations to decide what portion of their holdings to hedge via index put options or using other strategies such as covered calls.

Disclosure: I am long TER, MSFT.