After nearly a month away, I return to largely unchanged markets despite constant chatter about the U.S. debt ceiling crisis. Will politicians regain their senses in time to avoid a calamitous default or downgrade? If markets are a discounting mechanism, both bonds and stock are skeptical of such a possibility. I remain skeptical of the markets' vaunted reputation as forward-looking discounting mechanisms so the complacency surrounding a possible U.S. debt priced in the markets is not overly comforting.
The main question for investors is not what will happen but rather, how to position our portfolios? The answer to this question will vary depending on investment style. For event-driven or macro investors, the resolution to this politically-generated crisis is of some importance. For value investors such as myself, it is business as usual -- we continue our constant search for underpriced stocks and leave the big picture questions to resolve themselves (for what it's worth, I expect politicians to do the right thing in the end, though it may require a TARP-like scenario where intransigent politicians watch the Dow lose hundreds of points with each No vote before coming to realize that markets are more powerful than politics).
As such, I examined the following eight stocks for possible investment:
- Weatherford International Ltd (WFT)
- Callaway Golf Co (ELY)
- Regis Corp (RGS)
- Tractor Supply Co (TSCO)
- Leggett And Platt Inc (LEG)
- MeadWestvaco Corp (MWV)
- Rock Tenn Co (RKT)
- Sonoco Products Co (SON)
I did not consider how a U.S. debt crisis would impact these companies but did assume a 0% growth rate to factor in the anemic economy. While assuming zero growth may be a tad conservative, my investment strategy is not predicated on predicting companies' future growth rates. We are looking for cheap stocks -- a stock that looks appetizing at one growth rate but not another is probably not that cheap.
Of these eight names, I discarded Weatherford International Ltd (WFT) due to its lack of consistent free cash flow generation, a problem common with oil service companies which must constantly invest in their businesses. Callaway Golf Co (ELY) and Tractor Supply Co (TSCO) were passed over due to overvaluation relative to past cash flows.
Based solely on discount to free cash flow, Regis Corp (RGS) is the clear stand-out of this bunch, trading at 50% of my estimated intrinsic value. Of course, value investing is not all quantitative and some subjective judgments need to be made regarding the business' sustainability and prospects. Regis operates various high and low-end hair salons in the U.S. and internationally but is struggling with declining growth and customers downgrading services even as rivals such as Ulta (ULTA) report uptrending results. Clearly, more in-depth analysis is needed to determine whether RGS is a value trap.
Leggett & Platt Inc (LEG) may be the most attractive stock on this list due to a combination of a modest undervaluation and a manufacturing business model diversified by product and region. By rough statistical calculation, LEG may be selling at 75% of its intrinsic value. Leggett & Platt has averaged nearly 11% free cash flow on its assets over the past 5 years, a stellar result which suggests a durable business. Debt level appears manageable at 2x EBITDA. The biggest concerns would be the company's lack of growth and an abnormally high payout ratio, though this could be an accounting anomaly (earnings usually understated vs. free cash flow).
Finally, the last 3 names all operate in the packaging industry. The largest of these, MeadWestvaco Corp (MWV), trades at a premium to my estimate of intrinsic value but Rock Tenn Co (RKT) and Sonoco Products Co (SON) are reasonably priced at the moment. Of course, we aim to buy underpriced, not reasonably priced stocks, but with reasonable debt loads and attractive yields, these stocks could be an attractive investment should prices dive in the near future.