Three Stocks for a Tough Market

While I have become extremely bearish on the market, characterizing this as a bear market instead of the correction I had been anticipating earlier this summer, I do recognize that a small number of stocks typically is able to rise in a bear market. Looking at the current S&P 500 members, for instance, 150 (30%) actually rose in 2002, the last year of the last bear market. All 10 of the economic sectors were represented except for Telecommunications Services. Slightly higher percentages rose for the S&P 400 Mid-Cap and the S&P 600 Small-Cap indices (again, the current members, which has a bit of survivor bias). So, what types of stocks might rise even if my call on the overall market declining is correct? I believe that there are three characteristics that investors should demand of their stocks:

Expected earnings growth must be achieved

Balance sheet must be viewed as safe and providing a large safety margin

Valuation must be defensible (not necessarily cheap, but not unjustifiably expensive)

While stocks having these qualities aren’t assured of success by any means, it is a great starting point. Three that I have my eye upon meet these criteria. Common to all three, they are showing up on my most productive screen (using StockVal) that I employ as the basis for my Small-Cap Rocket Report. The screen attempts to identify stocks that are performing well, that are not too richly valued, that aren’t widely followed, that have rising 2-year out estimates and that produce high ROIC on low levels of debt. The screen typically generates 10-15 names, with many of the same names making the cut over time. As I look at the current output, which includes several excellent companies that I am not including because I think that the capital crunch might impact their earnings potential, the three names that stand out are: The Advisory Board Company (ABCO) (57.53, $1 billion), Astec Industries (ASTE) (50.58, $1.1 billion) and Surmodics (SRDX) (48.28, $868mm). While I don’t own any of these companies, I am monitoring them closely for potential purchase. My guess is that very few readers are familiar with all of these companies – I had never heard of two of them until they hit my screen recently. Below are very brief descriptions.

ABCO could get a lot of attention in the coming election year, as healthcare promises to be a predominant election issue. This company, free of debt, provides its 2600 members, who are hospitals, device companies, pharmaceutical companies and health insurance companies, with best practices research, analysis, education and decision support tools. Trading at 25X, the stock, covered by only four analysts, trades well below the 30 median since its IPO. While it is a tad expensive relative to the 16-18% potential growth, the earnings, which are based upon recurring subscription, seem likely to be met. I am hoping to see this one pull back to the 53-54 area, which looks to be technical support as well as about the highest level the company has paid for stock that it has been repurchasing over the past 18 months.

ASTE strikes me as very timely due to its high reliance upon public works (the company is involved in asphalt road construction around the world). I called the company to get a better understanding of the client base, and was happy with what I heard except for their exposure to commercial strip center repaving (hard to quantify precisely due to sales to contractors. I would expect that even in a global slowdown, we will see continued government spending on infrastructure, especially in an election year here. Quite remarkably for a cyclical industrial company, Astec is free of debt and loaded with cash. A closer look at the balance sheet shows falling inventory and AR relative to sales. The current valuation is consistent with mid-cycle valuations over the past decade, but the stock will trade at a much lower valuation if I am wrong about where we are in the road construction/repair cycle. With that said, this sounds like a very well run company – its founder, an engineer, is still CEO. The company employs a model that I like: decentralized structure, tuck-in acquisitions, niche focus. I would be even more patient on this name, looking for an entry closer to 43-45, as it has already had a big run this bull market..

SRDX is the one that I know best of the three. I have to confess that my initial reaction a month ago when it hit the screen was something between shock and concern that my screen was flawed. I had recalled Surmodics as a one-trick pony (coated stents), and one headed for the glue factory at best. I was pleasantly surprised to see how much more they have going on. The company has been quietly reinventing itself and has exciting applications for its specialty coatings in many areas. I prepared an 11-page review for a client earlier this month and am happy to forward it to anyone who emails me. Some of the things that stood out are the extremely high percentage of sales going into R&D, the high inside ownership (minimal insider sales in past year), the pristine balance sheet and the numerous shots on goal. One risk that stands out is that they have done several acquisitions lately. Of course, the company is still reliant to a great degree on the stent royalty payments. Perhaps it is just a fantasy, but this is one that would be quite attractive at 44.

Disclosure: I have no positions in any of the companies mentioned in this article