Buy These 3 Undervalued Stocks To Capitalize Off Of Economic Fear

Includes: M, MET, VALE
by: Takeover Analyst

With many investors fearing a double dip, value investors have an opportunity to generate high risk-adjusted returns from backing volatile companies. While a double dip is certainly possible, I do not believe this probability has been weighted into discount rates for future streams of free cash flow. In this article, I will consider three different high beta companies. These firms operate in entirely different sectors: mining (ie. Vale), insurance (ie. MetLife), and retail (ie. Macy's). All three sectors are highly sensitive to the state of the economy and thus are well positioned to surge if a full recovery materializes quicker than what the market anticipates.

Consider Vale (NYSE:VALE). Analysts are anticipating weak to little growth over the next half decade or so. I model growth trending from -1% to 10% over this time period. This is very bearish, in my view, due to the 30.2% growth experienced in FY2011.

Moving onto the cost-side of the equation, there are several items to consider when calculating free cash flow: operating expenses, capital expenditures, and taxes. I keep all three of these items at historical levels. Subtracting out net increases in working capital (also adjusted to historical averages), taking a perpetual growth rate of 2.5%, and discounting backwards by a WACC of 10% yields a fair value figure of around $20. However, this assumed minimal growth. A more reasonable explicit projection for per annum growth would be 5%. Inputting this into the model would put the intrinsic value at a 21% premium to the closing day value on May 11, 2012. This is on top of a very strong dividend yield of 5.6%.

Much of the reason why Vale remains cheap stems from the high level perceived in its industry. Perhaps financials are most affected by bearish sentiments. MetLife (NYSE:MET) trades at just a respective 6.3x and 6.2x past and forward earnings. Currently, it has a price target north of $49, which implies that the insurer is 41.4% undervalued. Consensus estimates forecast MetLife's EPS growing by 4% to $5.22 in 2012 and then by 7.9% and 9.6% in the following two years. Assuming a multiple of 9x and a conservative 2013 EPS of $5.60, the stock would hit $50.40 - virtually in-line with the consensus price target.

MetLife, meanwhile, has been an impressive performer:

MetLife delivered strong financial results in the first quarter. We had healthy top line growth with premiums, fees and other income rising by 7% year-over-year. Our bottom line performance was even stronger. MetLife generated operating earnings of $1.5 billion or $1.37 per share, up 11% year-over-year. MetLife's performance during the quarter was driven by some fundamentals in the core earnings power of our diversified global portfolio of businesses.

Retailers, which are directly tied to the economy, are the first beneficiaries of greater consumer expenditures. Increases in discretionary income, however, are being overly discounted due to the bearish outlook. Consensus estimates forecast Macy's (NYSE:M) EPS growing by 18.8% to $3.42 in FY2013 and then by 11.7% and 15.2% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $3.79, the stock would hit $49.27 for 29.7% upside. With the S&P 500 trading at 22.5x past earnings, Macy's is thus a very compelling "buy". When the negativity dissipates over the sluggish recovery, Macy's, MetLife, and Vale are well positioned to outperform broader indices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.