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American hedge fund manager John Paulson is the founder and President of Paulson & Co., a New York-based hedge fund. Paulson manages Paulson & Co. Inc. (NYSE:PCI), his own hedge fund investment company, which is an employee-owned hedge fund sponsor, mainly offering services to pooled investment vehicles. He earns money through commissions on funds under management, as well as a share of the profits.

The company administers separate client-focused portfolios, employing merger arbitrage, long/short, and event-driven project to perform its investments. Paulson & Co. Inc. employs basic analysis to make its investments, benchmarking the yield of its investments versus the S&P 500 Index.

In an interview with The Wall Street Journal, Paulson elaborates on his investment philosophy, saying that the flexibility of having long and short exposure across the capital structure allows him to optimize performance across market cycles. And that the objectives are capital preservation, above average returns over the long term and low correlation to the markets. While the market recovers from its deficiency during the past years, Paulson is betting on solid economic growth in the revival; he said that it is time to be in the stock market, and that now is not the time "to be under-invested."

I centered on businesses that attain good returns on equity, while employing little or no debt. Highly leveraged businesses are vulnerable in times of economic slowdowns. I believe that John Paulson also shares this vision, which is why I think it is fascinating to investigate his prime picks to obtain good "seed" investment ideas.

Quad Graphics (NYSE:QUAD)

Quad Graphics, Inc. is a supplier of print and related multichannel solutions for consumer magazines, special interest publications, catalogs, retail inserts and circulars, direct mail products, books and directories. Its print-related services include digital photography, digital imaging, binding, mailing and distribution and data optimization and analytics services. The firm also commits in the design, development, manufacture, and service of printing-related auxiliary equipment for original equipment manufacturers and printing companies globally. Quad Graphics, Inc. is based in Sussex, Wisconsin.

Main features:

  • $638 million in full-year Adjusted EBITDA, surpassing guidance of $610 million to $625 million.
  • Fourth quarter Adjusted EBITDA margin of 15.0% and full-year Adjusted EBITDA margin of 13.7%. Apart from Canadian operations, full-year Adjusted EBITDA margin increases to 14.3%.
  • $340 million in full-year Recurring Free Cash Flow, exceeding guidance of $260 million to $300 million.
  • Paid back $163 million in debt in the quarter and $325 million since the Worldcolor purchase, reducing leverage to 2.3x.
  • Raised quarterly cash dividend by 25% to $0.25 per share.
  • Won authorization from the Canadian Competition Bureau to continue with the sale of its Canadian business to Transcontinental.

Quad/Graphics is satisfied with its 2011 fourth quarter results, which reflect its continuous focus on enlarging productivity and aggressively managing costs, while advancing to pay down debt to strengthen its credit metrics and balance sheet. Considering the company's strong finish to the year, as well as the strength of its recurring free cash flow and lower risk profile that its current leverage reduction has provided, the company is happy to declare a 25% increment in its quarterly dividend, which will be payable on March 23, 2012, to shareholders of record on March 12, 2012.

QUAD's current net profit margin is -1.08%, currently higher that its 2010 margin of -7.37%. I like companies that have increased profit margins in comparison to other years. It is essential to know the reason why that happened. Its current return on equity is -3.37%, lower than the +20% standard I look for in companies I invest in, but higher than its 2010 average ROE of -22.10%.

In terms of income and revenue growth, QUAD has a 3-year average revenue growth of 24.03%. Its current revenue year-over-year growth is 35.75%, lower than its 2010 revenue growth of 78.13%. I do not like when current revenue growth is less than the past year. It generally shows that business is decelerating for some reason.

In terms of Valuation Ratios, QUAD is trading at a Price/Book of 0.5x, a Price/Sales of 0.2x and a Price/Cash Flow of 1.8x in comparison to its Industry Averages of 2.8x Book, 1.5x Sales and 10.7x Cash Flow. It is essential to analyze the current valuation of QUAD and check how is trading in relation to its peer group.

Veeco Instruments (NASDAQ:VECO)

Veeco Instruments Inc. designs, produces, sales and services a large line of precision beam etching and surface measurement systems used in the production of microelectronic products. The company sells its products globally to many of the major semiconductor and data storage manufacturers. Besides, it trades its products to companies in the flat panel display and high frequency device industries, and to other industries, research and development centers and universities.

Veeco Instruments has solid competitive positions in several niche markets. As a major supplier of equipment used to produce light-emitting diodes, the company is well positioned to take advantage of the increasing adoption of LED lighting in the long run.

Veeco is a major provider of manufacturing equipment to several high-tech industries, including the disk drive, LED, and solar cell markets. The company is the dominant provider of process equipment to the disk drive industry, with scale and an extensive product portfolio that is incomparable.

The company thinks the prime growth driver for Veeco in the future years will be the LED process equipment opportunity. LED-based lighting is being used in an increasing number of applications, ranging from television and notebook backlighting to general illumination. The propagation of LEDs should result in strong long-term growth in the LED end market, which will help manufacturers to boost production capacity and provide tailwinds for Veeco's LED equipment business over time. Veeco has also opportunities to extend in the solar manufacturing tool space, but has currently decided to stop its key copper-indium-gallium-selenide (CIGS) solar equipment product line in that business. Nonetheless, the firm continues to sell other types of process equipment to solar cell manufacturers.

VECO's current net profit margin is 13.07%, currently lower that its 2010 margin of 38.76%. I do not like when companies have lower profit margins than in the past. Thus it is essential to analyze why this happened. Its current return on equity is 16.81%, lower than the +20% standard I look for in companies I invest in, and also lower than its 2010 average ROE of 64.51%.

In terms of income and revenue growth, VECO has a 3-year average revenue growth of 30.28%. Its current revenue year-over-year growth is 5.18%, lower than its 2010 revenue growth of 229.62%. I do not like when current revenue growth is less than in the past year. It generally shows that business is decelerating for some reason. The current Net Income year-over-year growth is -64.62%.

In terms of Valuation Ratios, VECO is trading at a Price/Book of 5.5x, a Price/Sales of 1.2x and a Price/Cash Flow of 10.5x in comparison to its Industry Averages of 2.6x Book, 1.8x Sales and 9.0x Cash Flow. It is essential to analyze the current valuation of VECO and check how is trading in relation to its peer group.

At the end of 2011, Veeco had $492 million in cash and equivalents, whereas total liabilities were at $176 million. Its operations have a regular history of positive cash flow production.

AbitibiBowater (ABH)

AbitibiBowater manufactures a wide range of forest products sold in more than 80 countries around the world. Within its customers, there are many of the world's largest publishers, commercial printers, retailers, consumer products companies and building supply outlets. The company is also among the largest recyclers of newspapers and magazines in the world. The sustainability of its forest resources is a key priority: it is an ethical as well as business imperative. Its sustainability certification process is a proof of its engagement to current and future generations of employees, to the communities in which they live and operate, and to investors.

Main features:

  • Net income of $61 million, or $0.63 per diluted share
  • ACH sale was achieved for net proceeds of about $300 million
  • Debt reduction of about $270 million
  • Net debt to equity ratio increased to 11%

The cost for the company's pulp and paper products increased in the second quarter, and it accomplished its major annual maintenance at all its kraft pulp facilities. Although general economic indicators are weak, the company's focus on cost and debt reduction should deliver improved financial results in the second half of the year.

ABH's current net profit margin is 0.86%, currently lower that its 2010 margin of 55.08%. I do not like when companies have lower profit margins than in the past. That could be a reason to analyze why this happened. Its current return on equity is 1.15%, lower than the +20% standard I look for in companies I invest in, and also lower than its 2010 average ROE of 323.12%.

In terms of income and revenue growth, ABH has a 3-year average revenue growth of -11.11%. Its current revenue year-over-year growth is 0.21%, lower than its 2010 revenue growth of 8.70%. I do not like when current revenue growth is less than the past year. It generally shows that business is decelerating for some reason. The current Net Income year-over-year growth is -98.43%.

In terms of Valuation Ratios, ABH is trading at a Price/Book of 0.4x, a Price/Sales of 0.3x and a Price/Cash Flow of 7.4x in comparison to its Industry Averages of 1.3x Book, 0.6x Sales and 5.8x Cash Flow. It is essential to analyze the current valuation of ABH and check how is trading in relation to its peer group.

American Capital (NASDAQ:ACAS)

American Capital Ltd. is a different asset management company headquartered in Bethesda, Maryland that was established in 1986 and publicly traded since 1997. It operates as a Business Development Company, a form of publicly traded private equity firm.

American Capital offers capital to middle market corporations with sales between $10 million and $750 million. The firm, directly as well as through its global asset management business, is an investor in management and employee purchases, private equity purchases and early-stage and mature private and public companies. Before, most of its financing has been to aid in the funding of change of control management buyouts.

American Capital's capacity to fund the whole capital structure is a competitive advantage in completing many middle-market operations. The firm sponsors One-Stop Buyout by funding the whole transaction. Besides, when American Capital decides that it is time to sell a portfolio company, it may choose to provide the buyer with the appropriate debt financing to complement the equity to fund the transaction, an aptitude most of its competitors do not have. Hence, I continue to think that the company's capital flexibility and large deal flow will provide it with excellent investment and exit opportunities from now on.

Throughout the third quarter, American Capital expanded its capital to add important shareholder value. The firm invested $40 million as part of the IPO of its affiliate American Capital Mortgage Investment Corp (NASDAQ:MTGE), which increased the value of the asset management portfolio firm of American Capital. Furthermore, the company invested $72 million in seven current portfolio companies mainly to fund growth and acquisitions. The company continued to see sound liquidity in the portfolio during the quarter and centered on maximizing shareholder value through organic growth and accretive purchases along with originating new, attractive investments.

ACAS's current net profit margin is 164.81%, currently lower that its 2010 margin of 166.33%. I do not like when companies have lower profit margins than in the past. That could be a reason to analyze why this happened. Its current return on equity is 23.67%, higher than the +20% standard I look for in companies I invest in, but lower than its 2010 average ROE of 33.28%.

In terms of income and revenue growth, ACAS has a 3-year average revenue growth of -17.46%. Its current revenue year-over-year growth is -1.50%, higher than its 2010 revenue growth of -13.92%. The fact that revenue increased from last year shows that the business is performing well. The current Net Income year over year growth is -2.40%.

In terms of Valuation Ratios, ACAS is trading at a Price/Book of 0.7x, a Price/Sales of 5.4x and a Price/Cash Flow of 18.2x in comparison to its Industry Averages of 1.5x Book, 2.8x Sales and 11.9x Cash Flow. It is essential to analyze the current valuation of ACAS and check how is trading in relation to its peer group.

As regards Valuation, American Capital shares presently trade at 8.8x its 2011 earnings calculation, a 21% discount to the industry average of 11.2x. On a price-to-book basis, the shares trade at 0.6x, a 40% discount to the industry average of 1.0x. The valuation on a price-to-book basis seems reasonable considering a trailing 12- month ROE of 7.0%, which is over the negative industry average.

Capital One Financial Corp (NYSE:COF)

Based in McLean, Virginia, Capital One Financial Corporation is a diversified banking firm centered mainly on consumer and commercial lending and deposit origination. By means of its banking and non-banking subsidiaries, Capital One offers several financial products and services to consumers, small businesses and commercial clients in the United States.

The company posts the results of its business through three operating segments:

  • Credit Card (61%)
  • Commercial Banking (10%)
  • Consumer Banking (29%)

Even though Capital One has commercial lending concentrations in the New York metropolitan area and Louisiana, it keeps a geographically diversified loan portfolio. Besides, its purchases involve entry into new geographic markets. I believe the absence of geographical concentration diminished the operating risk for the company.

Basically, Capital One remained solid with regards to its banking and credit card businesses. In spite of an increasingly competitive deposit market, total customer deposits increased 5% year over year to $128.3 billion in 2011, driven by growth in branch and direct deposits. U.S. Card keeps delivering strong returns on a risk-adjusted basis, with constant expansion in revenue. To boost even further its card business, in August 2011, Capital One disclosed an agreement to purchase HSBC Holdings Plc's U.S. credit card business. I estimate the combined entity will create a valuable banking franchise to profit from a large number of branch banking in attractive high-growth markets.

COF's current net profit margin is 19.17%, currently higher that its 2010 margin of 16.96%. I like companies that increased profit margins in comparison to other years. It is essential to know the reason why that happened. Its current return on equity is 11.11%, lower than the +20% standard I look for in companies I invest in, but higher than its 2010 average ROE of 10.33%.

In terms of income and revenue growth, COF has a 3-year average revenue growth of 5.43%. Its current revenue year-over-year growth is 0.67%, lower than its 2010 revenue growth of 24.56%. I do not like when current revenue growth is less than the past year. It generally shows that the business is decelerating for some reason. The current Net Income year over year growth is 14.73%, lower than its 2010 Net Income y/y growth of 210.29%. I do not like when current net income growth is less than in the past year. I look for companies that increase both profits and revenues.

In terms of Valuation Ratios, COF is trading at a Price/Book of 0.9x, a Price/Sales of 1.6x and a Price/Cash Flow of 3.4x in comparison to its Industry Averages of 2.4x Book, 3.2x Sales and 7.8x Cash Flow. It is essential to analyze the current valuation of COF and check how is trading in relation to its peer group.

Regarding Valuation, Capital One presently trades at 9.4x its earnings assessment for 2012, 3% discount to the industry average of 9.7x. On a price-to-book basis, the shares trade at 0.8x, which is 47% discount to the 1.5x for the industry average. The valuation on a price-to-book basis seems appealing, considering a positive trailing 12- month ROE in comparison with the negative industry average.

Capital One is a well-reserved and well-capitalized company. I believe there is a very low probability of financial distress.

Source: 5 Low P/E Stock Picks By John Paulson