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Buying cheap stocks hasn't been a recipe for success of late, especially if the stocks are cyclical. For smaller stocks, it's been a disaster generally, as mutual fund outflows have kept pressure on many of the names in the sector. I think that we are likely at an inflection point. This past weekend, I shared my bullish views, suggesting that a slight lift in prices could trigger a move to new highs. The pre-July 4th fireworks have pushed us through the key resistance I cited, and I expect the summer rally, which began in June, to pick up speed. With this in mind, I set up a screen for deep value names, as I expect that they could benefit greatly from "catch up".

There are many ways to slice and dice the universe of stocks to find companies carrying very low valuations. I don't pretend to have the magic bullet, but I like to use Enterprise Value relative to Earnings Before Interest, Depreciation and Amortization (EV/EBITDA) as a primary measure rather than just PE. Enterprise Value, in case you aren't familiar with the concept, is Market Cap (price * number of shares) plus Debt less Cash. It's theoretically how much money you would have to pay to buy a whole company.

It's the topic for a different article, but there are many challenges to this metric because it doesn't take into account non-debt (but significant) liabilities, it's backwards looking, and it penalizes debt only in linear fashion. With those caveats, I set up a screen using Baseline to try to find low EV/EBITDA names but enhanced the screen to try to avoid value traps. Here is what I did:

  • Universe = Russell 3000
  • EV/EBITDA < 5
  • Net Debt to Capital < 0
  • 1-Year EPS Growth > 0
  • Total Liablities / Equity < 2X
  • CapEx / Sales < 8%
  • Forward EBITDA Growth > -15%

All of these tweaks are designed to help find cheap cashflows that aren't going away. There were 20 stocks that made the cut:

(click to enlarge)

20 may sound like a lot, but had I just run "EV/EBITDA < 5X", over 10% (more than 300 companies) made the cut. I have highlighted a few columns. First, I have in red the stocks that have been really beaten up this year, while I marked in green two names that have done well (yet remain cheap). I also highlighted four names trading at or below tangible book value. Again, a whole book could be written about the challenges to this metric. Next, I highlighted projected declines in EPS for calendar 2012 - several substantial cuts. Finally, I highlighted in green the companies whose Total Liabilities are less than half of the equity.

While many of these companies probably merit further attention, here are the six that jump out to me:

I have looked at a few of those I am not highlighting. Contango (MCF) is a great stock for those bullish on natural gas. The company has no sell-side coverage. MCF has a good record of shareholder value creation with its asset-lite strategy. LB Foster (FSTR) has a new CEO who joined out of industry and a large, unresolved product liability issue. CSS Industries (CSS) seems like a business that doesn't have a great future, though I like the reasonably high insider ownership (11.5%).

I have been burned by LTL trucker ABFS in the past. It was supposed to benefit from a competitor going under, but YRC (YRCW) managed to hang on. The company also has expensive union labor and pension issues. With that said, the stock still looks quite cheap. with about $4 per share of cash net of debt.

DRIV has been a real laggard. The company could benefit this year from the Microsoft Windows 8 rollout, but it could also hurt their near-term results by creating a delay in purchasing. The company, which hosts e-commerce websites for a percentage of the revenue, has strength in security and local taxation. I wonder about the move to apps away from the web being a big obstacle, but the company claims to be transitioning. This is one I hold (cautiously) in my Top 20 Model Portfolio. There is a lot of cash net of convertible debt and deferred revenue. While the growth isn't there, I believe that they have unique assets. George Soros (Soros Fund Management) recently increased his holdings to >10%.

HURC is one I don't know too well. There is 8% insider ownership at this computerized machine tools maker (mills and lathes). For a small company, it's very global. Clearly its 62% exposure to Europe is what's creating the low valuation. Cash net of debt is about $6 per share. There are just two analysts. The stock has a low PE, trading at TBV as well.

TECD is another one in my model (since 12/2010). This company's valuation blows me away. I have followed it for more than a decade. The major negative is that more than half the business is in Europe. The balance sheet is a bit expanded here - lots of inventory and receivables as well as payables. Why? The company acts almost like a bank to its VAR customers. Still, the company didn't have any issues with collections or obsolescence in the 2000-2002 downturn or more recently during the financial crisis. This company has been buying back stock and has said it won't pay a dividend. Too bad, as that would be a potential catalyst in my view. For a cheap stock, as it is, it's also a good chart in my view.

I didn't know PLUS at all until running this screen. The stock is up nicely in 2012 and looks like a growth stock more than a value stock, with earnings rising and price following. In fact, it has tripled since its IPO in 2007. PLUS has about $4 per share in cash net of debt. The company sells technology products and also operates an equipment leasing business. The 67-year old CEO, Phil Norton, owns about 27% of the company.

Finally, MW is the most expensive of the cheap stocks, but I think its quite attractive after getting slammed on its recent Q1 earnings release. The estimates came down only slightly, and the company is growing nicely still. More recently, the long-time CFO announced that he is leaving to take another job. The company has North American exposure and is doing a nice job of making its offerings more appealing to younger customers as well as more casual. I have followed this one for years and think very highly of their management team. 10PE, not incorporating the $2 per share in cash, is about as low as this one has ever been.

As I said at the beginning, the market is flooded with cheap. If the environment is improving, investors may become more interested in cheap stocks with some cyclical exposure rather than companies with less cyclicality or perhaps more secular growth. The 20 stocks that made the cut have strong balance sheets. While I have highlighted a few that stand out, some of the others may be bargains as well.

Source: Deep-Value Dive: 6 Super-Cheap Stocks

Additional disclosure: DRIV and TECD are in one or more models managed by the author at InvestByModel.com