I recently wrote an article on The Fool.com where I argued that equities will continue to rise this year. In short, my argument rested on the fact that the Fed has committed to an easy monetary policy through 2014. Additionally, tail risks out of a Eurozone break up, a US fiscal disaster, and a Chinese hard landing have been mitigated in the past year. Lastly, US equities remain cheap on a historical and relative basis. I concluded my article by presenting some very broad stroke recommendations on how to play this theory, and some hedging possibilities.
However, I think we can easily identify a few stocks that still have strong upside. Most investors mitigate risk of "stock picking" by buying the SPY. However, I think this method has many flaws. Joel Greenblat points out (You Can Be a Stock Market Genius, p. 21) that holding 6-8 stocks in different industries eliminates the risk of holding of one stock by 81%, but holding 32 stocks eliminates 96% of the risk. Meaning, the benefits of diversification decrease dramatically as investors diversify beyond owning 6-8 stocks. Additionally, by increasing your diversification, you lose out on the upside of many potential "winners." In this article, I will try to build a portfolio of "winners" by surveying what seem to me as obviously cheap stocks.
In order to find the winners, we will use a "cheapness" analysis based on simple "statistical methods" -- price to book discount, low p/e, etc. I think we can make some uncontroversial observations employing this method. Considering this article will function as more of a survey, I will not have the opportunity to dive deeply into each stock discussed. However, I think I can identify some glaringly cheap stocks most of which have not recovered from some perceived risk that I will identify and try to show why it does not exist. I will now go through each stock, sector by sector, and identify the stocks I view as cheap.
The US currently has four big banks -- Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Bank of America (NYSE:BAC). One easy measurement to value banks is price to book (p/b) ratio -- i.e. assets (tangible) less liabilities. Using this measurement we find, C with a p/b of .5 is the cheapest. Meaning, if you liquidated all of C assets and paid off all liabilities, you would double your money. A main reason for this has been because of Citi's difficulties during the financial crisis. Seemingly, the market has not forgiven them since that period, and has failed to pick up on a few major pieces of news. First, C has the highest Tier 1 capital ratio of all the "big banks". Second, Citi is uniquely positioned to profit in a global economy -- it has a much stronger international franchise than any of the other big banks. In fact, nearly 2/3's of its revenue and profit comes from internationally, whereas JPM and BAC generate less than 1/5 of revenue overseas, and WFC generates none. In short, Citi makes for an attractive investment because of its strong turnaround since 2008, and leading global position.
When BP (NYSE:BP) suffered the deep horizon rig explosion in April 2010, its stock plummeted. Amazingly, even after all this time, the stock has not recovered to comparable levels to its peers. Energy companies disclose something called the PV-10 in their annual reports. PV-10 takes the present value of the reserves and discounts them at 10% -- giving investors a pretty clear picture on the present value of the company's cash. Using this measurement, BP trades at par with its current PV-10. However, the other oil majors -- Exxon (NYSE:XOM), Chevron (NYSE:CVX), Royal Dutch Shell (NYSE:RDS.A), and Total (NYSE:TOT) -- all trade at significant premiums to PV-10, averaging about 2x current PV-10's. BP has settled its government litigation, and while it still has pending civil litigation, its $90bn in current assets and $20bn in cash should more than cover any lingering issues. Lastly, the PV-10 numbers mentioned above do not take into account BP's significant divestitures from last year, where it shored up its balance sheet to deal with lingering litigation issues. However, even considering this BP still trades at a significant discount to its peers on a PV-10 and NAV discount metric.
I find it sort of humorous to see what the market has done to Apple (NASDAQ:AAPL) over the past 4-5 months. Once the darling of Wall St. with seemingly ever-higher Wall Street price targets, all of sudden, Apple has found itself in a position where no one has confidence in the company. Let's take a step back for a moment, and try to find some redeeming qualities to this aging giant. AAPL currently has $170bn in cash, again $170bn in cash, it trades at 10x p/e, less than gangly Microsoft (NASDAQ:MSFT), and has probably one of the strongest consumer product franchises in the history of the world. I truly do not understand given these facts, how AAPL does not scream buy to any potential investor.
When evaluating pharmaceutical stocks we must pay extremely close attention to a company's "patented revenue" -- how much revenue will a company generate from a patent -- a monopoly. Using this measurement, AstraZeneca (NYSE:AZN) has the most patented revenue of any of the large pharmaceutical companies. AZN generates huge amounts of revenue from three sources -- Crestor ($6bn), Nexium ($4.5bn), and Symbicort ($3.6bn) all of which have patent protection through the end of this year and into 2016. All told, AZN has about $20bn in PV terms, higher than any of the pharma majors, scheduled to flow into company coffers over the next four years. Additionally, it pays a nearly 6% dividend, the highest amongst its peers, yet, it trades at 9x p/e, by far the lowest amongst its peers. It seems that the pharma industry has a lot of confusion swirling around it, which companies have problems with the "patent cliff", and which find themselves in safer waters. For some reason, investors have thrown the baby out with the bathwater, and have not realized AZN's relative lack of exposure to the patent cliff, and its strong future growth prospects.
Warren Buffett has amassed a truly extraordinary record at Berkshire Hathaway (NYSE:BRK.A). Over the course of his storied 50-year career, he has racked up 20% compounded annual returns. He has done this by amassing a motley crew of wholly owned companies, principally in the insurance business, but also in a wide range of other areas (most notably Burlington Northern Santa Fe Railroad and MidAmerican Energy Holdings). In addition to these wholly-owned businesses, he has amassed a huge stock portfolio with four core holdings -- Wells Fargo, IBM (NYSE:IBM), Coca-Cola (NYSE:KO), and American Express (NYSE:AXP). The cash flow from these companies gives BRK $1bn of capital it have to put to work on a monthly basis. Despite the irreplaceable nature of the businesses, and manager, the stock has not risen in accordance with its earnings.
Historically, BRK has not bought into its own shares, instead using its capital to buy other businesses. However, in recognition of the cheapness of its own stock, BRK has started buying into its shares. Most recently, late last year BRK bought $1.2bn of its own shares at a 20% premium to book value. This, too, represented a break from the boards original authorization to only buy shares at a 10% premium to book value. This tells us two very important pieces of information -- BRK has so much cash and limited M&A opportunities. These factors have forced it to look at its own stock, which because of its low price represents a good deal for BRK. Continued flows into its own stock, should send its stock higher and higher.
Before I turn to my next stock, a word about BRK's cheapness. Conventional wisdom amongst investors has been that BRK has lost its value because Mr. Buffett is 81 years old, won't live forever, and his replacement might be lacking. This is patently absurd. To quote Mr. Buffett's partner Charlie Munger, Mr. Buffett has one of the best decision making records when it comes to investing, do you think he will make a mistake when it comes to one of the most important of his career? Obviously not. BRK remains a strong value because of the underlying cheapness and BRK's willingness to put its own cash to work to buy back its own stock.
Here, I have a bit of an obscure pick -- Caplease (NYSE:LSE). LSE owns a portfolio of 12mm square feet of mostly net leased (that is tenant responsible for all expenses) to credit tenants across the country. This portfolio is valued at $1.7bn before depreciation. Caplease trades at 6x annualized 2012 FFO, a significant discount from its peers in the small cap net lease space, which trade around 14x annualized 2012 FFO. This discount reflects market concerns related to confusion regarding exact business strategy, high debt level, and low dividend payment. The most significant of these concerns relates to LSE's debt ratio, which stands significantly higher than its peers. Relating to this issue specifically, I believe LSE has control of its debt issues because it have financed its debt with long term, fixed rates, which gives them flexibility to weather difficult credit conditions. I am truly at a loss to fully explain its heavy discount relative to peers, and have an extremely strong conviction on the stock. You can see my article on this stock here.
The 6 stocks mentioned (C, BP, AZN, AAPL, BRK, LSE) trade at a discount because of some lingering, overblown, headline risk in most cases, and because of investor skepticism of consumer electronics companies in AAPL's case. As I tried to lay out in brief above, I think these concerns have either been blown out of proportion or are products of investors imaginations. Additionally, considering the overall positive outlook for equities, I think investors could see nice alpha holding these stocks as opposed to a broad based index fund.
However, some might remain skeptical over the arguments I made above, because of the underlying weakness in the US economy. Last quarter the US economy contracted by -0.1%, the first contraction in a long time. The economy probably won't grow much faster than 2.5% this year, a long ways away from the 3.5-4% growth the economy needs to really take off. Additionally, the Fed's loose monetary policy leaves us with significant inflation risks. Therefore, in addition to the above, I would recommend the following hedges. First, as I argued above, I don't think investors will flock to bonds or cash in the event of a continued downturn. However, TIPS and gold could both offer investors very nice protection in the event of a continued downdraft in the US economy. TIPS, especially, with the potential for capital appreciation and yield could serve investors nicely in hedging its overall portfolio.
Lastly, the threat of a nuclear Iran still casts a shadow on geopolitics. More to the point, a total lockdown of Iranian oil flows, and/or the halting of transports along the Straits of Hormuz remain a primary worry of investors. Though I think ultimately the world can pick up the slack in the event of an Iranian conflict, we must take this issue into consideration.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.