4 Undervalued Stocks: We Like These In An Overbought Stock Market

Includes: AA, AAPL, BA, FCX
by: Brian Gilmartin, CFA

If there is one "theme" missing in today's headlines it is that - for all practical purposes - better times could lie ahead, since the asset bubbles that existed in the late 1990s have mostly been punctured. One could also say that most asset classes today, with the possible notable exception of Treasuries, are pretty modestly valued, yet everyone still thinks Armageddon is just around the corner, and the S&P 500 is headed back to 800.

Just like no one seemed to (or could) predict the last 12 years of market malaise and panic the last 12 years, to think (as Jeff Miller, the author of A Dash of Insight so finely puts it) that we could actually see a period where things go right for a while, seems as distant and unlikely, as did a decade gold rally and the collapse of "risk on" for 12 years seemed in March 2000.

I continue to be surprised as how bearish the pundits get in today's market, with last week's surge in the VIX and the notable rise in pessimism being a prime example.

Although the S&P 500 is thought to be overbought, it has worked off part of its overbought status the last few weeks with short, sharp downside corrections, only to quickly find a bid again, and we think the reason for this is the general malaise and pessimism around stock market investing and potential returns for equities as an asset class.

However, one way we combat the downside price risk of picking individual securities in client accounts is that we look for technically oversold stocks that are fundamentally cheap on a valuation basis, and then wait for a catalyst to break them out of their trading range.

The point being that we hope that buying beaten-down, value-oriented stocks in what looks to be an overbought market will limit downside risk in client accounts, should we get a 10%, 15% or 20% correction as we did in 2010, 2011 and for a brief period in 2012.

Here is a list of stocks that have made our shopping list of late:

Boeing (NYSE:BA): BA is the largest component of the Aerospace and Defense sector, which is about 20% of the Industrial sector within the S&P 500. The battery issues around the 787 are real headline risk, but we love how the stock has acted since the issue broke.

Fundamentals: Even with the 787 issues and fewer deliveries expected in 2013, BA's 2013 non-GAAP earnings per share (EPS) estimate rose from $5.88 to 2012 to an expected $6.44 in 2013 (per ThomsonReuters), leaving the stock currently trading at 12(x) EPS for what could be (after adjusting for GAAP to non-GAAP) ab out 10% EPS growth in 2013:

Valuation: At 8(x) cash-flow and 11(x) free-cash-flow, not to mention the 0.70(x) price-to-sales, BA is (we think) a cheap stock with a lot of bad news baked into it. Operating cash flow was $2 billion better than expected in 2012, which is a nice cushion.

Technicals: A breakout above $78 and then $80 would be a huge positive for BA. The stock hit $107 per share in 2007 and seems to see "PE expansion" when the operating margin expands toward 10%, which is currently 7.5%. The stock could first pull back to under $75 though. A trade below $72.50 and it probably isn't going anywhere for a while.

Fair value: Our internal model values BA between $110 - $115 per share, while Morningstar values BA closer to $80. Split the difference and you get $95. Ultimately with better growth across the globe, I think the stock takes out the '07 high of $107.

Freeport Copper (NYSE:FCX): One of the larger components of the Basic Materials group, which is 3% of the S&P 500 by market cap, Freeport Copper is trading at the lower end of its 2010, 2011 and 2012 trading range.

Fundamentals: EPS fell 30% in 2012 but is expected to rise 30% in 2013 on 20% revenue growth this year. Copper is the primary catalyst for earnings delta, and looking at a 1-year chart of copper, I would NOT like to see copper fall below $3.30, currently trading at $3.50. Copper as a metal has traditionally fared well when China has grown at healthy rate of GDP.

Valuation: At 7(x) 2013 EPS, 8(x) cash-flow and with a 3.5% dividend yield, there is a lot to like about FCX at these prices, if you can be patient. There is one caveat: the announced acquisition of Plains Exploration (NYSE:PXP) and McMoran Exploration (NYSE:MMR) by Freeport was not well received by investors. A portfolio manager at BlackRock that owned a big chunk of the common just vilified the December 5th, 2012 acquisitions, with a lot of company from other investors. The acquisition is set to close in the 2nd quarter, 2013.

The acquisition put the end to any dividend hikes and share repurchases until at least 2015.

Technicals: The 2010 low of $28.35 would be our line in the sand for stop-losses, for those who want to start edging in here to the long side. The unpopularity of this seemingly strange multi-company acquisition by FCX could drive the stock price below the 2010 lows.

Fair Value: Our internal model values FCX at $44, while Morningstar values FCX at $34.

FCX even with the unpopular merger, FCX should trade back into the high $30s at some point, or even the low $40s, if copper doesn't collapse, and if management doesn't cut the dividend. The cash-flow generation is a nice cushion too.

Alcoa (NYSE:AA): Just when we thought the price of aluminum would break out of its recent range, instead in the last month the price per pound has fallen from $0.95 to $0.89 looking at the chart's courtesy of InvestmentMine.com.

Alcoa has hurt our performance the last few years, up just about 1/2 of 1% in 2012, and down a whole lot in 2010 and 2011.

Fundamentals: EPS fell 67% on a drop in revenues of 4% in calendar 2012. So far, 2013 consensus estimates are looking for 4% revenue growth and 168% EPS growth, which seems like a lot but isn't. The issue in Q4 '12 was or is that the aluminum spot curve is resulting in dealers holding inventory and thus there continues to be an excess supply of aluminum, relative to demand.

Valuation: AA is still trading at a 15% discount to tangible book value of $9.71 per share, and is the reason we still hold the stock. Could the company be broken up? Hard to say, but I wonder if they shouldn't take it private ala DELL.

Fair value: Our internal model values AA at $14.90 per share, while Morningstar puts a $19 value on the stock. Very frustrating long.

Technicals: The stock could trade back down to $8 before another bounce. If the price of aluminum traded above $1.20 - $1.25 I think the stock could trade above $11.75, and be a longer-term break out.

Apple (NASDAQ:AAPL): So much is written about AAPL, I hesitate to write about it publicly to anyone but clients.

However, the company is lapping two of its strongest quarters in company history with the Dec '12 quarter and now the March '13 quarter, thus "comp's" get easier as we move through 2013.

Fundamentals: 2013 revenue and EPS growth this year is expected to be 17% and 3% respectively, AAPL's slowest in years. The revenue and earnings growth rates are now "mid-teens" for revenues and EPS going forward, which makes AAPL just a normal growth company / stock.

Valuation: At 5(x) cash-flow, ex the large balance sheet stake, that is really all you need to know about AAPL. It is as cheap or cheaper than INTC here. The PE ratio is 11(x) the 2013 EPS estimate of $45 per share.

Fair value: our internal model puts a fair value on AAPL of $525, Morningstar values AAPL at $600.

Technicals: Here is the key - a drop to $425 fills the outstanding gap from the January 2012 earnings report. A high volume downside move through $425 and the stock is broken. AAPL is as oversold on the weekly chart today as it was in the late fall of 2008. We'll be nibbling in the $425 area.

One last fundamental point: \We do extensive fundamental homework on our holdings. While AAPL printed $44.15 in fiscal 2012 EPS, they in fact printed $53.65 in operating cash-flow per share (OCFPS). By the December quarter, AAPL's operating cash-flow per share was $59.89 or $60.

The quality of AAPL's earnings is actually improving as the "four quarter trailing cash-flow" is now covering its "four quarter trailing net income" by a larger and larger amount, 136% as of December, 2012, versus 84% in December, 2010, despite capex as a % of revenues growing from 3% to 6%.

I would prefer to see a sizable stock buyback than a dividend, but that opinion is in the minority in terms of those opining on AAPL's capital allocation of that gigantic cash hoard.

To conclude, we think these four stocks are undervalued and could move substantially higher in a "things can actually go right" market. If I were to rank the holdings from our top-to-bottom preference:

1.) Boeing

2.) Apple

3.) Freeport

4) Alcoa

Basic Materials has gotten hammered this year and is the most oversold of the 10 S&P 500 sectors. Two of the names of the four are from the Basic Mat sector. We think the group could rally into year-end 2013.

We have more names within the retail and technology space, but these will do for now.

Disclosure: I am long BA, AA, AAPL, INTC. 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.