The best part about investing in good companies at cheap stock valuations is that any small positive change to the company's outlook on future business prospects can lead to a substantial gap higher in the stock's price. To be sure, patient long term value investors do get stuck with losers at times, but taking a fairly diversified and conservative approach (and hedging risks at times like these) can help investors to make better money management decisions and can allow for buying shares of good companies at their cheapest valuations.
Just as Graham bought stocks in "baskets", so too can the conservative value investor today. Just because a stock is cheap does not mean it will make a wise investment decision, however, valuation is the foremost indicator of future results when looking for long term winners in the stock market. With that said, purchasing good stocks of well researched, low P/E and low price to free cash flow ratios stocks in a long only portfolio will make money over the long term.
Aside from finding special situation investments in asset plays or undervalued companies that are true high growth stocks with low PEG ratios, investing in cheap mid and large cap stocks with low P/E ratios is a strong investment strategy. Remember, a good investor manages the downside as much as the potential upside. If you are invested in the stock market, it pays to buy insurance against your risks in the form of hedging at certain times, which I will discuss in more detail at a later date.
The overall stock markets at current levels are not overly attractive on a valuation basis because of the CAPE and Tobin's Q ratio on the overall market, which on the whole are not discussed in the financial media to any large degree and are arguably very important factors when making investment decisions as stocks go up and down generally at the same times in the markets. It pays to do your homework, to own 20 plus names at a minimum, and to add on selloffs if the fundamental story has not changed.
It also pays to have hedged positions via index fund puts, short positions, etc. when markets become overly exuberant. In this way, investors can buy at prices much lower as a tiny starting position (tracking position) falls 50%, for example. When a stock of a good company crashes for no good reason to a valuation low point and a prudent value investor can buy a stock at 6X trailing earnings instead of 9X training earnings, as an example, the investor has a higher margin of safety for adding to his or her position, possibly taking the position from a 1% holding to a 3% position for his or her overall portfolio if the stock gets cheap enough.
In essence, if you think the market could become weak, hedging can allow you to take advantage of panic selling, weak hands exiting a concentrated stock position, and adding to positions in companies involved in large share repurchases whose stock is dropping from pessimism and not from fundamental business weakness. Here are eleven cheap names to keep on your radar screen, or if you are like me, to keep in your basket of stocks for nice 1-3% notional positions based on selling a Leap Jan 2012 put option, and in my case, always studying the market for hedging opportunities on the short side. When a fifty cent dollar falls to twenty cents and the dollar itself is still growing, you as an investor need to buy more, not sell.
The following list is not a buy recommendation, just a list of stocks with forward P/E multiples under 10X with good business prospects and solid long term growth characteristics. Each of these businesses carries with it slightly higher risks than many of the old guard stalwart companies, which in my view, means they should trade for 11-13 times historical earnings, provided that these companies can grow earnings over the next decade by a 3% or higher level.
At less than 10X earnings, stocks can represent solid bargains with the potential for significant long term capital gains if they have a decent growth rate. If profit margins, which are at all time highs for S&P companies, start to revert toward a lower mean, then S&P 500 companies, and possibly the following businesses, could see profits actually decline in future years which puts our value buys at risk of temporary impairment, or in some cases, permanent capital loss. It pays to do your homework and to buy things when they get truly cheap while keeping a long term focus on your investments.
RIMM -- RIMM was absolutely destroyed after the recent quarterly earnings release and the shares were skewered from $68 or so before the call to $53 or so Tuesday, making shares interesting to the skeptical value investor. RIMM is trading for around 7.5X forward earnings and has exhibited incredible growth over the past five years.
AZN -- Astrazeneca shares are looking rather cheap at current levels. The company trades for a whopping 8.86 times trailing earnings and for 7.91 times forward earnings with a ridiculous 7.5% dividend yield. Astrazenca is a new watch list member and portfolio candidate for a core 4% position.
GILD -- Gilead Sciences shares have rallied substantially from my initial interest point in the low $30's, but shares at $41.70 are still cheap (which is what we care about as investors, cheap with a solid business) at 9.14X forward earnings with a solid long term growth rate with high operating margins and strong industry position.
GD -- General Dynamics has been crushed recently on defense spending cut fears, but I would be more concerned if I was one of the bigger suppliers of NSA software or support services such as general contractors, etc. GD is trading for only 9.4X forward earnings and for 10.56X trailing earnings.
HPQ -- Hewlitt Packard continues to look relatively attractive with a large free cash flow yield and a forward P/E of only 7.5X earnings. HPQ covered calls can yield monthly returns of 2%, so investors should look to sell at the money calls against their stock positions in this name.
INTC -- Intel covered calls look appealing as well. INTC trades for just 9X forward and 9.9X trailing earnings. Price to free cash flow is even lower and I believe that the tablet market will not replace the laptop market because people need a keyboard and prefer a bigger screen. Both HPQ and INTC benefit from laptop sales and with prices coming down, unit volume may continue to increase.
MSFT -- Microsoft has not quite found a way to mass market a top of the line open source office product just yet, but I think such a product for a slightly lower price point is likely coming soon to MSFT. Microsoft trades for just 9X forward earnings while maintaining a large cash balance and a healthy dividend. Investors should consider selling the front month call options against MSFT stock holdings (the May $26 calls look rewarding for example) or selling the January 2012 $25 put options as an alternative to tying up capital in the stock.
JASO -- JA Solar is getting hammered still, and investors who stuck with a short put option or covered call option play in the name have likely broke even on their investments over the past six months, while they own the stock at a 15% better valuation. Look to buy the stock and sell the January 2012 $6 call options against the name or to sell the January 2012 $6 put options on the stock as a way to scale into a position at $5.45 per share. JASO has a P/E ratio of 3.99 and a forward P/E of 4X.
BBY -- Best Buy shares are starting to look like a good buy, and investors who want to have some covered call protection (as well they should) for insurance purposes can sell the September $30 calls against this.
STO -- Statoil has rallied significantly in recent months, but the shares are still a bargain at 8.5X forward earnings. A 3.6% dividend yield helps to make shares look cheap and investors can sell the October $30 call options for $1.5 for a bit of added margin of safety on this stock.
TOT -- Total is a must own name on this list because although shares have rallied, TOT is trading at only 8.89X trailing earnings and just 7.88X forward earnings estimates. TOT offers a 4.4% dividend yield -- the May $60 calls last traded for $1.55 per contract, which is not all that interesting, but does provide a bit of a cushion and a 2% or so max monthly return with the dividend. Personally, I think this one is a good buy and forget candidate.