The 3 Cheapest Stocks In The S&P 500

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Includes: FCX, MU, SPY, WRK
by: The Meticulous Investor
Summary

I have screened the S&P 500 for the three cheapest stocks on a P/E basis with positive earnings.

The stocks I found are all available for less than 6x P/E and two of them have decent dividend yields of 1.7% or greater.

Value investing yields great results over the long term, but any stock can be extremely volatile. Investors should invest in the stocks that match their time horizon and risk tolerance.

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Finding Value in the S&P 500

Call me old fashioned, but I am still a believer in value investing. The prospect of buying assets at a discount to fair value has always struck me as straight forward and obvious. There is a catch, though. The assessment of value needs to be somewhat correct or you risk overpaying. Avoiding value traps or stocks that depreciate in value over time is key.

There are many ways to skin a cat, but one solid way to identify stocks that could be selling for a discount to fair value is to screen trading for cheap valuation multiples relative to the market. Generally speaking, the market is the S&P 500 (SPY) which currently trades for 19.8x trailing P/E.

In this exercise, I used Capital IQ to run a screen for the cheapest stocks in the S&P 500 by trailing P/E. After throwing out the companies with no earnings or negative earnings, I chose to take a close look at the three cheapest stocks to determine if they are good investments. I will start in descending order from most expensive to least expensive.

A Quick Note on Screening for Value Using P/E

I chose to conduct my analysis by focusing on the trailing P/E multiple. Trailing P/E is a good apples to apples comparison of stocks to each other and to the index. However, trailing P/E has some limitations.

The biggest limitation is its focus on historical earnings as opposed to forward earnings which are more relevant to a stock's future performance. Many stocks appear cheap on a P/E basis simply because their future earnings are expected to decline. This is well understood, however, low P/E multiples often reflect pessimism that is overly discounted, resulting in a buying opportunity.

A second drawback to using P/E is that it doesn't do a good job accounting for different capital structures. For example, a stock could have a low P/E because it has very high debt levels or a high P/E because it has very high cash levels. My advice is to corroborate P/E multiples with enterprise value multiples that do account for balance sheet items.

Finally, P/E multiples do not account for companies that are not profitable according to GAAP. Some of these companies may actually be quite cheap on a tangible asset basis or may be cash flow positive. Again, I would recommend using multiple ways to screen for value. No single metric is perfect. As long as you understand what you are looking for (cheap stocks), a careful value screen could turn up interesting results.

1. WestRock Company at 5.3x P/E

WestRock (WRK) is a packaging company which primarily produces corrugated packaging (cardboard boxes for shipping goods) and cardboard packaging for consumer goods. Packaging companies are closely tied to the macro economy because more packages need to be boxed and shipped when economic activity is high. In recent years, the packaging industry has benefited from a strong economy and increased e-commerce activity. The growth in e-commerce is a long-term tailwind that will continue to support corrugated packaging companies like WestRock well into the future.

Source: finviz.com

WestRock's stock price is down over 40% from its high of approximately $70 a year ago. However, this isn't just a WRK issue, most of the other large packaging companies are down in similar fashion. This can largely be traced to concerns that the economy is slowing. Investors should be relieved that nothing appears to be broken at WestRock specifically.

The above table shows WestRock's financial performance over the past 9 years. The company has steadily grown revenue, profit margins, and dividends per share. WRK has grown organically and through M&A. The company completed major acquisitions in 2011, 2015, and 2018. In November, the company completed the $5 billion acquisition of rival KapStone. The acquisitions have all been of other packaging companies which have enhanced WestRock's scale, helping to improve profit margins over time through synergies.

However, M&A has also left the balance sheet with $5.8 billion in net debt. Net leverage (pro-forma for the acquired company) is around 1.6x which is very manageable even if we do head into a recession and financial performance suffers. Overall, I believe WestRock's fundamentals are strong and the balance sheet is healthy enough to not worry about.

There is an interesting discrepancy between trailing P/E and forward P/E. The culprit is a one-time tax benefit of $874.5 million realized in 2018. Normalizing valuation multiples is an important aspect to value investing. I believe the forward multiple of 8.8x to be reflective of "normalized" earnings.

At just 8.8x forward P/E, WestRock's valuation is extremely cheap and already appears to be discounting a recession hitting the financials. Therefore, if economic conditions do not deteriorate, I would expect WRK's stock to rally. The 4.7% dividend yield makes the stock even more attractive. Based on the financials, the dividend is extremely safe and should continue increasing over time.

2. Freeport-McMoRan at 5.3x P/E

Freeport-McMoRan (FCX) is primarily a copper mining company but also produces gold and molybdenum. The company has a storied history as a large public company. As you can see from the chart below, the stock has had a wild ride.

Source: finviz.com

Most of the problems of the past are in the past. The most notable issue was when FCX acquired oil and gas assets in a series of transactions between 2012 and 2013. The company accumulated net debt of $20 billion and when the oil markets rolled over in 2014, net leverage at the company spiked to over 5x. The company has divested its oil and gas assets and has almost fully de-levered. Today FCX carries less than 1 turn of net leverage.

FCX's stock has remained under pressure, declining over 40% in the past year. Two issues dominate investor concerns: the price of copper and the transition from open pit mining to underground mining at the company's largest operating copper mine in Indonesia.

The price of copper is primarily influenced by global macroeconomic conditions influencing demand. Copper is used in a wide variety of end-markets but the most notable one is wiring for buildings driven by construction. Construction is highly cyclical. Much of the world's construction activity occurs in developing markets which have seen their economic growth slow. China is a large consumer of copper and indications show that China's economy is slowing. The U.S.-China trade war has exacerbated the issue, causing the price of copper to decline further. If macroeconomic conditions improve, then the price of copper will improve; however, predicting the price of copper is a nearly impossible task. To illustrate just how sensitive the company is to the price of copper, every 10 cent move in the price translates to $325 million in EBITDA.

Source: finviz.com

2019 will be a transitory year where copper production temporarily declines while the company shifts production to a new underground mine. The new mine will be fully operational by 2020. This will translate to an earnings decline in 2019, which could hit the stock. However, the earnings decline is likely already priced in due to how well the shift has been broadcasted by management.

The table above shows financial performance at FCX over the past 9 years. Performance has been choppy due to the ill-conceived oil and gas investments in 2012/2013 followed by their divestiture in 2015. The fluctuating price of copper also creates volatility in revenue and margins. However, in its current state, the company has a healthy balance sheet and is producing solid free cash flow. Cash flow was even positive when the price of copper was much lower in 2016. This leads me to believe that the company will be fine even if we head into a global recession this year.

Net income converts to free cash flow at a high rate, which is a very good sign of earnings quality. The company reintroduced the dividend this past year, which is a sign that management is confident in earnings power. The dividend has plenty of room to grow given the low payout ratio. However, the company will be cash strapped in 2019 during its copper mine transition.

Earnings are temporarily expected to decline as much as 25% in 2019 due to the transition to the new copper mine. However, at 5.2x forward EV/EBIT and 7x forward P/E, the stock is extremely cheap and seemingly priced for a recession.

3. Micron Technology at 2.9x P/E

Micron Technology (MU) makes computer memory used for computing, networking, and storage. The company primarily sells DRAM (70% of sales) and NAND 26% of sales). DRAM (Dynamic random access memory) is a type of volatile memory used in personal computers and servers for high-speed data storage. NAND is a type of flash memory used in memory cards, USBs, SSDs, and internet of things devices. In the long term, demand for memory storage and data transfer will continue to rise at a nice clip due to the proliferation of devices. Intense cyclicality dominates over the short and medium term due to industry pricing and technological progress between different product generations. As we can see from Micron's stock price chart below, this stock is extremely volatile and is not for the faint of heart or those with short time horizons. While the stock is up nicely over a longer time horizon, it is down over 40% from its 52 week high of ~$65.

Source: finviz.com

Over the past several years, Micron rode a wave of higher DRAM prices due to growing demand and constrained production capacity. However, industry participants have increased production which has resulted in an oversupply situation. Micron and others are now focused on reducing DRAM supply so that customers can work through the glut of inventory.

Micron's NAND business has headwinds of its own. According to Gartner, NAND prices were expected to fall 24% in 2018 and 23% in 2019. This is because the industry is transitioning to more efficient 3D NAND from planar NAND which has more bit density. While long term demand for NAND is still robust, a shorter-term adjustment will hurt industry revenue and margins.

The issues at Micron are exacerbated by the trade war with China. Over 50% of the company's revenue comes from China. As a result, Micron will need to discount their prices in order to not lose business to its Korean competitors. The company has lowered its profit margin guidance as a direct result of tariffs. The upside is that if the U.S. and China reach a trade deal, this headwind will immediately disappear.

As you can see from the above table, Micron's revenue and earnings growth have been very strong in recent years. EPS has more than quadrupled from 2014 to 2018. However, financial performance has also been extremely volatile due to intense cyclicality of supply/demand and its impact on inventory and pricing for the company's products. After revenue rose 80% in 2014, revenue fell 1% in 2015 and 23% in 2016. The company is entering another period where earnings are sure to decline again. According to Capital IQ, the median Wall St. analyst projects 2019 revenue to decline 14.5% and EPS to decline 34%. Analysts expect the industry's pain to continue for a few years.

The expected decline in earnings puts the dirt cheap valuation into context. Investors now need to ask themselves how cheap is cheap enough? The forward valuation takes into account the expected decline in 2019 earnings and then some. The S&P 500's forward P/E ratio is 15.7x, Micron could see its earnings fall 40% for 2 years in a row and still be cheaper. Given how volatile the semiconductor industry is, we have little visibility on what earnings will be in 3-5 years and investors have placed an additional discount on that uncertainty. Micron is clearly a very cheap stock but investors need to have a high risk tolerance due to earnings and stock price volatility. Of course, that level of volatility is what may make Micron an attractive opportunity.

Final Thoughts

I have used simple screening techniques to uncover three of the cheapest stocks in the S&P 500. Each are cheap for their own unique reasons.

WestRock appears to be the least risky opportunity. The company has a very conservative balance sheet and pays a 4.7% dividend yield. The packaging industry is very stable over the long run, and investors will likely do extremely well in the shorter term if we do not head into a recession.

Freeport and Micron are quite cheap, but are riskier because they are more levered to the global economy and changes in volatile commodity prices. Freeport pays a decent 1.7% dividend and has a reasonably secure balance sheet after years of delevering. Micron on the other hand pays no dividend and has poor earnings visibility beyond one year out.

I believe all of these companies could represent good investments depending on an investor's time horizon and risk tolerance.

Disclosure: I/we 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.