Hunting for Value: Part 1

In my last commentary, Beat the Street With Value, I made my case for value investing. To quickly sum up, I'd rather have $33,630 in profits, compared with $16,520 for growth stocks and $7,471 with the S&P 500.

Today, as promised, I'll outline how I hunt for value for my Inside Value newsletter. I generally break the field down into six areas:

  • Wounded elephants
  • Cyclicals
  • Former glamour stocks
  • Fallen angels
  • Bankruptcy survivors
  • Stealth stocks

Wounded elephants
I always keep an eye on the industry stalwarts, the stocks that most people want to own because they have the financial muscle to withstand stormy weather and can provide steady, predictable earnings and cash flow growth over a long period. The trouble is that these characteristics are well-known, and I usually find such companies overvalued.

Once in a while, however, these companies fall temporarily out of favor, and I wait, like a patient big-game hunter, to see whether one of these wounded elephants will come into my price range. Often, it will be after a bad quarter or two, the expiration of a patent on a blockbuster, or some other bad news that will have the institutional investors dumping the stock. This is quickly followed by analyst downgrades after the stock price has fallen. The market psychology dictates that it almost always overreacts, which gives value investors their opportunity. A classic example was Altria (NYSE: MO  ) back in the early part of 2003. At the time, I had valued the stock at a conservative $52. Fears of humongous litigation awards against the company drove the stock price all the way down to $28, more than 40% below my conservative valuation. Incredible, considering that Altria's share of Kraft (NYSE: KFT  ) was worth in excess of $20 per Altria share, and the dividend yield was approaching 10%. Today Altria is trading at $54.

Today, a sector that interests me in this category is large pharmaceuticals. As the pressure builds to find cheaper alternatives to patented drugs and as blockbusters come off patent, the press is almost all negative about the group as a whole. I'm not talking about special cases such as Merck (NYSE: MRK  ) , because it falls into my "fallen angel" category. I'm looking at companies such as GlaxoSmithKline (NYSE: GSK  ) , with Paxil and Wellbutrin just off patent, and Pfizer (NYSE: PFE  ) , suffering from investor angst that arthritis drug Celebrex/Bextra may suffer the same fate as Merck's Vioxx.

I'm also hearing that the blockbuster model is broken, but I don't think so. Wall Street expects blockbusters to roll off the assembly line -- as one goes off patent another should take its place -- but it doesn't work like that. In my opinion, Glaxo and Pfizer have the best R&D, long-term pipelines, and alliances with smaller pharmas and biotechs. On a P/E basis, big pharma is cheaper than it's been for a long time -- maybe not quite cheap enough, but I'm watching.

Cyclicals
Cyclical companies have inconsistent earnings, and, consequently, a look at their stock price chart resembles a roller coaster ride. The key here is that the industry cycle is predictable. Natural resource companies, chemicals and other industrials, automobiles, and, more recently, semiconductor manufacturers and generic pharmaceuticals fall into this category. When shopping among the cyclicals, I usually stick to industry leaders with rock-solid management and strong balance sheets. It's notoriously difficult to forecast the U.S. and global economies with any degree of precision. Strong balance sheets help companies stay afloat if a downturn persists longer than expected.

A good example of a classic cyclical company is Inside Value Watch List stock Intel (Nasdaq: INTC  ) , which made a tremendous move off a cyclical bottom in early 2003. The stock went from $15 in early 2003 to near $35 by the end of the year. The key here is that you did not have to pick the ultimate low and subsequent high to make a quick double. You just had to be on the bus! It's pulled back quite a bit lately. I would watch it from here, along with leading chip-equipment maker Applied Materials (Nasdaq: AMAT  ) . I might be a buyer on further weakness.

Generic pharmaceutical companies such as Teva (Nasdaq: TEVA  ) and Mylan Labs (NYSE: MYL  ) are good examples of companies that have come down from their highs after the expiration of their six-month exclusivity to sell formerly patented blockbuster drugs. These companies have strong underlying generic products and are set to benefit from an aging population and the inexorable search for cheaper drug alternatives. They are also in position to benefit as more blockbuster drugs come off patent in the next few years, which will kick-start the cycle.

Former glamour stocks
David Gardner loves glamour stocks over at his Motley FoolRule Breakers newsletter, and so do I, but for a completely different reason. I know David has been successful in the past spotting companies such as AOL and Amazon (Nasdaq: AMZN  ) , and I'm sure he will be successful in the future, but most investors aren't like David. Most average growth investors don't know when to get on board, which train to board, and where the train is going. Often, they are on too late as momentum players are propelling it to the stratosphere, and they are ultimately left holding the bag when they find out that the momentum players got off at the last station. In desperation, they get off at the next stop, further depressing the stock price. Just around the corner at the next station, the platform is sparsely populated with value investors checking to see whether this is a train wreck in the making or the reincarnation of the opulent Orient Express.

Don't think for a moment, however, that story stocks cannot be values. Just last year, I salivated over Home Depot (NYSE: HD  ) . In 1995, you could have bought Home Depot at a little more than $8 (split adjusted), and its big orange stores started popping up everywhere. By mid-1998, the stock had soared to $30, and Home Depot was a full-blown glamour stock. The stock price continued upward like a runaway train and reached $68 in early 2000. Mid-2000, the wheels gradually started falling off, and this was a glamour stock no more. Fast-forward to late 2002, and suddenly everybody thought Lowe's (NYSE: LOW  ) was going to eat Home Depot's lunch. By January 2003, you could take Home Depot home for just more than $20, at which point it stood out to a value investor like one of its big orange signs. Were there problems? Sure, but this was no WorldCom or Enron. Expectations were reeled in. Management compressed the cash conversion cycle. Most importantly, cash flow rebounded. Today, Home Depot is close to $42, no longer a bargain, but man, what a value pick in 2003!

A former story stock that I've been watching is Krispy Kreme Doughnuts (NYSE: KKD  ) , one of the most ballyhooed stocks of the last few years. Krispy Kreme rose from under $10 in early 2000 to a peak of just a tad under $50 in August of last year. Today, it trades for $12 and change. Krispy Kreme reports third-quarter earnings soon, and I'll be listening in on the conference call. Fellow Fool Richard Gibbons still thinks that it has a shot at being the next Starbucks (Nasdaq: SBUX  ) , while uber-Fool Bill Mann thinks that Krispy Kreme's true value might be zero.

Next week, I'll continue the hunt for value by outlining the Fallen Angels, Bankruptcy Survivors, and Stealth Stocks. If you are intrigued by value investing and can't wait until then, why don't you try out Inside Value, with the first 30 days on me? No charge. There, you will be able to join the Value Team and me in our discussions and access all current and previous issues. We can talk about the market, your favorite value picks, and those on my current Watch List.

So, I wish you good value investing until we chat again.

Philip Durell is the analyst for theMotley Fool Inside Valuenewsletter. He owns shares in GlaxoSmithKline, and his wife owns shares in Home Depot.


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