The Most Undervalued Stocks in the Market

There are three areas of the market that I've been scouring for undervalued stocks: banks, oil, and small caps. Why these three in particular? Here's my rationale for each (as well as some specific stock ideas):

Banks
The banking sector may be the most complex, opaque market segment. Derivatives, accounting quirks, deleveraging, and government intervention make this so. As a result, there is a lot of opportunity out there for those who can parse out the winners. But just because there is opportunity doesn't mean it's a good idea to make individual calls in the sector.

I've written before about the dangers inherent in the sector. Bank of America (NYSE: BAC  ) and Citigroup are popular because they were left for dead at one point. They've recovered somewhat from a price standpoint -- leading to multibaggers off the lows -- but they still share the complexity problem with their stronger peers including Wells Fargo (NYSE: WFC  ) , Goldman Sachs (NYSE: GS  ) , and JPMorgan Chase (NYSE: JPM  ) . All of these banks either have significant investment banking operations or have swallowed up a fallen toxic bank.

I see more opportunity in the smaller, simpler banks. I detailed my thoughts a few months ago and later bought into one of my research candidates, Community Bank System.

Oil
I chose oil specifically rather than the energy sector as a whole because I feel more confident in buying into an oil major like ExxonMobil (NYSE: XOM  ) than I do an alternative energy player like First Solar (Nasdaq: FSLR  ) . The gains in alternative energy could indeed be huge, but similar to the slew of Internet companies in the late '90s, it's exceedingly difficult to separate the few winners from the many losers.

Even with the alternative energy threats, our dependency on oil should exist for quite a while. The opportunity for large gains comes in buying oil companies (from the little guys like Dawson Geophysical to the ExxonMobils of the world) on weakness -- specifically when there's oil price weakness. I first wrote about this back in the spring when oil was closer to $50 a barrel. There may be good opportunities now, but if oil falls back into the 40s and 50s and oil stocks weaken, definitely do your research and consider seizing the opportunity.

Small caps
There are certainly bank and oil small caps that are worth researching (I mentioned a bank example already) if you have the requisite expertise. But small caps (i.e., companies with market capitalizations between $200 million and $2 billion) span every sector out there, so if banks and oil aren't your thing, you can tailor your search to your circle of competence.

Small caps tend to be more volatile than their larger brethren, so when the stock market experiences turbulence (read: now!), small caps experience earthquake-like movement.

When the price is right, we can capitalize.

Let me walk you through a screen I'm using to find promising small caps. It's a little boring, but stick with me because there are some interesting stocks at the end.

I'm not interested in temporary beauty, so I looked for companies that had both positive earnings and positive free cash flow for the last five years. For cheapness' sake, I also made sure the companies were trading for less than 10 times the most recent earnings and free cash flow numbers via the P/E and P/FCF metrics. A lot of wonks bicker over whether P/E or P/FCF is a better metric. Frankly, I see no reason why both earnings and cash flow shouldn't be strong -- we want companies that are both profitable and generating cash off of that profitability. As a final check, I made sure the companies were easily able to cover their interest payments.

The screen generated 22 companies, but one in particular caught my eye. Here's the complete list: 

Company

P/E ratio

P/FCF ratio

TransGlobe Energy

8.4

9.8

Force Protection

8.4

8.8

Esterline Technologies

9.1

8.3

EarthLink

6.1

7.9

Suburban Propane Partners

7.7

7.7

Gentiva Health Services

3.7

7.2

Pre-Paid Legal Services

8.8

7.1

Life Partners Holdings Inc.

8.7

6.7

ProAssurance

9.8

6.2

Knoll

6.8

6.0

Advance America

9.1

5.9

American Physicians Capital

8.7

5.6

Huron Consulting Group

9.4

4.9

CIBER

9.1

4.8

EMCOR Group

8.4

4.7

Chart Industries 

7.6

4.5

FPIC Insurance Group

9.4

4.4

Hawaiian Holdings

7.9

4.0

CNA Surety

6.8

3.6

Employers Holdings

8.0

3.4

Innophos Holdings (Nasdaq: IPHS  )

2.1

2.4

Rent-A-Center

8.9

2.1

Source: Capital IQ, a division of Standard & Poor's.

Of the select 22, the one that caught my eye was Innophos Holdings, a specialty phosphates producer. First, because of its minuscule P/E and P/FCF ratios under 3.0. Second, because it's the only one in this list that is a recommendation of our small- cap experts over at Motley Fool Hidden Gems.

Their goal is to identify the most unloved, undervalued small-cap stocks in the market, so it's not surprising that a phosphate producer has made their list. They feel strongly enough about Innophos that they have bought shares with The Motley Fool's own money.

I invite you to learn more about the stock and see their entire real-money portfolio by taking a free 30-day trial. There's no obligation to subscribe.

Anand Chokkavelu owns shares of Community Bank System and long-held shares of Citigroup. First Solar is a Motley Fool Rule Breakers recommendation. Dawson Geophysical and Innophos Holdings are Motley Fool Hidden Gems selections. The Fool owns shares of Innophos Holdings. The Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (45)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 21, 2009, at 7:13 PM, footchester wrote:

    Question - when an article on the 'free' site mentions that a stock is an official recommendation of one of the premium newsletters, like Hidden Gems, does anyone confirm that this info is current? In other words, is Innophos a current, ongoing recommendation by Hidden Gems, or was it recommended in 2008 only to have Hidden Gems later tell everyone to pull their money out? The disclosure statement at the end of the article makes it seem that the stock is currently on the Hidden Gems 'buy' list. True?

  • Report this Comment On August 21, 2009, at 7:37 PM, TMFBomb wrote:

    @footchester,

    Barring errors, all the info in articles is current as of the date of publication. We do not update recommendations after the fact.

    Innophos is a current pick. Of course, you should never make an investment decision without doing your own due diligence.

    -Anand

  • Report this Comment On August 21, 2009, at 10:01 PM, automaticaev wrote:

    I dont like any of those...

  • Report this Comment On August 22, 2009, at 3:09 AM, davally wrote:

    Great post. it is great that we have the information from 1981 to refer back to.

    Although we must check this for ourselves it is very handy to have a guide.

    Dave

    http://fxonlinetrading.net

  • Report this Comment On August 22, 2009, at 5:08 AM, exseries7 wrote:

    Some may not like any of these stocks, but I am positively enamored with Chart Industries (GTLS), which I bought as a MF recommendation back in March. Since then, it had tripled in value and does not seem to lose its upward momentum. Although tied to the price of energy, it seems to have a moat because of its cryogenic technology.

  • Report this Comment On August 22, 2009, at 7:13 AM, malcolmcochran wrote:

    IPHS might have a very low PE but it is strictly a Commodity Stock. You wouldn't want to be buying with a PE of, say, six or more. I'm sure it's got a bit more to run but not sure about LTBH.

    It had an increase in earnings because of a big surge in sales late 2008. I suppose sales are seasonal, for fertilizer.

    And the other thing that's helped is much reduced interest payment on debt, as the bank rates have come down.

    Finally, (I admit a nearly-worthless observation) its chart is now pretty flat, logwise, in a markey that's gone slightly insane.

    So I don't see much magic in it.

    (<_>)

    Malc

  • Report this Comment On August 22, 2009, at 2:09 PM, automaticaev wrote:

    they might go up a lot but i still do not like them.

  • Report this Comment On August 22, 2009, at 10:13 PM, trecer wrote:

    Referring indirectly to Dawson as an "oil company" will lose you credibility points. Dawson is in the natural gas industry.

  • Report this Comment On August 22, 2009, at 11:49 PM, castilloelmorro wrote:

    Uh huh...

    Yeah.

    OK....

    Sure...

    Hehehe

    Right

    G'night

    zzzzzzzzzzzzzzz..........

  • Report this Comment On August 26, 2009, at 1:46 PM, LoneWolf888 wrote:

    IPHS has been fabulous in maintaining a close to $20.level.

    Especially impressive in the way it bounced back from its last disappointing earnings report.

    IPHS is a winner. Patience...The dividend makes the wait worthwhile.

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