This Is the Market's Cheapest Stock

You may never have heard of Arkansas Best, but its 462% gain between 1999 and 2009 makes it one of the great success stories of the past decade or so.

So what made Arkansas Best so special? A decade ago, the stock was cheap. And I mean dirt cheap.

Using Capital IQ, an institutional database, I ranked the 1999 stock universe by price-to-sales, price-to-earnings, and price-to-book multiples, and ordered the stocks by their combined rankings. Based on how it stacked up against the rest, Arkansas Best was literally the market's cheapest stock. It was one of those rare "no-brainer" bets that made a small number of savvy investors rich:

Data from Capital IQ, a division of Standard & Poor's; includes companies traded on major U.S. exchanges with market capitalizations greater than $100 million.

One company out there today looks remarkably similar to Arkansas Best before its spectacular run -- Star Gas Partners (NYSE: SGU), currently the market's cheapest stock.

Data from Capital IQ.

This looks pretty much like a "can't-lose" investment. Even if its earnings never grew, with a P/E of below 3, you'd theoretically make all of your money back in fewer than three years.

Except...

Tomfoolery aside...
I'm sure that recent events can pretty easily illustrate the fallacy in that line of thought.

In mid-2008, AIG (NYSE: AIG) and Fannie Mae (NYSE: FNM) were trading for less than book value. But billions in losses later, both stocks are down more than 90%, and they could still be huge value traps.

Why? Because no one -- not investors, not financial pundits, not management, not even The Man Upstairs -- knows what their inscrutable assets and liabilities are. If you don't believe me, please turn to pages 202-347 of AIG's most recent 10-K filing for the footnotes to its consolidated financial statements. Pay close attention to pages 240-242 if you're curious about AIG Financial Products' multi-sector CDO portfolios and their BET modeling criteria. (I'll save you some time: It's long, and there are lots of big, boring numbers.) It's the same story for Fannie.

See, the trouble with backward-looking multiples -- especially in this unusual environment -- is that they're, well, backward-looking. They don't take into account future business prospects.

So despite being the market's cheapest stock on a trailing-multiple basis, Star Gas wouldn't necessarily be a great stock for you to buy. While the home heating oil distributor has done an excellent job growing earnings and reducing debt, it has been losing customers for a few years, spiking at 7.5% of its customer base lost last year.

Moreover, according to management, the company's debt burden of $133 million "place us at a competitive disadvantage compared to our competitors that have proportionately less debt." Though the company is far less levered than its largest direct competitor, Global Partners (NYSE: GLP), it is quite dependent on its revolving credit facility.

Finally, the stock is far less cheap than it appears. Around half of Star Gas' reported earnings in fiscal 2009 came not from its operations, but from changes in deferred taxes and fluctuations in the value of its derivatives hedges. Actual free cash flow was less than one-fifth of accounting earnings.

If you're interested in looking into Star Gas further, keep in mind that there are other gas distribution partnerships such as Kinder Morgan (NYSE: KMP) and Magellan Midstream (NYSE: MMP) that, despite their higher debt levels, generate substantial free cash flow, maintain higher operating margins, and pay out comparable dividend yields.

Most importantly, remember that despite its numerical "cheapness," Star Gas might not be as great a stock as, say, Google (Nasdaq: GOOG), whose P/E is a somewhat lofty 30. While Star sorts out the aforementioned problems, Google continues to grow, has $26 billion in net cash, and generates substantially more free cash flow than net income.

But just in case you're curious ...
You may be interested to see how much money you could have made buying the lowest-multiple stocks in the past:

Data from Yahoo! Finance and Capital IQ.

Those are some impressive, albeit inconsistent, gains. Of course, you could have made even more money investing in a number of other value stocks, though they may have appeared somewhat pricier based on a cursory look at their multiples. Consider these monster performers:

Data from Yahoo! Finance and Capital IQ.

While this comparison is by no means a conclusive survey, we can draw a couple of important conclusions:

1. With some valuations so depressed right now, investors today are likely to see a number of strong performers in the coming years.
2. The "cheapest" stocks on a multiples basis are not always the best value stocks.

Point taken
While I've shown you which name the multiples tell us is the market's cheapest stock, I should caution that it's not one I would recommend buying. As investors, we should always keep in mind that valuation is a forward-looking exercise that requires anticipating how the company will perform under future conditions.

At Inside Value, The Motley Fool's value investing service, we also consider a company's competitive position, its market opportunities, its relationships with customers and suppliers, and the quality of its management when building our models. We learned that from Warren Buffett, and this weekend, we're heading to Omaha to learn more. If you'd like to hear first-hand what we learn, click here to sign up for dispatches.

This article was originally published May 22, 2009. It has been updated.

Ilan Moscovitz owns shares of Google, a Rule Breakers recommendation. Magellan Midstream is an Income Investor pick. Sasol is a Global Gains choice. The Fool has a disclosure policy that makes us all proud.