Searching for Value in a Picked-Over Market

I don't know about you, but I'm not seeing an awful lot of bargains in the stock market today. The strong rally since September has floated all sorts of boats, with plenty of dinghies now priced like 100-foot yachts. I think we have the magic of QE2 to "thank" for that.

At times like this, you may feel the impulse to relax your standards, and buy what's relatively cheap. That can get you in trouble when valuations are broadly too high, however. For that reason, it can be helpful to adhere to valuation criteria that don't change with the season.

One investor who approaches investing this way is Alexander Roepers of Atlantic Investment Management. At day 2 of the Value Investing Congress, which I attended alongside Motley Fool Inside Value advisor Joe Magyer, Roepers laid out a very clear rubric for what he seeks in an undervalued firm:

  • Market cap between $1 billion and $20 billion (this offers both liquidity and contact with management).
  • Interest expense less than 25% of "gross cash flow" or EBITDA.
  • Non-cyclical, with consistent operating profitability and predictable cash flows.
  • High barriers to entry and low capital expenditure requirements.
  • Low insider ownership (signaling takeover vulnerability).

As for valuation, Atlantic seeks to buy rock-solid companies at rock-bottom prices. That typically means a price-to-earnings ratio of eight to 11, an enterprise value-to-EBITDA multiple of five or six, or a 10% or greater free cash flow yield.

To see what stocks might make the grade today, I crafted a "Roepers screen" and came up with just 14 names. Let's take a stroll through these results and see what might be worth a closer look.

Defense dynamos
The first thing that jumped out at me here was how many defense-related companies made the cut, in addition to Roepers' own VIC recommendation, ITT (NYSE: ITT  ) . Some of the big boys were there, like Northrop Grumman and Lockheed Martin (NYSE: LMT  ) . Also present were perhaps lesser-known companies like Alliant Techsystems (NYSE: ATK  ) and Oshkosh.

My Foolish colleague Andrew Sullivan recently made the case for investing in defense companies, which are nearly always out of favor, barring the occasional dustup in the Persian Gulf. Rather than rehash Andrew's argument, I'll simply point you to his sharp commentary. I agree with Andrew that Alliant Techsystems looks worthy of a deeper dive, given its track record of terrific returns on equity.

Candidates with caveats
Another firm on the list with a history of fat profits is ITT Educational Services (NYSE: ESI  ) . I believe this for-profit education provider would fall under the "government intervention" risk area explicitly avoided by the Atlantic folks, however. The same goes for Exelon (NYSE: EXC  ) , a regulated utility. Another risk area, "product liability," might take Big Pharma candidates Pfizer (NYSE: PFE  ) and Eli Lilly out of the running. The thought of a Vioxx redux is enough to give one acid reflux.

Then again, the company that Roepers touted most heavily in his VIC presentation -- glass container titan Owens-Illinois -- has accrued a multibillion-dollar asbestos liability. None of the above companies should be dismissed out of hand. Exelon, with its large nuclear footprint, should be attractive to anyone looking for a utility that stands to benefit from carbon legislation (not that any appears likely to emerge from the current Congress). ITT, however, may see its business model fundamentally challenged under new legislation, so that's a security I find very difficult to evaluate.

The paper chase
As a manufacturer of paper-based packaging products, Rock-Tenn (NYSE: RKT  ) strikes me as the sort of company I could get up to speed on relatively quickly. I've reviewed the recently filed form 10-K, and I see reasons to dig deeper.

Like Owens-Illinois, Rock-Tenn appears to be well-shielded from overseas competition. Combine this barrier to entry with recent industry consolidation, a low cost structure, and relatively little risk of technological disruption, and you have what looks like a solid competitive position. Rock-Tenn is somewhat vulnerable to rising energy costs, but the firm appears to have fairly strong pricing power, judging by a recent flurry of price increases (and, of course, the consistent profitability that landed this company on my screen in the first place). The packaging powerhouse has an underfunded pension, but nothing too daunting. Rock-Tenn has doubled its annual dividend over the past year or so, reflecting its firm financial footing.

What can I say? I have a soft spot for steady, boring, beautiful businesses like this. You know who else does? The private equity industry. Competitor Pactiv was bought out this year for 8.6 times EBITDA and 11.7 times EBIT. A similar takeout would value Rock-Tenn at a greater than 50% premium to today's price. Still bored?

Exelon, ITT, and Pfizer are Motley Fool Inside Value recommendations. Motley Fool Options has recommended writing covered calls on Exelon. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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