With the stock market having recovered nicely from its May swoon and boasting decent gains so far for 2012, savvy investors are again starting to wonder how much further the three-year-old bull market can run. Fearing an inevitable reversal at some point, they're looking for investments with some margin of safety to protect them from the next correction -- or major bear market.
Traditionally, the obvious way that investors seek to minimize their risk is to find stocks that trade at relatively cheap valuations. But by itself, focusing solely on the relationship between share price and earnings can put you into companies whose future prospects look questionable at best. What you need are stocks that are both fairly inexpensive and still have successful business models that can produce strong returns well into the future.
Finding top prospects
To ferret out some ideas for further research, I decided to look at S&P 500 stocks that had attractive valuations of 12 times earnings or less on both a trailing and forward basis. But rather than simply relying on P/E ratios to identify promising candidates, I added another requirement: Companies had to have returns on capital of at least 20%.
Unlike the price-to-earnings ratio, return on capital isn't a metric that many ordinary investors are all that familiar with. But the measure is important because it helps tell you how successful a company is in taking the money that's available to it and finding ways to use it productively on profitable business projects.
Those familiar with the related concept of return on equity may wonder why that isn't a more appropriate measure for evaluating a stock. The problem with ROE, though, is that companies can manipulate it more easily by making decisions about capital allocation between debt and equity. Debt-laden companies can produce fairly high returns on equity, especially in low-interest-rate environments like the current one. ROC, on the other hand, treats debt and equity financing as equivalent, and that can give you a more stable picture of the actual operations that are responsible for producing profits.
The ideal mix of value and ROC
In the entire S&P 500, there were just nine companies that met both conditions. The one with the highest ROC was Apollo Group, but that company comes with the big caveat that for-profit educators have taken a lot of criticism lately for the questionable practices that some industry members use.
The other companies fall more neatly into some definable categories:
- Tech giants Intel (Nasdaq: INTC ) and Microsoft make the list, with Microsoft having a slight edge on both metrics. But I'd argue that Intel's feat deserves more credit, because the company has a more capital-intensive model in producing semiconductors than Microsoft's software-focused business.
- Natural resources plays also make a big showing. Freeport-McMoRan Copper & Gold (NYSE: FCX ) and Joy Global (NYSE: JOY ) rely on the mining industry for their respective success, and while a potential slowdown in global economic growth could threaten demand for mined products, fears may well prove overblown. In other areas, CF Industries (NYSE: CF ) has turned agricultural demand for fertilizer into high internal returns.
- Diversified manufacturers Lockheed Martin and Cummins (NYSE: CMI ) also made a good showing. Cummins in particular seems promising as it goes beyond its traditional truck-engine business to develop innovative natural-gas-powered engines that could take advantage of the recent energy boom.
- Western Union may seem like the odd company out here, with its emphasis on financial services, a traditionally high-capital business that makes it hard to produce high ROC. But Western Union's stranglehold on international payment transfers helps it boost its margins. Increased competition could hurt the stock going forward, but it's still an interesting play for now.
Of these, the five I think have the most potential going forward are Intel, Freeport, Joy Global, CF Industries, and Cummins. Intel's move to mobile gives it growth potential, while Cummins is similarly taking advantage of the changing environment for energy to try to innovate. The other three stocks are poised to rebound sharply as soon as the global economy stops worrying about a slowdown.
Go for value
Clearly, return on capital by itself doesn't tell you if a company is a perfect investment. But as a method of uncovering some interesting ideas, ROC can be useful in weeding out stocks that don't have the profit-producing power in their business models that smart investors demand.
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