5 Value Stocks With Profit-Producing Power

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.

Value stocks are great, but it also helps to balance them with big-growth companies. We've identified four prospective winners in our new special report, which highlights stocks that could skyrocket after the presidential election later this year. It's free, so let me invite you to click here and get your copy today!

Fool contributor Dan Caplinger is always on the lookout for profit-producing power. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Intel, Microsoft, Freeport-McMoRan Copper & Gold, CF Industries, Joy Global, and Lockheed Martin. Motley Fool newsletter services have recommended buying shares of Microsoft, Western Union, Cummins, and Intel, as well as writing a covered straddle position in Western Union and creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. 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 Fool's disclosure policy gives you the power.


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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 June 21, 2012, at 5:21 PM, crca99 wrote:

    It's a 3 yr bull market if you had cash and began investing at the bottom of the housing and bank crashes. If you were invested before then with little new money to add, it's been 3 yrs of getting back to even. Is the lesson to always hold cash?

  • Report this Comment On June 21, 2012, at 8:15 PM, TMFGalagan wrote:

    @crca99 - Not at all. The lesson is to look for strong companies with reasonable valuations at all times, whether the market's low, high, or somewhere in between.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 22, 2012, at 10:33 AM, leroyandkathleen wrote:

    I have enjoyed Motley Fool ever since I joined in however I probably have not usrd it as judiciously as I should. Would appreciate any tips available.Idid not partake of your offer of a few weeks ago because I felt I didnot have enough available cash to be able to make it what you expected of me.

  • Report this Comment On June 22, 2012, at 11:10 PM, 1chumpchange wrote:

    i am trying to understand motley fools,whole web sits and do reasearch stock choises but for me hard to understand,hope i get it guick!

  • Report this Comment On June 24, 2012, at 10:42 AM, bobbyk1 wrote:

    I generally hold 15% in cash to take advantage of dips on stocks I like.

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