FOOL ON THE HILL
Stocks to Buy Now

If you're an investor, rather than a speculator or seller, then today's market is a dream come true. Whitney Tilson shares some of the bargains he's finding.

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By Whitney Tilson
July 24, 2002

It's a lousy time in the stock market to be a speculator or seller, but it's a great time to be an investor. In fact, I think it's the best time to start buying stocks in years, even better than Sept. 21 of last year, the day the market bottomed after 9/11 (and we all know what the stock market did shortly thereafter).

So am I calling bottom? Am I predicting that a strong rebound is at hand? Absolutely not! I don't want to be distracted from what's important -- finding good companies with severely undervalued stocks -- so I try hard not to have an opinion on such matters (though I occasionally break this vow and warn investors when I think the market or particular sectors are at dangerously high levels, as I did most recently in Are Investors Being Duped Again? and Beware of Tumbling Tech Titans).

I simply believe that the selling in the market has become indiscriminate, and that many babies are being thrown out with the bathwater. Great companies are, for the first time in memory, trading at reasonable -- and in some cases, downright cheap -- multiples. This is the market I've been dreaming about for years, and I intend to take full advantage of it.

Specifically, my strategy is to upgrade the quality of my portfolio. Until quite recently, with most stocks at such lofty levels, I was forced to root around in the nooks and crannies of the market to find bargains, investing in undiscovered gems such as Imperial Parking (AMEX: IPK) and Aaon (Nasdaq: AAON), or really cheap but not-so-good businesses such as Huttig Building Products (NYSE: HBP), Sport-Haley (Nasdaq: SPOR), and Cutter & Buck (Nasdaq: CBUK).

In general, I'm not interested in selling these stocks, especially since many have been beaten down along with the market in recent weeks, but I would much rather be buying the stocks -- assuming they are reasonably priced -- of dominant, market-leading, high-margin, high return on capital, growing businesses. So without further ado, in no particular order, here are some of my best mid- to large-cap ideas (I own a position in each of these stocks; all prices are as of yesterday's close):

Berkshire Hathaway
The recent decline of Berkshire Hathaway (NYSE: BRK.A) is particularly puzzling not only because insurance pricing remains strong -- so, unlike most companies, Berkshire largely has the wind at its back -- but also because I think the stock, logically, should become more valuable as the market falls for at least two reasons: 1) Other insurers, as their investment portfolios get hammered, have to raise prices to compensate, making pricing even better, and 2) Warren Buffett's biggest problem in recent years has been his inability to find attractive places in which to invest Berkshire's enormous and rapidly growing war chest, due to generally high valuation levels in the market.

With more than $60 billion of net worth and a float of more than $37 billion (both as of March 31), plus cash flow of at least $1 billion per quarter, I would argue that Berkshire's liquidity rivals that of any other company in the world. Having so much invested in low-return cash and short-term investments has acted as a drag on the growth of Berkshire's intrinsic value. However, acquiring a large company, which becomes more and more likely as the market craters, would create tremendous shareholder value. Berkshire is flat-out cheap today, trading at a mere 1.1x Morgan Stanley's estimated 2003 book value of $53,759 per share.

Barnes & Noble stub
Barnes & Noble (NYSE: BKS) -- including B&N.com (Nasdaq: BNBN), but excluding Gamestop (NYSE: GME), which B&N owns 57% of, and which I short out when I buy BKS -- is the market leader, generates mid-teens return on equity, and has decent growth prospects and sensible management. Fears of a poor holiday season for all retailers and recent, weak same-store sales comparisons for B&N have contributed to the stock's free fall, but this is a typical Wall Street overreaction to a short-term phenomenon, as the previous year's comparisons were difficult (and get much easier for the next few months).

I don't claim that this is a great business, but it's better than most people think. Consider that the capital markets threw billions of dollars at Amazon.com (Nasdaq: AMZN) to displace B&N, yet today B&N is stronger than ever, while Amazon has $1.4 billion of net debt (as of yesterday's earnings release) and is struggling to grow its core U.S. new book business and earn any profit or free cash flow whatsoever. In contrast, B&N has its strongest balance sheet ever (a mere $236 million of net debt, again, excluding Gamestop) and should generate about $260 million of operating cash flow this year. I estimate that maintenance cap ex is about $100 million (total cap ex, which should fall over time, is about $160 million).

So, what would you pay for $160 million of free cash flow from a business with these characteristics? Today, the market is valuing the B&N stub at a mere $884 million, an absurd 5.5 times free cash flow. Even adding in the net debt, the multiple is only 7x.

Kinder Morgan
I wrote about Kinder Morgan (NYSE: KMI) in March, and since then, the stock is down 22% from $45 to $35. Yet the story has gotten better, as the company just reported a blowout quarter. KMI grew EPS 44%, doubled its dividend, increased its share buyback, and announced that it would generate $1.2 billion of free cash flow (I think this is a highly conservative number) over the next three years, noting that, "While a portion of the $1.2 billion will be used to pay down debt and fund modest expansion projects, Kinder expects much of that cash will be returned to shareholders via additional share repurchases and dividends." With a $4.2 billion market cap, the stock is trading at about 10 times my estimate for this year's free cash flow.

So what's not to like? Plenty, according to many skeptics and short-sellers I've spoken with extensively since my March column, but after considering all the issues they raised, I'm convinced that their concerns are ill founded. CEO Richard Kinder thinks so too, which he expressed in an all-time great rant at the end of his opening statement on the Q2 conference call (click here to read it). "Witches in the brew"?! This is great stuff! I love this guy!

John Harland
John Harland (NYSE: JH) is the number two check printer in the U.S., serving mostly community banks and credit unions. The company also prints forms and documents, owns Scantron (remember those tests in school?), and has a rapidly growing software business. After being mismanaged for years, Harland brought in turnaround specialist Tim Tuff, who is working his magic again (I've known him for years and have the utmost respect for him, which is one of the main reasons I got comfortable with this stock).

I think the turnaround still has quite a ways to run, despite the fact that checks are a declining business, as the decline appears to be only 1-2% annually. In the meantime, check printing is a wonderful business: Harland's Printed Products division has pre-tax margins that exceed 16%, and Harland's return on equity is more than 20% and rising. The company is squeezing more and more cash out of its core business, while growing its software and Scantron segments. At $23.36, the stock today is trading at just over 11x this year's consensus EPS estimates, which I think is plenty cheap.

R.H. Donnelley
R.H. Donnelley (NYSE: RHD), the largest independent marketer of yellow pages advertising in the U.S., has a stable, lucrative business that generates a ton of cash. How many businesses have a 26% return on assets? And how many media/advertising businesses will grow earnings this year, in the midst of a meltdown in the industry? This morning, the company reported earnings that matched estimates and confirmed its EPS guidance of $2.40 to $2.44 this year, so the stock, at $22.02, is trading at only 9.1x this year's EPS. That's absurdly cheap for a business of this quality.

Other stocks on my radar
I'm already over my word limit for this column, so let me toss out the names of companies that I could easily see myself buying in the near future (again, in no particular order): Liberty Media (NYSE: L), Merck (NYSE: MRK), Abbott Labs (NYSE: ABT), SBC Communications (NYSE: SBC), Office Depot (NYSE: ODP), Smithfield Foods (NYSE: SFD), Zale (NYSE: ZLC), Automatic Data Processing (NYSE: ADP), and IMS Health (NYSE: RX)

Here's a list of companies that are beginning to look interesting, but are still quite a ways yet from being cheap enough to buy (keep in mind that I won't pay 20 times normalized EPS for any business): Johnson & Johnson (NYSE: JNJ), Home Depot (NYSE: HD), Investment Technology Group (NYSE: ITG), Costco (NYSE: COST), Coke (NYSE: KO), Gillette (NYSE: G), American Express (NYSE: AXP), Paychex (Nasdaq: PAYX), Pepsi (NYSE: PEP), Wal-Mart (NYSE: WMT), Wrigley (NYSE: WWY), Colgate-Palmolive (NYSE: CL), and Dover (NYSE: DOV).

Finally, here are stocks I have no interest in, due either to valuation or concerns about the companies (I've written about all of these stocks in the past; see my website for links): IBM (NYSE: IBM), Dell (Nasdaq: DELL), eBay (Nasdaq: EBAY), Cisco (Nasdaq: CSCO), GE (NYSE: GE), AOL Time Warner (NYSE: AOL), Tyco (NYSE: TYC), Kohl's (NYSE: KSS), Starbucks (Nasdaq: SBUX)P.F. Changs (Nasdaq: PFCB), Krispy Kreme (NYSE: KKD), and most tech/telecom, financial, and housing stocks.

Conclusion
Times like these separate true investors from pretenders. It's tough to watch one's portfolio get hammered every day -- endlessly, it seems, but if you know what you own, why you own it, and what it's worth, then you should become more and more bullish as prices fall. Better yet, if you have dry powder, this market is offering tremendous opportunities.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. He owned shares of Imperial Parking, AAON, Huttig Building Products, Sport Haley, Cutter & Buck, Berkshire Hathaway, Barnes & Noble, Kinder Morgan Inc., John Harland, R.H. Donnelley, and was short Gamestop at the time of publication. Whitney appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.