It's a Stock Picker's Market

Stock pickers can do a lot better than the index fund, which is currently priced at nosebleed levels. By screening for companies with a track record of positive cash flow from operations, more cash than debt, and a valuation below 10 times free cash flow or earnings, we've uncovered 16 promising small caps. Among the four companies we study today, two seem to offer good value: The Buckle and OshKosh B'Gosh.

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By Matt Richey (TMF Matt)
October 29, 2002

The market's rally over the past few weeks has caused many to wonder whether the bull is back. Count me as skeptical. Stocks, as a whole, are still very pricey. That fact became all the more clear late last week when Standard & Poor's announced that the S&P 500's "core earnings" for the past year amounted to $18.48, which equates to a nosebleed P/E of 48.2.

The new definition of core earnings captures some important expenses, such as employee stock option grants, pension costs, and restructuring charges. Previously, these expenses had gone ignored under the more liberally defined "operating earnings" calculation, which for the past year amounted to aggregate S&P 500 profits of $41.59. Even that figure, however, places the market at a not-so-low P/E multiple of 21.4. Over the past 75 years, the market's average multiple is closer to 14.

So the bad news is that most stocks are flat-out overvalued. But that doesn't mean Fools should abandon stocks altogether. The good news is that there are bargains to be found, especially for individual investors who can choose among the small, out-of-the-way companies Wall Street tends to overlook.

That brings us to the purpose of today's article -- to locate the few stocks out there with solid, cash-generating businesses and reasonable stock prices. This is the fourth and final part of a series in which I've quickly profiled 16 promising companies. (The links to the first three parts of this series can be found in the "related links" box to the right side of this page.) To review, we've been looking at companies with the following characteristics:

  • A valuation of no more than 10 times free cash flow or earnings,
  • A balance sheet with more cash than debt,
  • A three-year track record of consistently positive cash flow from operations,
  • A stock price above $5.

Companies that meet these strict criteria have a lot going for them. Focusing on companies with consistent cash flow, a sturdy balance sheet, and a reasonable valuation eliminates a lot of investment risk. That said, a note of caution is warranted: Some of these stocks are cheap for good reason. That's why these write-ups are recommendations to research, not recommendations to buy.

One company I mentioned last week unfortunately exemplifies why more research is imperative. Metro One (Nasdaq: MTON), the provider of enhanced directory service for wireless carriers, saw its stock price cut in half after reporting it lost its largest customer, Sprint PCS (NYSE: PCS), which had been responsible for close to a third of Metro One's revenues. Whenever a company has a large percentage of its business tied up with a single customer, there's risk of that type of setback.

Not every risk can be screened out, so please use these ideas as a short list for closer research. That said, here are four more companies worth a look.

Ennis Business Forms (NYSE: EBF)
Ennis Business Forms is one of those unexciting businesses that just plugs along and makes a tidy profit year-in and year-out. As one of the largest private-label printed business-product suppliers in the U.S., Ennis sells its vast array of tags, labels, and presentation products to some 48,000 dealers nationwide.

Organic growth opportunities are limited in this mature business, but over the years, Ennis has used its cash flow to acquire competitors, and has thereby grown its sales at a 7.8% annual pace over the past seven years. Cash flow has been consistently positive, with free cash flow well in excess of net income in each of the past three years and in five of the past seven years. All of the company's acquisitions have been paid for with cash, and stock options are virtually nil. As such, the share count has remained constant over the years -- something rarely seen in this age of stock option ridiculosity.

Ennis occasionally buys back stock and uses about half of its annual free cash flow to pay a dividend, which currently yields a handsome 5.1%. At a price of $12.11, the stock trades for 9.9 times free cash flow and 13.6 times earnings, with $0.29 per share in net cash.

The Buckle (NYSE: BKE)
Buckle is a denim-focused chain of 300 casual retail stores, mostly located in regional malls in 37 states. Unlike Gap Stores (NYSE: GPS) and privately owned J. Crew, Buckle doesn't design its own wares, but rather sells name-brand merchandise designed by others, such as Liz Claiborne (NYSE: LIZ). Over the past seven years, Buckle has expanded its store base at a 10% average pace, while expanding sales by an average of 15% per year.

The company is solidly profitable, with net profit margins consistently above 8% for the past five years. Over the past year, the company earned a net margin of 8.4% and a free cash flow margin of 9.7%. These are fantastic margins for an apparel retailer. Gap wishes it could earn margins even half as high as Buckle's.

At a recent $18, the stock trades for 9.9 times free cash flow and 11.7 times earnings, plus $6.41 in net cash per share. Buckle has a track record of occasionally buying back shares.

OshKosh B'Gosh (Nasdaq: GOSHA)
Distinguished by an unforgettable brand name, OshKosh B'Gosh is well-known for its high-quality children's wear. Sales over the past year of $444 million are roughly the same level as sales earned five years ago -- so this is not a growth story. But the company has been an aggressive buyer of its own stock, having retired fully half of its outstanding shares over the past five years. In addition, the company earns very high returns on its capital, with an ROIC over the past year of 35.3%.

OshKosh's sales include both wholesale and retail channels, with the wholesale channel generally on the decline and the retail channel generally increasing. Over the past nine months, wholesale sales declined 13.8%, while retail sales increased 2.3%. The retail sales come through a chain of 153 OshKosh B'Gosh stores, mostly comprised of factory outlet locations. In the most recent quarter, same-store sales declined 9.4%. For the fourth quarter, currently in progress, management is projecting a high single-digit comparable-store sales decrease.

The stock is currently hovering around $30, where it trades for 8.0 times free cash flow and 13.0 times earnings. Cash per share is $1.99.

TeleTech Holdings (Nasdaq: TTEC)
Compared to the other three businesses we've looked at, TeleTech is more complex and consequently riskier. TeleTech provides business process outsourcing services with a specialty in inbound customer management programs, which comprise 90% of revenues. Client contracts typically range from one to eight years, so revenues are generally recurring. Nevertheless, the company relies on large customer contracts, and that's a risk.

TeleTech's financial results have been pretty choppy over the years. Gross margins have hovered mostly in the mid-30% range, while net margins have been anywhere from -0.2% (2001) to 8.3% (2000). Free cash flow margins have been similarly variable, with frequent years of negative free cash flow.

At $5.88, the stock trades for 8.1 times free cash flow and 23.5 times earnings. The company recently announced a stock repurchase authorization, but the company doesn't have much net cash available -- only $0.20 per share.

This concludes our small-cap value radar series. I hope you're walking away with some stocks you want to research more closely. Personally, out of the four companies we looked at today, I'm most intrigued by Buckle and OshKosh B'Gosh. Both are characterized by predictable business results and shareholder-friendly managerial policies. More research is necessary to assess fair value on either company, but chances look good that value exists in one or both -- certainly more value than currently exists in the S&P 500 at a P/E of somewhere between 21 and 48.

As always, I appreciate your feedback (, and I'm especially interested in any insights you have on today's companies.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. For Matt's best Foolish stock ideas and analysis that you won't find anywhere else each month, check out our unparalleled newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.