Value stocks sometimes can seem very risky if they're being driven down by the market for a reason. Maybe it's the death of retail, or another PR nightmare that the market is selling, which may leave a stock trading for less than its underlying value.
With that in mind, we asked three of our investors for their favorite daring value play, and Kohl's Corporation (KSS 2.48%), Valeant Pharmaceuticals Intl Inc (VRX 3.42%), and MGM Resorts International (MGM +1.46%) made the list for a number of different reasons. Here's why they're all good buys in their own way.
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I dare you to buy this deep-value stock
Rich Smith (Kohl's Corporation): It sometimes takes real courage to buy stocks when other investors are fearful of investing in them. And yet, like Warren Buffett says, the fact that investors fear buying a disfavored stock is exactly what can push it into value territory -- and right now, there are few stocks less favored than bricks-and-mortar retailers like Kohl's Corporation.
Amazon.com (AMZN 1.18%) is making a full-court press against the rest of the retail industry. Amazon's plan began barely 20 years ago with a plan to sell books delivered by parcel post. It's since expanded into mail-order trampolines, and now includes everything from groceries to the Kenmore appliances that store and cook them. Amazon's relentless pursuit of everyone else's market share, however, has pushed Kohl's stock down to ridiculously cheap levels.
How cheap is Kohl's today, precisely? The stock sells for a mere 11.4 times trailing earnings, which seems like a great bargain given that analysts peg the stock for 8% long-term earnings growth. Combined with Kohl's generous 5.4% dividend yield, that works out to a 13.4% expected total return on this 11.4 P/E (price-to-earnings) stock.
Such a valuation would be cheap even if Kohl's only was earning the $605 million in trailing profits reflected on its income statement. But in fact, Kohl's cash flow statement confirms that it actually generated free cash flow of twice that amount -- $1.2 billion -- over the past year. At a price-to-free-cash-flow ratio of just 5.6 times, Kohl's dividend covers almost the entire fair value of Kohl's stock, even if the company doesn't grow its earnings at all.
At these prices, Kohl's stock is so cheap that I'm not sure you even have to be that daring of an investor to invest in it.
Climbing back from the abyss
Dan Caplinger (Valeant Pharmaceuticals): The pharmaceutical space has been a dangerous place to invest lately. Washington has its eyes squarely on trying to get drugmakers to reduce the cost of the prescription drugs they sell, and the strategic vision that Valeant Pharmaceuticals had during its heyday was in stark contrast to the new reality for the industry. Even with current efforts to reform healthcare in limbo, Valeant has already had to take drastic measures in order to take control of its highly leveraged balance sheet and make its business sustainable.
Valeant's efforts so far have paid off well for the company and for investors. Asset sales of non-core businesses have raised cash that the company has used to reduce its debt levels, and hedge-fund investor John Paulson boosted his stake in the beleaguered drug company, further enhancing the fund's status as Valeant's largest shareholder. In addition, some reports have suggested that Valeant might successfully negotiate a debt swap with creditors, granting bondholders an equity stake in the company in exchange for more lenient debt terms. That would give Valeant even more control over its balance sheet.
There are still risks for Valeant. The terms of any debt swap could dilute current shareholders' interest in the company dramatically, and further regulatory moves from the federal government could pose threats to its business model. Yet with so many positive moves already, Valeant has the potential for rewards that, for some, will outweigh the risks involved.
A gamble worth taking
Travis Hoium (MGM Resorts): Betting on gaming stocks isn't for the faint of heart. An economic downturn, like the financial crisis, can leave highly leveraged gaming stocks with few financial options, and if one of their gaming markets falls, stocks can tumble with it (see Macau 2014-2016).
What MGM Resorts has going for it is a more geographically diverse base than competitors, and solid trends in its gaming markets. MGM owns nearly half of the megaresorts on the Las Vegas Strip, has a resort in Macau with another due to open within a year, and new properties outside of Washington, D.C. and in Springfield, Massachusetts.
In the second quarter, MGM's properties generated $2.64 billion in revenue and $823.7 million in property earnings before interest, taxes, depreciation, and amortization (EBITDA), which is a proxy for cash flow from a resort. On an annualized basis, that would be $3.3 billion in EBITDA, leaving the company with a very reasonable 10.2 enterprise value/EBITDA ratio, a measure of value commonly used in gaming stocks because it pulls out non-cash costs like depreciation.
What makes MGM Resorts a daring bet is the company's $13.3 billion in debt. It costs a lot of money to build the resorts MGM owns, and if either Las Vegas or Macau go into another downturn, it would be terrible for the company's stock. But the debt also provides a lot of leverage for investors if the company performs well. And that's exactly what it's been doing. Revenue grew 22% and adjusted EBITDA was up 28% last quarter as new resorts began contributing to results.
I think there's more growth ahead, which makes this stock a great bet for investors with a daring streak in them.
