Some stocks trade at cheap valuations for good reason. For others, temporary discounts based on misunderstandings and short-term issues can set shrewd investors up for big returns as the real story plays out and the discounts fall away.
We asked a panel of Foolish investors to share their best examples of misunderstood value plays in this market. Read on to see why they selected Medical Properties Trust (MPW +0.88%), KB Home (KBH 1.62%), and NeoPhotonics (NPTN +0.00%).
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A dirt-cheap high-yield stock
Matt DiLallo (Medical Properties Trust): Hospital-focused REIT Medical Properties Trust currently pays a 7.4% dividend that should catch the eye of income investors. However, one reason the yield is so appealing is shares' embarrassingly cheap price. It's a value that the market seems to be overlooking, which gives shrewd investors an opportunity to pick up an excellent income stock at a great price.
To put its valuation into perspective, we need to dig a bit deeper into the numbers. In Medical Properties Trust's case, the company initially expected to generate between $1.35 to $1.40 per share in normalized funds from operations (FFO) this year, which is how REITs report their underlying earnings. However, that forecast assumed it would make $500 million to $1 billion in acquisitions, which has proven to be conservative since it recently announced a $1.4 billion deal that should add $0.10 per share to its FFO in the future. Given that updated projection, and using the stock's current trading price of around $13 per share, it suggests a valuation of just 9.0 times FFO.
That's dirt cheap considering that the S&P 500 trades at more than 24 times earnings these days. Furthermore, the stock is also ridiculously cheap compared to other healthcare-focused REITs. For example, industry leader Welltower currently expects to generate $4.15 to $4.25 per share in FFO this year, which at its recent low-$70 share price implies that it's trading at about 17 times FFO. That higher valuation is why Welltower only yields 4.8% even though it pays out a higher percentage of its cash flow in dividends than Medical Properties Trust and has a higher leverage ratio. Both of those metrics suggest that Medical Properties' payout is on stronger ground, which is why smart investors should take a closer look at this compelling value stock.
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Facing down short-lived trouble in China
Anders Bylund (NeoPhotonics): This maker of optoelectronic networking components is having a difficult year on Wall Street. Share prices have fallen 36% over the last 52 weeks and 25% in 2017 alone. And why not? After all, NeoPhotonics set up gloomy guidance for May's first-quarter report and then failed to clear even that low bar.
But that's not even the reason why NeoPhotonics stock is suffering in 2017. Share prices immediately jumped on both the March and May reports, but the overall downward trend continued.
So here's the real scoop. NeoPhotonics is a small-cap stock with a $347 million market cap and a ton of built-in volatility. The company's cash profits and top-line sales are taking a beating right now due to low order volumes from China, but that's a temporary problem. So we get a business with solid long-term prospects, but the stock is trading at bargain-bin prices.
The Chinese situation deserves an explanation. Telecom equipment builders in the Middle Kingdom expected to do a lot of infrastructure building in 2017, so they stocked up on the components necessary for building fiber networks with next-generation 100G connection interfaces. But local giant China Mobile tapped the brakes on network upgrades, sending ripples through the fiber-optic industry.
The excess inventories should be consumed by the end of the second quarter, setting up NeoPhotonics and other vendors with big Chinese exposure for a sharp rebound. All told, NeoPhotonics' management expects overall Chinese orders to increase in 2017 and again in 2018.
Meanwhile, the stock is trading at sector-low price-to-sales and price-to-book-value ratios. I'm so convinced of NeoPhotonics' clear path back to stronger financial results and higher share prices that I recently added a few shares to my own real-world investment portfolio. If you don't want to follow suit, this stock most certainly belongs on your watch list for further research.
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Creating value from the ground up
Sean Williams (KB Home): Shrewd investors looking for a great deal might be wise to stare rising interest rates right in the eye and go against convention by taking a closer look at homebuilder KB Home.
Generally, an environment where the Federal Reserve is tightening monetary policy and interest rates are rising isn't a good thing for homebuilders, since it tends to lift mortgage rates as well. In recent years we've witnessed a pretty sharp decline in mortgage applications following 50- to 75-basis-point short-term increases in mortgage rates. Thusly, most investors will likely be thumbing their noses at homebuilders, despite many trading at value stock levels.
As for this Fool, I'd suggest that KB Home could be just what value stock investors need. After all, it fits all the specs of a value stock, with a PEG ratio of just 0.63 and a forward P/E of just 11. Normally, a PEG ratio below 1 signals a cheap stock.
But we'd like to see more than just cheap fundamentals as a rationale to buy, and KB Home does offer an intriguing reason. As noted in its recently reported second-quarter results, the average selling price of its homes rose by 11% to $385,900. Relative to its peers, KB Home has moved toward catering to a middle- to upper-middle-income clientele. More affluent homebuyers are less influenced by minor fluctuations in GDP growth and minor moves in mortgage rates. Therefore, KB Home should be better positioned than its peers to succeed in our current environment of low inflation, modest growth, and slow interest rate hikes.
KB Home's management team is also not falling into the same trap it did a decade ago when it was building homes without regard for demand trends. The company now works to ensure that its new home construction more accurately reflects demand trends, which in turn helps give KB Home relatively strong pricing power.
Though KB Home is a cyclical company, and this bull market rally will end eventually, it offers intriguing long-term value given its focus on a more affluent clientele and more popular homebuying markets.
