Value investing is a lot more than simply buying stocks that look cheap. Shares of a business in permanent decline may look inexpensive, relative to earnings, sales, book value, or another metric, but they're cheap for a reason.
The best value stocks are cheap because the market is wrong about their potential. Sometimes, a solid company that has a good shot at turning itself around after facing some temporary setbacks can be priced like the world is ending. If the world doesn't end, that stock can produce stunning returns in the long run.
As we enter 2022, AT&T (T -0.00%), International Business Machines (IBM -0.43%), and Intel (INTC -0.33%) all fit into this category. All three have a decent growth story to tell, and all three have a lot of pessimism priced in.
Shares of AT&T have been hammered over the past few years as the company's acquisitions of DirecTV and Time Warner failed to deliver. AT&T fancied itself a media conglomerate, and it spent heavily in a bungled attempt to fulfill that vision.
DirecTV has been spun off, and Time Warner (now WarnerMedia) is set to be merged with Discovery to create a media and streaming giant. After the dust settles, AT&T will be a telecom company again, free from the distractions of the media business and better able to invest in its core business.
AT&T expects to produce around $20 billion of free cash flow in the first full year after the WarnerMedia deal closes. With a current market capitalization of around $175 billion, the market is clearly pessimistic. AT&T shareholders will also own 71% of the media company created by the spin-off. That media company is expected to produce $52 billion of revenue in 2023.
This all seems like a pretty good deal. Buy AT&T for less than 10 times expected post-spin-off free cash flow, and later this year you'll own a leading telecom company and a big chunk of a new media and streaming giant. AT&T will cut its dividend once the deal closes, which is probably weighing on the shares. And AT&T's post-spin-off estimates could very well be overly optimistic. But given the rock-bottom valuation and the stability of the core wireless business, it's hard to see an investment in AT&T going all that badly over the next five years.
International Business Machines
IBM has dumped its slow-growing and labor-intensive managed infrastructure services business, spinning it off as a new company called Kyndryl. What's left of the century-old tech giant is now laser focused on hybrid cloud computing and artificial intelligence.
While IBM's cloud business has grown substantially over the past decade, the company has been weighed down by legacy businesses. Revenues and profits have been trending lower for a long time. A sustainable return to growth has proved elusive.
With around $19 billion of low-margin revenue now out of the picture, IBM's growth profile looks a lot better. The company expects sustainable mid-single-digit revenue growth to be the norm, along with high single-digit growth in free cash flow. Over the next three years, IBM expects to produce around $35 billion of free cash flow in total, or nearly $12 billion on average each year. The company is valued at just $120 billion.
It's been a very long road for IBM shareholders betting on a turnaround, and the stock has a lot of pessimism priced in. If IBM can deliver on its targets, or even come close, the iconic tech company could be worth far more in five years than it's worth today.
Chip giant Intel is working on its own turnaround. Under CEO Pat Gelsinger, an Intel veteran lured back to right the ship, the company is embarking on a costly plan to regain its manufacturing edge and build a world-class foundry business.
Intel is still a highly profitable company, but years of delays bringing new process nodes to volume production have degraded its key competitive advantages. Third-party foundries like Taiwan Semiconductor have surpassed Intel on the manufacturing side, and rival AMD has taken advantage. AMD is now producing PC and server chips that are as good or better than what Intel is producing.
Intel's plan is to pour cash into new manufacturing facilities. The company will spend as much as $28 billion on capital expenditures this year, and that number may increase in future years. For comparison, the company expected to spend around $19 billion in 2021.
Intel's manufacturing push will take years to play out, and earnings will take a hit until the company's heavy investments pay off. But if Intel gets it right, it can maintain its dominant position in the PC and server chip markets while claiming a big chunk of the foundry market. Foundries soaked up around $100 billion of spending last year, and there's no reason Intel can't compete in that growing market.
Even factoring in the expected earnings hit, Intel stock is priced at a pessimistic level. The stock trades for just 14 times the average analyst estimate for 2022 earnings. The market seems to be completely ignoring Intel's long-term potential.
Intel has a proven leader at the helm and plenty of cash flow to fund much of its capital spending plans. Demand for semiconductors is high, supply is constrained, and it doesn't look like that situation will change anytime soon. Intel has a good story to tell. Add in a beaten-down valuation, and you've got yourself a stock that could soar.