Blue-Chip Bargains?

I'm often asked how I generate stock ideas. There are many sources, but mostly, I read constantly, regularly talk to a lot of smart investors, and occasionally use stock screens. There are dozens of screening tools -- some free, others very expensive -- and countless criteria that one might use to filter stocks, but I've found that one of the best is to simply search for stocks trading at or near their 52-week lows. This makes sense since I'm looking for 50-cent dollars -- stocks trading for half or less of their intrinsic value -- and such bargains are likely to be severely out of favor.

Free, simple stock screening
Every day TheWall Street Journal publishes a list of stocks that hit a 52-week low on the previous day, but I prefer to look at a broader group of stocks, those trading within 5% of their 52-week lows. Using the free Yahoo! Finance stock screener (see below for exact instructions on how to run this screen), 260 companies qualify based on yesterday's closing prices. Since I like high-quality companies and liquid stocks (all other things being equal), I sorted by market capitalization. Here are the results, sorted by market capitalization, of the 10 largest market cap U.S.-based companies whose stocks are within 5% of their 52-week lows:

Source: Yahoo! Finance
* Liberty Media is a holding company, so EPS (and therefore ROE and P/E ratio) are not good ways to evaluate it.
** Because of a few extremely high numbers, I used the median ROE.

Now that's an interesting list, isn't it? Some of the world's greatest companies are trading at or near their 52-week lows and, as a group, they have much higher returns on equity and dividend yields than the average company in the S&P 500, yet they trade at a substantial P/E discount. To be sure, some of these companies have real issues -- Merck, for example, just pulled its second-best-selling product from the market, which is going to crush its earnings -- but much of this is the market overreacting to short-term issues. In fact, I'll go as far as to say that I believe it's highly likely that these 10 companies, as a group, will substantially outperform the S&P 500 over any period longer than a year.

So why am I not buying these stocks? The reasons vary, but they mostly relate to circle of competence. I have little ability to evaluate pharmaceutical companies' drug pipelines, for example, and valuation. Simply because a stock is near a 52-week low doesn't mean it's cheap.

Of the 10 stocks, six fall into two categories: three in branded consumer household products and three pharmaceutical companies. Let's take a closer look at them.

Consumer products companies
Coca-Cola (NYSE:KO), Anheuser-Busch (NYSE:BUD), and Colgate-Palmolive (NYSE:CL) are three all-time great companies that every businessperson should study, even if the stocks never get cheap enough to buy. Of the three, Coke has the most serious issues, with management turmoil, stale marketing, and stagnant sales. Despite these issues, however, cash flows are extraordinary and growing -- and let's not forget that Warren Buffett once named this business an "inevitable." It speaks to the broad-based complacency and overall high valuation levels in the market today that a company with such difficulties still trades at nearly 20 times next year's estimates.

Colgate issued its first formal profit warning in almost a decade last month, which is the main reason why the stock has fallen 25% recently. It continues to be an exceptional company with fabulous management, however, so it's absurd that it trades at a discount to the average company in the S&P 500. A few more dollars and it'll be cheap enough for me to buy.

I feel similarly about Anheuser-Busch, a stock I've always wanted to own. It hasn't really sold off much because the business is doing just fine. While the stock is 4% above its 52-week low, it's also only 8% below its 52-week high, and the company is on track to record its 24th consecutive quarter of double-digit EPS growth.

In summary, there's little doubt in my mind that these three stocks are undervalued, but just not enough for me to buy them. I'll pay up for the stocks of really high-quality businesses, but that means buying at most 65-cent dollars, and these stocks are all roughly 80-cent dollars. They're pretty close to my buy points though, so I'm starting to get my hopes up.

Pharmaceutical companies
It's not just Pfizer (NYSE:PFE), Merck (NYSE:MRK), and Eli Lilly (NYSE:LLY) -- for a variety of reasons, the stocks of most of the major pharma companies are trading near their 52-week lows, and the Amex Pharmaceutical Index is currently at its 52-week low. One of the major reasons is that investors are waking up to the fact that, as I wrote in a column more than three years ago, "How AIDS Threatens Drug Makers," "the profitability of the pharmaceutical industry depends almost entirely on charging high prices in the major industrialized countries -- especially the United States." When we're facing so many issues of our own, that's just not sustainable, and pharma companies are starting to feel the pinch.

Pharma companies will still be great businesses for a long time to come, but I think it's quite likely that they will slowly decline and become merely good businesses over time, so I'm reluctant to pay up for these stocks.

I'm not buying any of these three stocks, but I view Pfizer most favorably, as I think Lilly is too expensive and Merck has too much potential legal liability related to Vioxx, the drug it just withdrew from the market. A study led by a Food and Drug Administration safety official projects that Vioxx may have led to more than 27,000 heart attacks and sudden cardiac deaths. To get a sense of the potential magnitude of the liability, consider that Wyeth (NYSE:WYE) has taken $16 billion to $17 billion in charges and has paid out over $13 billion for settling lawsuits related to the fen-phen diet drugs.

Conclusion
Sifting through 52-week-low lists is a good way to generate interesting stock ideas, but be careful. Most beaten-down stocks are that way for good reasons, especially in today's fully priced market, so it takes a lot of work to find the occasional gem in the rough.

Instructions for Yahoo! Finance stock screener

1. Go to: http://screen.finance.yahoo.com/newscreener.html.
2. Click: Launch Yahoo! Finance Stock Screener.
3. Near the top, under Criteria, click on the green text, "Click to add Criteria."
4. On the pull-down menus that appear, select "Share Performance," then "Extreme Price Parameters (%)," then "Current Price Greater Than 52-Week Low (%)."
5. In the next box to the right, under Conditions, select "<=".
6. In the third box to the right, under Values, type in "5".
7. Click the Run Screen box on the left side.

Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. He did not own shares in any of the companies mentioned in this article at press time, though positions may change at any time. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.