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Missed Out On 2013's Hot IPO Market? These 3 Stocks Still Hold Value

Thursday, December 26, 2013 - 2:30pm

In most instances, it no longer pays to retain the services of a sophisticated stock broker. Many self-directed investors are now perfectly capable of building their own portfolios, or at least well-served by a lower-cost independent financial advisor.

But stock brokers still hold one clear virtue: They can get you a piece of a hot new IPO, right at the offering price, if the broker's firm helped underwrite the deal. The rest of us have had to wait until these IPOs have already begun trading. Often times, these stocks open for trading far above the offering price, which makes it hard to spot a good entry point.

A few months ago, I suggested that most of the time, "you should wait for these stocks to come back into earth before giving them a fresh look."

Roughly a month later, I gave an example of how to patiently wait for IPOs, highlighting the deep value in busted IPO Ply Gem Holdings (Nasdaq: PGEM). That turned out to be a timely suggestion as shares have begun to rebound. Frankly, it's hard to find such scenarios where good companies have been deeply oversold. Most of the stocks that plunge after IPO (such as Violin Memory (Nasdaq: VMEM)) deserve to trade far below the offering price.

Rather than waiting for those rare occasions for the next Ply Gem to come along, you can still profit from recent IPOs by focusing on good companies that have risen only modestly from their offering price. I scoured the heavy slate of companies that came public in just the past two months and found three clear bargains:

1. Houghton Mifflin Harcourt (Nasdaq: HMHC)
Shares of this textbook publisher were priced at $14 in mid-November, finished its first-day trading at around $16 and now trade for $17. The timing of the deal makes sense. A few years ago, most school budgets were frozen in the face of a tough economy. But school budgets have begun to loosen, and aging textbooks are starting to be replaced with new ones. Sales for HMHC likely grew around 6% in 2013, and are expected to rise 8% in 2014, according to Goldman Sachs.

Yet the real value in this business is the strong free cash flow generation. Dominant market share has led to firm pricing, which sets the stage for roughly $1.50 a share in free cash flow by 2015, according to Goldman.

To be sure, the U.S. textbook is fairly mature, and once school systems complete the current textbook upgrade cycle, then growth is unlikely to exceed 5%. In response, HMHC is beginning to pursue international markets, especially in the area of english-language textbooks, which are increasingly being sought after in many countries that want to boost english proficiency.

2. Extended Stay America (Nasdaq: STAY)
This mid-November IPO was priced at $22.75 a share and currently trades around $25. The company is the largest provider of long-term hotel lodging, with more rooms than its next five rivals combined. It's an appealing business model, led by solid pricing and low expenses, thanks to low daily turnover.

Extended Stay was bought out of bankruptcy by The Blackstone Group L.P. (NYSE: BX) and others in 2010, and while in private hands, more than $600 million in investments were made in modernizing each facility. (Blackstone also re-branded other extended stay hotels into with names such as StudioPlus and Homestead into the Extended Stay brand to gain better marketing traction.)

The upgrades are expected to yield solid gains in terms of revenue per available room (RevPAR) and higher profit margins. Analysts at Deutsche Bank note that although the company's RevPAR is now rising at a double-digit clip, they remain 26% below the peer group average. "That leads us to believe that STAY doesn't need much external help (from the economy), it just needs to execute its plan."

Despite low room rates, Extended Stay America has among the best margin profiles in the industry, according to Goldman Sachs: "The standout profitability is due to very high unit economics. Hotels are staffed with fewer people as the property does not provide daily maid service, room service, meeting space or any other high expense amenities," the analysts note, adding that "We expect these margins to expand an additional 200-250 bps as STAY continues to improve pricing and roll out new initiatives that will lead incremental expense to drop even further. Earnings before interest, taxes, depreciation, and amortization (EBITDA) of around $415 million in 2012 is expected to exceed $600 million by 2015, according to Factset Research.

3. Blue Capital Reinsurance (Nasdaq: BCRH)
Not only is this recent IPO trading below its offering price, it's also trading below book value. That's the case with other insurers and reinsurers as well (reinsurers provide backstop insurance to insurance companies in the event of catastrophic claims), though it's rare to see any IPO debut below book.

Yet there are a pair of other key reasons you should consider Blue Capital. First, the company is structured to pay out more than 90% of its income in the form of dividends. The dividend is likely to exceed $2.25 a share in 2014, according to UBS, and exceed $2.50 a share in 2015. That means the effective yield is already above 10%.

Moreover, this business model was built for rising interest rates. It generates larger profit spreads as rates rise, a key consideration at a time when the Fed has begun the tapering process.

Of course any stock that trades below book value and sports such a high prospective dividend yield may seem to be too good to be true. The catch: "Large catastrophe losses might materially impair Blue Capital Re's capital, and hurt the reinsurer's ability to underwrite new collateralized reinsurance deals," note UBS' analysts. Nearly a decade ago, Hurricane Katrina caused massive losses for reinsurers, and even though Blue Capital aims to minimize its exposure to any specific region or type of catastrophe, investors should brace for a bad year from time to time.

Risks to Consider: These are not the kinds of business models that would lead a surging bull market in 2014, as they are more steady-as-she-goes businesses. Indeed, if the market posts another great year, these stocks could underperform.

Action to Take --> These three IPOs represent solid values in a frothy IPO market. These are all better long-term investments than short-term trades, but each has catalysts to generate improving results in coming years.

P.S. If the hot IPO market has you excited about triple-digit gains, wait until you see what StreetAuthority's Andy Obermueller has been working on. Andy has identified five "game-changing" trends with the potential to revolutionize the way we live our lives -- and make early investors a killing. Among other things, these technological developments could allow blind people to drive... eradicate the gasoline engine... and revolutionize the way we think of healthcare. To learn more about these developing technologies -- and the companies behind them -- follow this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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