3 Recent Stock Buys From One of the Greatest Value Investors of All Time

In the value investing Hall of Fame, financial expert Mario Gabelli should earn top honors. Gabelli leads GAMCO, a $36 billion global investment firm that has generated 16% annual returns for investors since the firm’s inception in 1977.

Gabelli uses a bottom-up, value-driven approach to identify stocks that are undervalued. His unique approach involves determining a public company‘s worth based on what a private investor might be willing to pay for it, and then looks for a catalyst that could unlock the company’s hidden value. The catalyst can be a regulatory change, business sale or spin-off, or a change in management.

In the case of three of his latest portfolio additions, Gabelli looked for recent spinoffs that have great upside potential. Each stock has posted double-digit gains since becoming independent companies. And there could be further gains ahead.

Here they are…

1. Xylem (NYSE: XYL)

Gabelli acquired a $50.5 million stake in Xylem, a provider of equipment and technology for water-testing and wastewater remediation. Since being spun off from ITT Corp. (NYSE: ITT) last October, Xylem shares have climbed almost 17%.

One of the long-term catalysts for Xylem’s growth is an aging global water infrastructure that will require nearly $1 trillion of investment during the next 20 years. Another one is the increasing demand for new technologies to treat wastewater created by hydraulic fracturing (or “fracking”), a technique used for extracting oil and gas from underground rock formations. The process requires millions of gallons of water for each well, and water shortages are becoming a major challenge at drilling sites.

Drillers have been investing in technologies to recycle wastewater produced by fracking, and Xylem is particularly well-positioned to benefit since it already supplies the instruments that test water quality for fracking contaminants. Water testing and treatment is a $500 billion business globally, and Xylem has the scale and worldwide presence to be an attractive asset to a much larger company.

Looking at the numbers, it’s easy to see why the stock is a solid pick. Xylem grew revenue 7% in 2011 to $3.8 billion in comparison with the previous year, while earnings improved a nice 30% to $358 million, or $1.93 per share. The company’s EBITDA totaled $624 million — nearly twice the reported earnings figure — which gives it plenty of cash to fund growth initiatives. Xylem is targeting 4%-6% revenue growth and 8%-17% earnings growth this year. Analysts peg earnings growth at 13%.

2. Fortune Brands Home & Security (NYSE: FBHS)
Gabelli purchased 2.5 million shares of Fortune Brands Home & Security during the December quarter at prices averaging $15 a share. Since then, the value of his investment has climbed nearly 40%.

This company was formed last year when diversified conglomerate Fortune Brands spun off its liquor business, now known as Beam (NYSE: BEAM). The remaining businesses became Fortune Brands Home & Security, a pure play on the housing market recovery. Fortune Brands owns top brand names like Master Lock, MasterBrand cabinets, Moen faucets, Simonton windows and Therma-Tru entry door systems.

Unlike others in the construction industry, Fortune Brands remained profitable through the worst of the housing crisis because of its more recession-resistant lock and faucet businesses. The company’s cabinet and window businesses are poised for a major rebound when housing starts improve.

Last year, Fortune Brands’ revenue rose 3% to $3.3 billion compared with 2010. Earnings fell 17% to $149.5 million in the same period, primarily because the weak sales in the windows and door segment dragged earnings down. Cash flow, however, improved 26% to $175.4 million.

Fortune Brands says even a slight improvement in the construction and home-remodeling market could boost earnings growth to roughly 20% this year. Analysts also have a positive outlook for the stock, saying it could produce 22% yearly earnings growth during the next five years.   

3. Liberty Media (Nasdaq: LMCA)

Liberty Media was formed when Liberty Interactive (Nasdaq: LINTA) spun off its online shopping channels business last September. The remaining business — Liberty Media — owns the Starz and Encore movie channels, the Atlanta Braves baseball team and numerous smaller assets. But Liberty Media’s most valuable holding is its 40% stake in satellite radio firm SiriusXM (Nasdaq: SIRI), which is currently worth nearly $4 billion. Liberty can increase its position up to 100% ownership at any time.

SiriusXM is the United States’ only provider of subscription-based satellite radio service. With 20 million subscribers currently, the company produced more than $3 billion in revenue last year. The key driver of subscriber growth for SiriusXM is auto sales, and 2012 is expected to be an exceptional year, with sales estimated at 13.7 million units. As a result, analysts forecast 20% yearly revenue growth for SiriusXM in the next five years. 

In addition to the robust results for SiriusXM, an 8% year-over-year increase in the subscriber base for Starz last year fueled 48% growth in Liberty Media’s total revenue, up to more than $3 billion. The company’s earnings fell 19% to $812 million compared with 2010, however, because of a big jump in the tax rate it had to pay. Analysts look for the company to post 25% earnings growth this year and 5% yearly growth during the next five years

Gabelli bought $62.3 million in shares of Liberty Media in the fourth quarter of 2011 at prices averaging $70 a share. Since then, the value of these shares has soared 25%. 

Risks to consider: Fortune Brands relies on an improving housing market to drive future earnings, but a sustainable recovery may be years away. Investors who buy Liberty Media for its SiriusXM stake should also note that Liberty Media could also sell some or all of its SiriusXM shares at any time.  

Action to Take — > Gabelli clearly knows how to identify stocks with great catalysts and upside potential. I like Liberty Media, in particular, because it’s an ideal stock for investors who want to benefit from SiriusXM’s high growth, while limiting their risk exposure through Liberty Media’s diversified media portfolio. Fortune Brands is a good holding for investors who believe a sustained housing market rebound is not far away. Xylem is a great stock to consider for investors seeking exposure to infrastructure and energy-related services.