Nathan Slaughter Explains Why Now is an Amazing Time to be a Value Investor

Brad Briggs's picture

Friday, February 13, 2009 - 2:29pm

by Brad Briggs

Nathan, some investors may feel we've found ourselves in uncharted territory during this market, but you seem to think value investors should be salivating right now. Why?
Nathan Slaughter: There are always bargains to be had in the market. Unfortunately, during normal conditions value hunters looking for deeply underpriced stocks must often settle for troubled turnaround candidates or sluggish companies without any real growth drivers. But during last year's panic, worried investors dumped their holdings indiscriminately and threw the good out with the bad.

So now, even the most attractive growth stocks have slipped well into value territory -- the best of both worlds. We're finding a number of high quality companies with promising outlooks and unimpaired fundamentals whose share prices have become completely disconnected from their underlying value. Thanks to this short-sighted selloff, investors can drive home these sleek luxury stocks for the price of an old clunker.

As you might imagine, we rarely get the opportunity to invest in premium companies at discounted prices. Sooner or later, the market will realize its mistake and begin adjusting the price tags. In the meantime, we're cashing in on the situation by greedily scooping shares of powerful industry leaders out of the bargain bin.

Given the sheer number of bargains in the market right now, what strategies are you using to help readers identify and Well, as I mentioned in Tuesday's issue, there are actually three areas where I see value investors profiting in this market.

In terms of valuation, P/E and PEG ratios can help give us a ballpark idea of whether a stock is undervalued relative to its peer group or historical average. But these blunt instruments don't really quantify just how much a stock is worth -- so I only use them as a starting off point. From there, I dig deeper into a company's competitive position, balance sheet assets, and future cash flow projections to calculate a more precise fair value.

This discounted cash flow analysis unquestionably shows that the number of half-priced stocks (those trading at a -50% or more discount to fair value) has exploded.

For example, Nam Tai Electronics (NYSE: NTE) has no business trading below $5 per share. The stock is worth at least $10 -- implying triple-digit upside potential. Sure the electronics manufacturer is facing some challenges this year, but how often do you find a company with a market cap of $203 million that has $240 million ($5.40 per share) in net cash in the bank? Essentially, that means the market is giving away the firm's equipment and operations for free.

If you're a value investor with a thirst for growth, then this is your market, too. For example, Fuel Systems Solutions (Nasdaq: FSYS), which makes components for natural gas vehicles, has raised its earnings forecast three times in the past three quarters and delivered an explosive 20-fold surge in profits over that period. However, the market wasn't paying attention and pushed the shares down to a P/E of 12.5, against an expected long-term growth rate of +25%. That means the stock can be had for an unheard-of PEG ratio of around 0.5.

Finally, I'm using this downturn to lock up extraordinarily high yields on cash-rich companies in stable industries that have been unfairly punished -- such as utilities and master limited partnerships (MLPs). With crystal-clear cash flow visibility and limited exposure to the problems plaguing the broader economy, these stocks are throwing off double-digit payouts and are likely to rebound sooner rather than later.

What are some key factors you look for in an undervalued stock?
My overriding goal is to seek out wide-moat companies with sustainable competitive advantages that translate into superior long-term returns on capital. Without a powerful brand name, a patented technology, a sticky customer base, or some other type of defensible competitive advantage, nothing else matters and profitability will ultimately be sub-par.

It's possible for a company to grow earnings and still squander shareholder value, so I pay close attention to returns on equity and look for savvy, efficient management teams. I also place a premium on industry leaders who are aggressively picking up market share, particularly if the overall industry itself is growing rapidly and has high barriers to entry. And if the business model allows for some scalability as the company grows, even better.

In the end, the traits that most investors covet (expanding margins, healthy earnings growth, etc.) are all driven by something larger -- a blockbuster drug, a disruptive new technology, or aggressive store expansion. So I look beneath the numbers to determine just what's influencing them. Ideally, all of this points to steady cash flow generation (the ultimate measure of a company’s worth) for years to come.

#-editor_pick-#What are some examples of stocks you've found in the past that rebounded once investors spotted value and what are some things you're looking at now?
In my November 2008 issue of Half-Priced Stocks, I flagged heavy truck maker Oshkosh (NYSE: OSK) as an undervalued company to watch. The shares had slid from $56 to just $7.66 and were being pressured in part by weakness in the residential housing market.

But I saw a company whose military vehicle division was on the Department of Defense's speed dial -- it had just secured a $187 million contract from the U.S. Marine Corps. I also liked the firm's habit of hiking dividends about +35% annually, and the fact that it was still upping its earnings outlook even in this grim environment.

But the market saw the glass as half-empty, and the shares sunk to just 2 times earnings (down from a historical average of 18). At that point, the stock was trading well below half its fair value. I saw a compelling opportunity, and was happy to see OSK vault +60% over the next couple months and rally back above the $12 mark.

In December, I called readers' attention to Brunswick (NYSE: BC), a leading global supplier of boats, billiard tables and other leisure equipment. Given tighter access to credit and slack demand for big-ticket goods, the firm is facing some stiff headwinds. But after an -85% plunge, most of that weakness had already been priced into the shares. Furthermore, management had recently unveiled cost-cutting initiatives that would slash expenses and keep the company cash flow positive even if sales plunged. In the meantime, the shares could be had at valuation levels last seen in 1983. With all that in mind, I added BC to my portfolio at a price of $3.29 per share in early December -- just before it surged +85% over the next month.

Today, I'm concentrating a good deal of my analysis in the infrastructure sector -- an area where both the United States and China will be spending heavily over the next few years. Elsewhere, demand for oil may be soft at the moment, but there's little to suggest this downturn is permanent. Exploration and production companies will still spend billions each year to find and develop new offshore discoveries, which means steady business for offshore drillers like the one you'll find in the "High-Growth Value Portfolio" of Half-Priced Stocks.

I'm also bullish on a company that makes pollution control systems for coal plants. This firm's groundbreaking technology will help bridge the gap between traditional and alternative energy. I profiled this company in this month's issue of Half-Priced Stocks and added it to my "High-Growth Value Portfolio." It should do well in the coming year.

In fairness to my paid subscribers, I can't reveal the names of these firms here... but you'll get all the details -- as well as instant access to all three of my model portfolios -- when you join me at Half-Priced Stocks.

Brad Briggs 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.