Take a Look at My "Cheat Sheet" of Undervalued Stocks

David Sterman's picture

Thursday, January 5, 2012 - 10:00am

by David Sterman

They say stocks "climb a wall of worry." Well, investors now have something new to worry about.

Concerns are growing that profit margins may have peaked for many companies in 2011 and could slip a bit in 2012 and 2013. It's a valid concern. In past economic cycles, companies operated in an ultra-lean fashion during periods of economic weakness, but needed to spend more money on staff and raw materials when the economy starts to strengthen.

If profit margins have indeed peaked and earnings-per-share (EPS) growth is hard to muster, then investors are likely to focus on other metrics that help point the way toward value. My favorite litmus test for a stock's value is in the area of free cash flow (defined as operating income minus capital spending). Every dollar of free cash flow goes right to the cash balance, giving a company even greater flexibility in terms of dividends, stock buybacks and acquisitions.

Perhaps of greater import, free cash flow yields (defined here as the free cash flow divided by the market capitalization -- though some prefer to use enterprise value) are so much higher than actual yields on government or corporate bonds. Any time you can find a company with free cash flow yields in excess of 10%, you need to take notice.

I've found 15 of them.

Actually, I found more than 50 of these free cash flow yield powerhouses, based on 2010 results. I narrowed the list down to companies that are likely to post robust free cash flow in 2011 (when results are announced) and 2012 as well.

How do I know what free cash flow will look like?  No one has a crystal ball, but all of these companies are expected to post EPS that is higher in 2011 and even higher in 2012. Free cash flow and EPS aren't always in sync, but it's the closest correlation we can find. By using EPS as a measuring stick, we can see that each of the 15 stocks in the table below trades for less than 10 times projected 2012 earnings.

All of these companies are thus inexpensive in two ways. The fact that they are expected to boost profits in what is expected to be a tough 2012 speaks to the resilience of their business models. You'll note three names at the bottom of the table that speak to a clear theme. Each firm can count on recurring revenue to keep profits -- and free cash flow -- at peak levels.

In the case of Xerox Corp. (NYSE: XRX), a reliance on long-term outsourcing contracts surely helps build confidence that near-term results won't fluctuate. My colleague Adam Fischbaum laid out the merits of Xerox's business model back in November. [See Adam's article here.]

In a similar vein, Gilead Sciences (Nasdaq: GILD) can count on steady demand for its existing portfolio demand of biotech drugs while it invests in the next generation of potential blockbuster drugs. AGCO (Nasdaq: AGCO), which makes tractors and other farm equipment, should benefit from the ongoing profits generated in the agriculture sector.

Yet one other stock holds the greatest appeal for me...

Hertz Global Holdings (NYSE: HTZ)
The economic slowdown of 2008 was a wake up call for Hertz -- and the entire rental car industry., The industry lacked discipline in earlier years, offering too many cars, and price wars became inevitable. In some markets, it was possible to rent cars for just $25 a day. Adding insult, the used car market slumped badly in 2008, and these firms were hard-pressed to generate much cash when it came time to sell cars after a year or two of service in their rental fleets.

The tough times brought a silver lining. Hertz, along with rivals Avis Budget (NYSE: CAR), Dollar Thrifty (NYSE: DTG) and privately-held Enterprise Rent-A-Car, sharply reduced the number of cars they bought. Scarcity has a way of boosting prices, and that's just what happened as rental car prices rose higher and higher during the next two years. Equally important, used car prices have risen in value, so these firms now collect more money when it comes time to sell vehicles.

Those trends led to impressive results for industry leader Hertz, which saw a 30% jump in free cash flow in 2010 to $2 billion. Results have been solid in 2011 as well. In the third quarter, Hertz posted an 89% jump in operating income (to $296 million) on an 11% rise in sales (to $2.4 billion).

The year ahead is unlikely to present further robust growth, as the U.S. and European economies remain in a weakened state. But Hertz's free cash flow should remain prodigious.

The fact that this company's $5 billion market value is less than the $5.8 billion in free cash flow generated during the past three years highlights a clear disconnect. Sporting a 38% trailing free cash flow yield, and a forward price-to-earnings (P/E) multiple below 10, this stock looks to have 30% to 50% upside in the year ahead.

Risks to Consider: The greatest risk to free cash flow doesn't come from a slower economy, but from a management decision to sharply boost capital spending. Still, this would simply set the stage for the next round of strong free cash flow in subsequent years.

Action to Take --> The greatest charm of these free cash flow yielding stocks is their defensive nature. Shares are likely well-supported by the robust free cash flow, as the companies could look to boost share buybacks or dividends if the stock weakens to create interest in these stocks. Hertz is clearly my favorite stock of the group (which, as I said, has up to 50% upside), but any of the other stocks in this table are deserving of further research as well.

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.