Core Concepts: A Look at Chemical Stocks

This column was originally published on RealMoney on Feb. 1 at 8:52 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

So you want to be a better investor. There's a key prerequisite: You must have a desire to learn. By enhancing your investing skill set, you'll improve your odds of identifying bargain stocks more easily and be less likely to overlook multi-bagger opportunities.

Over the next few months, I'll be integrating core investing concepts into a methodical review of stocks in every major market sector. Today, I'll take a look at chemical companies, and tomorrow, I'll examine stocks in the computer and office supply sectors.

Although chemical stocks don't hold much allure for many investors, don't make the mistake of dismissing this group out of hand. Bargain-hunters are willing to go anywhere and everywhere in pursuit of heavily discounted assets. In fact, it's easier to spot bargains in sectors that are largely ignored by the investing crowd.

Avery Dennison: Too Stable

First, let's take a look at Avery Dennison (AVY Quote). This specialty chemical company makes for an interesting case study for students of the stock market. It might be counterintuitive, but Avery Dennison illustrates the risk of buying companies that are too stable.

Companies with stable margins and average sales growth generally have both limited downside and limited upside. Study the operating history of Avery Dennison, and you'll see very little oscillation in its operating metrics. This consistency makes it easy for the market to price the stock. Below-average operating change translates into a stock with below-average price change, as this five-year chart shows.

Avery Dennison

Source: BigCharts.com

As a bargain-hunter, I'm interested in mispriced -- or "inefficiently priced" -- stocks, and that requires reasonably wide swings in operating performance. Therefore, Avery Dennison is not an appealing stock.

However, the good news is that this particular company is the exception rather than the rule. The stuff of business is highly irregular and inconsistent, and that creates an abundance of opportunity in the stock market.

Sherwin-Williams: Panic Can Pay

For instance, the operating history of Sherwin-Williams (SHW Quote), the No. 1 supplier of paints and varnishes, is a thing of beauty: strong sales growth, hefty free cash flow, a shrinking share base and an impressive balance sheet. But even best-of-breed companies suffer a crisis occasionally, and that gives astute investors the chance to buy at bargain prices.

In early 2006, there was a brief panic in Sherwin-Williams stock -- a sudden 25% decline -- over litigation concerns.

Sherwin-Williams

Source: BigCharts.com

Investors should take a close look at any company in the midst of a panic. When the underlying cause is transitory in nature, there is almost always a compelling investment opportunity. As you can see in the chart above, buying on the panic dip in Sherwin-Williams would have paid off nicely.

IFF: It's in the Balance Sheet

I'm interested in buying companies ahead of significant improvement. But if you're looking for that kind of potential, don't focus only on the income statement. Sometimes material improvement in the balance sheet alone can make for an outsized investment opportunity.

Over the past six years, the business of International Flavors & Fragrances (IFF Quote) hasn't changed much. Sales have grown about 2% per year, while margins are about the same as they were six years ago. Why, then, has the stock more than tripled since the middle of 2000?

International Flavors & Fragrances

Source: BigCharts.com

The source of the improvement at International Flavors & Fragrances is in the balance sheet. Six years ago, the balance sheet weakened materially because debt was used to make a major acquisition; debt increased from near zero to $1 billion. Since then, though, management has allocated the company's rich free-cash-flow stream to reduce debt (from $1 billion to $500 million) and to buy back shares (about 10% of the share base). The net result is a greatly improved balance sheet.

Despite minimal operating change, the market has responded by valuing the stock at 2 times sales instead of 1 times sales. The fact that management plowed free cash flow into balance-sheet improvement increased investor confidence in the durability of the franchise.

It's not just inconsistency within the income statement that makes for investing opportunities. Instability in the balance sheet, followed by improvement, can also create opportunity.

Georgia Gulf: A Name to Consider

The situation at Georgia Gulf (GGC Quote) here is analogous to International Flavors & Fragrances' in 2000. Georgia Gulf has taken on a lot of debt to acquire Royal Group. The combination of an added debt load and the company's exposure to the housing market has resulted in the stock trading at a five-year low.

Georgia Gulf

Source: BigCharts.com

An upward adjustment in the stock's valuation will be precipitated through a deleveraging of the balance sheet, like with IFF, above. By next year, the company will be generating more than $150 million per year in free cash flow. Against the market cap of $712 million, that translates into a 21% free-cash-flow yield.

The bugaboo for Georgia Gulf is debt, now at $1.2 billion. As free cash flow is allocated to repay debt, the market will price this stock at higher levels. My calculations indicate a value of more than $50 per share in a couple of years. The stock closed Wednesday at $20.81.