RealMoney Silver - Two Ports in the Storm

Two Ports in the Storm
By Tim Melvin
RealMoney.com Contributor
4/9/2008 3:14 PM EDT

Things in the financial world still look bleak, but there are bright spots. It helps to know where to look, so I often emulate the investors who have proved themselves the best of the best. There's always value out there somewhere, but you sometimes have to wade through a lot of muck to find the treasures.

The bad news just continues to crawl across the tape. It has been relentless. Look at the major headlines just from Tuesday. Washington Mutual (WM) raised $7 billion from private-equity investor TPG. This represents a 100% dilution to current shareholders just to remain viable and patch up its fractured balance sheet. It does not look like it will get any better anytime soon, either.

Pending home sales in February dropped the most since 2001, and economists from Moody's estimated that sales will drop another 1.6% in March. As most of the problems at major banks and financial institutions stem from the collapsing real estate market, the continued declines do not bode well for the months ahead. We will know a lot more about the condition of the banking system by the end of April, when all of the major banks and brokerages will have reported earnings (or the lack thereof).

The International Money Fund presented a very gloomy outlook in an update to its global financial stability report. According to the IMF, global financial markets remain under strain, compounded by a slowing economy, the low levels of capital at financial institutions and a widespread attempt to sell debt holdings. The fund also estimates that the total losses form the mortgage and credit crisis could reach as much as $1 trillion. That estimate far exceeds the Wall Street estimates of $400 billion to $600 billion. The update was released as the finance ministers and central bankers of IMF member nations prepare to meet this weekend in Washington.

At times, it seems the only thing working in this market is surfing along with other momentum investors. The hot areas have been energy, gold and fertilizer stocks, and buying the dips in these groups has been working very well of late. Energy in particular seems to bounce ever higher after any selloff. Prices for crude oil dipped slightly on Tuesday but still remain over $108 a barrel. The official government estimate for gas prices was released today, and they think gas prices as a result of higher oil will reach $3.60, although many private forecasters think the real high will be closer to $4 a gallon. This type of price run-up is fueling earnings for energy companies, and they are one of the top-performing groups so far this year. As global food demand continues to rise, fertilizer stocks have been blistering hot, with many of the leading companies in the group doubling in the last year.

My problem is that as a dyed-in-the-wool value and distressed investor, I am more comfortable buying stocks on the steps of the bankruptcy court than at new highs.

Fortunately, there is one method I use that is working very well in the current market. I have written about the stock screen I developed based on the investment strategy of legendary investor Walter Schloss. This approach is working. Many of the stocks are showing double-digit gains and almost none of them have gone down any appreciable amount. I ran the screens again yesterday afternoon, and I found two names worth writing about. Many of the names fall into the micro-cap space and I cannot mention them here, but two new names of adequate size are worth a look at current prices.

Armstrong World Industries (AWI) is not in the best of industry groups right now. The company sells flooring, building products and cabinets, primarily through individual distributors and large home-care stores. The company is holding up fairly well, which is surprising given the overall slowdown in home spending. Declines in the U.S. market were more than offset by international results, particularly in building products.

The company just paid a $4.50 special dividend to shareholders, and if operating results are in line with projections, the company expects to make an additional payment of more than $4 a share later this year. The company also has more than $700 million in net operating losses that will shield income from taxes for the next four years, according to management estimates.

The stock is cheap, trading below book value at 60 cents on the dollar of sales, and sports an enterprise-value-to-EBITDA ratio of just 5.6. The stock is up a little off the lows but is still down 24% on the year. If it slips again in the weak stock market, I would be a buyer of this one.

The second name that jumped out at me was Validius Holdings (VR) . The company is the reinsurance business, specializing in those contracts with what are known as short-tail risks. These are risks that are not long-lasting, and the gain or loss on the contract is known relatively quickly. Validius writes business in the property, marine and special risks markets and has shown itself to be among the best in underwriting risks.

The combined ratio -- losses plus expenses compared to premiums -- was just 63% last year, one of the lowest in the industry. On the numbers, the shares are ridiculously cheap. The generate a return on equity of 29% but trade below book value and less than 5 times earnings. The shares pay a comfortable dividend of more than 3%, and the company has twice as much cash as debt on the balance sheet. There has been some insider buying, and Goldman Sachs (GS) and Merrill Lynch (MER) own almost 30% of the shares between them. Once again, the shares have moved up off the lows but could probably be bought on weakness.

I cannot be bullish on the overall market. I can, however, find some names that appear safe and cheap that are worth buying on market weakness. I am far from totally committed to the market and hold a lot of cash overall right now. However, these stocks are trading below book value and have positive earnings and cash flow with very little debt, and the long-term results for these two names should be very good.