Learning How to Bottom-Fish, Part 2: Buying on the Cheap

Click here for Part 1.

For many investors, discounted cash flow is too futuristic a concept and it considers too many arbitrary factors. Jeff Matthews, manager of the Ram Partners hedge fund, often uses a much simpler approach that doesn't rely on too powerful a crystal ball and so many inputs. When scouring markets for companies that are having tough times, he looks for those that trade at, or below, 10 times what earnings could be two years into the future.

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He uses struggling retailer Nordstrom (JWN Quote) as an example. In its 2001 fiscal year ended Jan. 31, Nordstrom made 78 cents a share on sales of around $42 a share. Its operating margin for the year was only 2.4%.

Yet Matthews believes that the company can hike its operating margin to 7% in two years, as it has decided not to expand in certain areas, thus reducing expense pressures. Therefore, if Nordstrom boosts sales to $45 a share in its fiscal year ended January, 2003, it could make $3.15 a share in operating income. If interest expense remains around $60 million a year, or 50 cents a share, the company will have pretax income of $2.65 a share, and $1.60 in after-tax income, assuming a 40% tax rate. Matthews' fund bought Nordstrom around $15 (and still holds it), giving a price-to-earnings ratio of just under 10 on that $1.60 projection.

Cheap Stocks? Looking at Nordstrom (top) and Lubrizol

Matthews watches margins very closely. When they're compressed by factors that are definable and probably temporary, he's tempted to dive in. This was the case late last year, he says, with Lubrizol (LZ Quote), a company that makes chemicals that go into lubricants. (Matthews' fund owns this one, too.) Sharply higher raw material costs and the strong dollar hurt earnings in 2000. But such trends were likely to reverse themselves, at least partially, Matthews believed. To some extent they have, causing Lubrizol stock to soar nearly two-thirds since fall 2000 from around $20 to $33. Anyone buying at around $20 was paying under 10 times forecast 2001 earnings of $2.13 a share, according to First Call/Financial. And it would've been just eight times the 2002 projection of $2.38.

This approach can be useful in a recession, as good companies will bounce back when growth returns. But what if the slowdown turns into a drawn-out slump, like the one in Japan? Well, that's a whole other ball game...