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Three Good Companies for Next to Nothing

Stocks in this article: KHD HNR KSWS

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for readers.

It's official: The general investing public truly hates the stock market. How else can you explain the absurdity surrounding some valuations today? And no, I am not talking about low price-to-earnings or low price-to-book ratios, although they are fine metrics to lean on.

Instead, I am referring to businesses that have gone beyond low earnings valuations and have gotten to where they trade near net cash on the balance sheet. In other words, the market is giving you the businesses for next to nothing.

When looking today at business that have lots of cash, keep two caveats in mind. First, before getting too excited about cash levels, you have to anticipate how the business will operate in the future. If a business is currently burning through a lot of cash, then the cash on hand today is not as big as it may seem in the context of valuation. In this environment, you want to find companies that look capable of generating enough internal cash from operating activities.

Second, most investors should understand that over the last few years, the levels of corporate profitability were, in most cases, generated during the cyclical peak of the business cycle. So if you believe, as I do, that corporate profitability will contract over the next year, don't rely on profits and cash flows when you make your estimates for 2009.

While I certainly believe that many businesses will be earning record profits four or five years from now, we need to consider the situation at hand. And the reality is that profits are likely to contract in the near term.

I'm always looking for a margin of safety, and in this environment I like to look at average profits and cash flows for the last four or five years to get a more accurate picture of the numbers for next year.

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