NEW YORK (
) -- I often recommend value plays in the small-cap world, but today I want to explore large-cap stocks that are undervalued.
I found these companies while looking through the top holdings of
, the famous value investor.
Although these stocks are not as undervalued as
, they should be prove less volatile, and I understand that volatility bothers many investors.
Still, it's important to note that long-term investors should not use volatility to measure risk in a company. Instead, they should measure risk by the sustainability of a company's underlying business and the price they pay for its stock. Was
worth 300 times earnings at the height of the dot-com bubble? No. Investors grossly overpaid for a business that was not necessarily sustainable.
The companies I'm introducing today have attractive ratios of price-to-owners' earnings, a measure of the cash a business is generating for its shareholders. I use this metric to evaluate companies, and it's the method
has always used.
I determine owners' earnings using this formula: owners' earnings = net income + depreciation and amortization + changes in net working capital - capital expenditures.
A price-to-owners' earnings ratio can essentially be viewed as an equity bond to shareholders. If the ratio is 5, the "equity bond" is paying out 20%, and if the ratio is 2, the "equity bond" is paying out 50%. So if I buy a local convenience store at a price-to-owners' earnings ratio of 2, I am essentially getting a 50% bond. The same analysis applies to stocks.
I like thinking of equities in this way because it allows me to compare equities and bonds. It also demonstrates to investors why paying high price-to-earnings ratios for companies is an unsound investing strategy.
For example, although I think
is a fantastic company, it is trading at a price-to-owners' earnings ratio of 28. This means the equity bond for Chipotle is paying 3.5%. Although I believe that equity bond will grow over time because Chipotle is a fantastic business, I think that ratio is too high in comparison to those of other growing, profitable companies. Simply put, there are better buys available.
Humana is a health care company that operates in the government and commercial segments. I am very attracted to the low ratio of price-to-operating cash flow the company has reported over previous years. The stock is currently trading with a price-to-owners' earnings ratio of a little more than 6. I believe Humana will still be a very profitable company despite the recent health care reform legislation.
Sears is a well-known retail chain. I believe it is undervalued at its current price. It is trading at a price-to-owners' earnings ratio of about 11. The company's standard price-to-earnings ratio misrepresents Sears' value because the company has such high annual depreciation costs. Sears may not grow at breakneck rates, but I believe it will keep generating lots of cash for its shareholders.
Americredit is another value play for investors and currently trades at a price-to-owners' earnings ratio of close to 3. The company purchases loans directly from car dealers and then collects the receivables from the car purchasers. The net income is not a good reflection of the value of this company because Americredit's provisions for loan losses are so high. When I look at owners earnings, however, I can see this company is worth owning.
Hertz generates lots of operating cash flow for its investors. The company has extremely high depreciation expenses due to its large fleet of autos. It also has a high annual cost of buying and selling the cars. I value Hertz by taking the $1.8 billion in operating cash flow for 2009 and subtracting out the $1.3 billion cost of buying and disposing of the car fleet. This gives me an owner's earnings total of $500 million and a price-to-owners' earnings ratio of 10.
I hope this analysis was helpful for those of you looking at large-cap stocks.
I recommend ignoring the crowd, doing your own research and finding the most undervalued companies out there.
Also, stay away from the
of the world even though they have great products. (I use Google every hour, and I own an iPod and an iPhone.) Technology is so unpredictable that who knows where these companies will be 10 years from now.
At the time of publication, Buckley owned shares of Berkshire Hathaway
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Zack Buckley is General Partner for Buckley Capital Partners Hedge Fund and writes a blog at Uncoveringalpha.com. He developed his investing methodology by synthesizing the ideas from the best investors of all time: Warren Buffett, Peter Lynch, Seth Klarman and Benjamin Graham. Using a value approach, he researched thousands of companies in order to pursue the most undervalued ones, which led primarily to companies in China. Buckley will be spending three months this year in China visiting companies that are exciting investment opportunities. Follow him on his blog, Uncoveringalpha.com, as he travels across China touring factories and interviewing management.