At least once a month or so I log onto my Value Line account and run some screens looking for cheap stocks. One of my favorites is the list produced by the present bargain basement stocks. These are stocks that sell in the lowest percentile of the Value Line universe in terms of price to working capital and PE ratio. They are generally unloved stocks that have performed very poorly in recent months.
Given my somewhat negative views on the overall market in the weeks and months ahead, I scour the list looking for this companies selling cheap compared to tangible assets with little debt. I like them be profitable as well, or at a minimum not burning through their cash and assets at a rapid rate.
Keep in mind that even though I am finding cheap stocks, I am still very cautious on overall market direction. This is the kind of market where cheap becomes ridiculously cheap in a very short period of time. I am of the opinion that it is best to stay small and move slow. If you normally buy 1,000 shares of stock, start with just 200 at first. Take the time to build your position as the market falls. Although I think most of the undervalued situations I am seeing today will be a lot higher five or six years from now, I am very much aware that they can fall quickly in the current perilous market environment.
Catching up with old friends
I was pleasantly surprised to find an old friend on the list when I ran it this month. Arrow Electronics (NYSE:ARW) is a stock I owned back in the 1990s and did very well with. It is an electronics distributor -- primarily semiconductor chips and computer components -- that operates in 53 countries with 225 locations. Given the global tech slowdown, it comes as no surprise that business has been weak for Arrow in recent months. That is more than reflected in the stock price: The shares currently fetch around $14 a share, well off the high of $44 reached in 2007.
The truth is that while business is bad, this company is still profitable. In the fourth quarter the company had revenues of $4.1 billion and produced net income of $43.2 million, or 36 cents a share. Without one-time charges, the quarterly profit was 60 cents a share for Arrow. While this does not compare favorably with prior-year earnings of $114 million or $3.28 a share, the company is still profitable.
Arrow also reduced its guidance for the first quarter, lowering estimates to between 32 cents and 44 cents a share. This is below the consensus analyst estimate of 45 cents, but even those reduced levels would lead to earnings of $1.28 to $1.76 for 2009. The final numbers for 2009 will likely be higher if the company is successful in implementing $175 million of cost reductions this year.
The company is clearly sailing into economic headwinds right now. The slowdown in the computer and technology businesses make it likely that sales will fall in 2009 and also that margins will be compressed somewhat. In a recent conference call, the company admitted it does not see a bottom for its key semiconductor and storage markets. Arrow also acknowledged that they have seen some order cancellations. By all accounts business is bad and not improving anytime soon.
I think all of this is reflected in the current stock price. This company has a strong balance sheet. In spite of the weak economy in the fourth quarter, Arrow generated $275 million of cash flow. It was the ninth consecutive quarter of positive cash flow for the company. The debt to equity ratio stands at a manageable 0.36%. Arrow has no debt repayments until 2010 and it generates more than enough cash to pay the $200 million maturing at that time.
The stock trades at about 7 times earnings and just a little bit above tangible book value. The Enterprise value to EBITDA ratio is just 4.2, well below my threshold of 5.When the economy and the market for semiconductor chips recovers, the company should do very well. Apparently I am not the only one who thinks so: Noted value investors FPA advisors were heavy buyers of the stock in the fourth quarter of 2008.
Difficulties priced into the stock
Emulex (NYSE:ELX) was another technology stock on the bargain basement list this month. It too is another stock I have owned before with positive results. The company makes data storage products and components. Again, we find a company that is flying into the face of the storm and being hurt by the slowdown in consumer demand. The weakness in global demand is going to hurt sales of host servers as well as embedded storage solutions, two of the company's major products. They will undoubtedly face a tough selling climate that will cause reduced profit margins in 2009 as well. In spite of this, Emulex should be able to keep gross margins slightly north of the 60% level.
As with Arrow, the difficult market appears to be more than priced into the stock. Today's price is the lowest for Emulex stock since 1999. Revenues then were less than 25% of current levels, as was shareholder equity. The shares trade right around tangible book value. Emulex has more than 50% of the current stock price in cash and no debt. The Enterprise Value to EBITDA ratio is under 2, a very low level for this company.
Emulex is buying back stock and will likely continue to use its cash to do so at current depressed levels. The long-term outlook for the company's products is very good as well. From current levels, I think the stock has incredible long-term potential. The company president agrees: Jim McCluney recently told investors that although we are in troubled times, the company is in good shape.
A starting point, but not foolproof
The bargain basement list is not a foolproof stock-picking system. Many of the stocks on the list are there for very good reasons and have poor prospects. Others have highly leveraged balance sheets that are just too risky to invest in given the economic outlook. It is however an excellent shopping list and starting point for finding cheap stocks with excellent long-term recovery prospects. Look for those bargain stocks that have cash, manageable debt on the books and a solid business. The two outlined here seem to me to meet these criteria and, for long-term investors, they have exciting prospects.
¿ Many of the stocks in the so-called "bargain basement," stocks that sell in the lowest percentile in terms of price to working capital and price to equity, have good reasons for being there. However, others are good long-term investments mired by the current environment - for example, many tech stocks feeling the pinch of the global market slowdown. ¿ I like companies with little debt that are selling cheap compared to tangible assets. In addition, they should be profitable, or at least not burning through cash and assets. ¿ In this perilous market environment, it's best to stay small and move slow, as stocks can turn from cheap to ridiculously cheap very quickly.