Three Good Companies for Next to Nothing

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

Even so, I still find some very favorable names sitting on heaps of cash.

Worth a closer look is KHD Humboldt Wedag ( KHD), an industrial engineering supply company. The company basically provides know-how in building and designing cement and coal and mineral plants all over the world. Today the stock trades at about $15, for a market cap of around $445 million. The company has a net cash position of $430 million, or about $14 a share.

Business still seems to be OK. The company earned 89 cents a share in the second quarter, but you should understand that it prospers from the growth in global infrastructure, which is likely going to slow down further. Nonetheless, the company continues to grow backlog, which stood around $1 billion at the end of June 2008. I don't depend on backlog in an environment where credit is all but gone to everyone except those who don't need it. Still, the company does business all over the world, and regions such as the Middle East have not been as severely hit.

Another little gem is Harvest Natural Resources ( HNR), an oil company trading for $7.50 a share, which has no debt and $4.50 a share in cash. For $3.50, or an enterprise value of $100 million, you get a business that earned $100 million in free cash flow in 2005, when oil prices were closer to what they are today. And let's face it, there will always be demand for oil. And just as OPEC doesn't want to see $150 oil, it doesn't want to see $60-a-barrel oil for a prolonged period of time, either.

Regardless, most oil companies are profitable at $60-$70 oil anyway. With Harvest you get 44 million barrels or proved reserves, worth $10 to $15 a share on a discounted basis, depending on the value per barrel you assign. With this resource base alone, the company is cheap, but it estimates $25 to $30 per share in possible and potential reserves.

Finally, we have the athletic footwear supplier K-Swiss ( KSWS), currently trading at $12.60 a share, which has no debt and $8.50 per share in cash. Average free cash flow over the past four years has exceeded $65 million a year, or just under $2 a share on the basis of today's 35.5 million shares outstanding. Knock out the excess cash of $8.50 per share, and you are getting a free cash flow yield of over 40% a year.

Rest assured that when you have situations like this where the companies are not burning cash and pay little or no interest expenses, someone will take notice. These irrational equity prices are due to the current lack of liquidity in the marketplace, not because they are poor businesses.

Rest assured that when the mood improves, if investment funds don't jump on board, private equity will. In meantime, your risk of a permanent loss of capital -- which is completely different from a daily declining stock price -- is mitigated by the hefty cash levels.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider KHD, HNR and KSWS to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

This was originally published on RealMoney on Oct. 24, 2008. For more information about subscribing to RealMoney, please click here.

At the time of publication, Gad was long Harvest Natural Resources, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a value investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at sham@gadcapital.com.

More from Investing

Market Can't Handle the Wild Ride: Cramer's 'Mad Money' Recap (Thursday 5/24/18)

Market Can't Handle the Wild Ride: Cramer's 'Mad Money' Recap (Thursday 5/24/18)

Musk's Tweets About Unions Draw Fire From United Auto Workers

Musk's Tweets About Unions Draw Fire From United Auto Workers

Replay: Jim Cramer on North Korea, Oil Prices, Apple and Carnival Corporation

Replay: Jim Cramer on North Korea, Oil Prices, Apple and Carnival Corporation

Gap Drops After Hours on Disappointing Earnings, Weak Same-Store Sales

Gap Drops After Hours on Disappointing Earnings, Weak Same-Store Sales

Canopy Growth: First Cannabis Firm on the NYSE Fails to Generate Buzz

Canopy Growth: First Cannabis Firm on the NYSE Fails to Generate Buzz