3 "Deep Value" Stocks You Can't Afford to Ignore

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In a rising stock market , it pays to focus on a company's income statement . Each move up in the share price usually correlates to the company's bottom-line performance. But when the market is in sell-off mode, you should shift your focus to the balance sheet . That's where you can measure a company's real worth and get a handle on how much risk the stock can hold. 

Although a company's market value can fall below the level of tangible book value on its balance sheet, it is likely to fall much less than most, even if the broader market plunges to fresh lows. That's no small concern at a time when the European and Chinese economies are now weakening. Fresh reports point to a global economic slowdown, and you should be focusing on defensive "below book" stocks right now. These carry solid upside like growth stocks, but defensive stocks that trade below tangible book value will allow you to sleep better at night. 

After reviewing the 1,500 stocks that comprise the S&P 400 (which tracks mid-cap stocks), S&P 500 (large-caps) and S&P 600 (small caps) indices, I've found that roughly 7% of them trade below tangible book value right now. These are the stocks should be catching your eye right now.  And I'll share my thoughts on three of them in a moment. 

But first a quick note... A lot of these "below book" stocks are in the financial services sector, including big banks such as Morgan Stanley (NYSE: MS ) , at 51% of tangible book, Bank of America (NYSE: BAC ) at 51%, and Citigroup (NYSE: C ) , at 53% of tangible book. If you're a follower of my $100,000 Real-Money Portfolio , then you know I've been pounding the table on these stocks for some time now. These banks are under huge pressure right now on fears that the Greek economic crisis will de-stabilize global financial markets. If and when this crisis is diffused, these banks may post a huge rally.

Here are three other "below book" plays that are in my sights right now...

1. Arkansas Best (Nasdaq: ABFS )
This trucking firm delivered a sub-par first quarter, and shares have been pummeled, falling more than 50% from the 52-week high . First-quarter sales of $440 million missed forecasts by about $10 million. And for a company that has relatively high labor costs, sales leverage is crucial. Analysts at Citigroup "believe Arkansas will see weaker margins than peers until the cost structure disadvantage from its union contract is resolved." 

But the sell-off has gone too far. The company's market value of $330 million is far below the $449 million on the balance sheet. Said another way, nearly half of the company's market value is supported by the trucker's $183 million net cash position. Of course investors are concerned that a slow economy could cause that balance sheet to weaken. Yet Arkansas Best has generated negative free cash flow only once in the past eight years, when it shed $59 million in 2009. Notably, the trucking industry has become much leaner since 2009, and it's highly unlikely that free cash flow will turn negative this time around -- assuming a mild U.S. recession .

Meanwhile, shares are so cheap that Citigroup, which has a "Neutral" rating on the stock, still suggests shares are worth $18 -- 40% above current levels. That target price is just three times Citigroup's projected 2012 EBITDA forecast. It also happens to coincide with tangible book value.

2. Century Aluminum (Nasdaq: CENX )
Though Alcoa (NYSE: AA ) remains my favorite aluminum producer due to its industry-leading cost structure, it's very hard to deny the appeal of this second-tier producer, which would benefit from the same pricing dynamics from which I expect Alcoa to eventually benefit. 

Spot aluminum prices at a recent $0.90 per pound are leading to significant industry output cuts, which should benefit pricing down the road. But the industry is in pain right now, as evidenced by the fact that Century Aluminum's market value has fallen more than 50% in the past year to a recent $625 million, even though it carries more than $1 billion in tangible book value on its balance sheet.

Even in a tough pricing and demand environment, Century Aluminum's free cash flow should still be around $0.90 a share this year, according to Goldman Sachs analysts. They anticipate a modest rebound for aluminum in the next few years, which should help free cash flow to hit $1.30 per share by 2014. In that context, the recent $7 stock price looks like a screaming bargain.

3. Valero (NYSE: VLO )
Turning crude oil into gasoline, diesel and other distillate fuels has historically been a lousy business. International competition made it very hard for U.S. refineries to generate targeted returns on capital investments. But the tide is starting to turn. European refineries are less capable of converting heavy crude oil, and American counterparts, which are equipped to work with this lower-cost source of crude oil, are starting to benefit.

As a result, the investment community is starting to warm up to these oil refining stocks. And some see deep value in Valero, the nation's largest oil refinery, which also operates a network of retail gas stations. The key for this stock is to own it when its return on capital is higher than its cost of capital . That hasn't been the case in recent years, but net returns are now positive and expected to keep expanding. 

Refineries generated positive net returns from 2003 through 2007, and a similar cycle is playing out now. Back then, the sector traded for about 4.5 times the EBITDA run rate, based on enterprise value . By that metric, Valero should be worth around $28 a share. That's around 25% upside from the recent stock price. This kind of upside can also be found when looking at the balance sheet. Valero carries a market value of $12.2 billion but holds $15.7 billion in tangible book value.

Risks to Consider: These stocks are all economically sensitive. Anything deeper than a mild economic recession in the United States could hurt shares. 

Action to Take --> Though these stocks may lack some of the upside sizzle of high-growth stocks, they have solid asset support and are likely to fare better than most if the market weakens further. As I said earlier, you should keep an eye on these types of stocks and pounce on them when you think the time is right. The three stocks above are a good place to start.

[ Note: Be sure not to miss a single thing and have $100,000 Portfolio updates sent to your email inbox, free for a limited time, as soon as they're published by signing up here .]


-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of AA, C in one or more if its "real money" portfolios.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas

Referenced Stocks: AA , ABFS , C , CENX , MS

David Sterman

David Sterman

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