As we head into the final trimester of 2012, it's time to take a
fresh look at where we stand in terms of the stockmarket and
theeconomy . So far this year, the S&P 500 has delivered a
solid 12% gain, despite countless headwinds in place.
That kind of return shouldn't be sneezed at: strategists suggest
that 6% to 7% is a reasonable expectation for annual gains. To
some, this means we're living on borrowed time. Sure, the market
can still post further gains, but it's crucial that your preserve
this year's gains in case we hit the (likely inevitable) bout of
This doesn'tmean it's time to run for the hills. It just means
you should be adding inexpensive stocks to your portfolio while
lightening up on more expensive ones. We've decided to make the
task a bit easier for you by ferreting out the cheapest stocks in
the S&P 500. What's cheap? Well, we can use several measures
and see how these 500 companies stack up. By the end, we can even
arrive at our destination: the cheapest stocks in the S&P
It's not hard to find stocks sporting reasonable
price-to-earnings (P/E )multiples . Roughly 40% of the stocks in
the S&P 500 trade for less than 12 times projected 2013
profits. You won't find many tech stocks in this group. Instead,
the list is dominated by industrial firms, financial institutions
Of course, David Dodd and Benjamin Graham, the grandfathers of
value investing, would tell you thatnet income doesn't always tell
you the real value of a business. In the first half of the 20th
century, they were much more concerned with a company'sbalance
sheet . They simply wanted to know the value of a company's assets
in the real world. If the balance sheet had even greater value than
the stockmarket value , then it was a simple decision to buy. At
least until the stock traded up tobook value .
Unfortunately, the only stocks that trade below book value
(which represent thenet assets on the balance sheet after
liabilities are subtracted) are usually facing a bout of distress.
So to maintain solid, quality companies in our screening process,
it's wise to let any companies in that trade for less than 1.5
times book value.
Looking for companies that trade for less than 12 times
projected 2013 profits and less than 1.5 times book value, we've
narrowed the list down to 51 companies, or about 10% of the S&P
500. And now that we've measured these companies in terms ofincome
statement and balance sheet, it's time to look at third financial
statement -- thecash flow statement .
Free and clear
While many investors gauge a company's health by its operatingcash
flow , you need to go a step further. You need to look at how much
cash flow is left -- after you've deducted for capital spending. In
other words, the cash that ends up on the balance sheet when all
internal investments are made. In my view,free cash flow is the
single most important gauge of a company's health.
Many companies are valued at around 15, 20 or even 25 times fee
cash flow. It's harder to find stocks that sport very low free cash
multiples. Yet these are really the kings of value investing. Think
about it: if a company trades for around eight times free cash
flow, then this means its entire market value can be earned back in
just eight years. Any residual value of the business after that is
Well, we found 23 companies in the S&P 500 that trade for
less than 12 times projected 2013 profits, less than 1.5 times
tangible book value, and less than 10 times trailing free cash
flow. Of these 23 firms, 10 of them are banks. And it may be wise
to exclude banks from these discussions. With ongoing legal
proceedings regarding themortgage mess andLIBOR as well as the
still-unresolved crisis in Europe that could hamper global
financial markets, these companies possess more risk than a
typicalvalue stock .
What's left? We have 13 companies, all of which are worthy of
further research, simply because they sport some terrific numbers.
Though they don't necessarily all possess huge near-term upside,
they should be steady gainers over the long haul, thanks to that
prodigious free cash flow. Equally important, the downside support
-- by these measures -- is surely impressive.
If Graham & Dodd were alive today, then they'd likely single
out seven stocks in this group for special attention:
Prudential Financial (NYSE:
Hartford Financial (NYSE:
Unum Group (NYSE:
-- all of which trade for less than tangible book value. The
fact they also represent value by other measures is just icing on
Risks to Consider:
These insurers hold many financial instruments on their balance
sheets, so a major global economic meltdown could erode book
Action to Take -->
Insurers remain in the doghouse because low interest rates are
hampering their returns on investment. They are likely to
appreciate only steadily in the near-term as free cash flow further
fattens their balance sheet, but an eventual rising interest rate
environment should help propel them well higher.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.