This Little-Known Ratio Shows Just How Cheap Stocks Are Right Now

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The U.S.economy sure looks dicey. This week's trading kicked off with news that the Institute of Supply Management's ( ISM )index of manufacturing activity came in well short of forecasts -- just another sign the economy has slowed. You may think it's yet another reason to avoid stocks and park your cash under a mattress. But by doing so, you may overlook another feature of the current stock market. By one key measure, stocks are absurdly cheap, helping the market to flash a "buy" signal.

That measure? It's the ratio between corporateprofit margins and price-to-earnings ( P/E ) ratios. Over the decades, investors have been willing to pay a premium for stocks that deliver impressive margin gains. Not right now. In some instances, a company's operating margins are many times higher than the stock's forward P/E ratio, which is a relatively rare event. As an example, chip-making behemoth Intel (Nasdaq: INTC ) generated 35% operating margins in 2010 -- a company record, yetshares trade for just 9.4 times projected 2011 profits.

To be sure, there are other variables investors consider, such as balance sheet strength. And investors are more concerned with sales growth and further margin gains, preferring to look ahead and not behind. Yet it's undeniable that profit margins are the clearest measure of the health of a business, and P/E ratios are the most typical gauge of a business' value. With that in mind, I went screening for companies with operating margins that are high and getting higher (as measured by expected 2011 profit growth of at least 15%), yet trade for less than 11 times projected 2011 profits.

In the table below, you'll note the "Magic 20." Each of these S&P 500 components have operating margins at least 50% higher than their forward P/E ratio. These are "buy-and-hold" names because they may continue to languish if the economy stalls in the near-term, but should be rally leaders when the market is back on its feet.

 

It's no coincidence there are many tech stocks on the list. Industry leaders such as Cisco Systems (Nasdaq: CSCO ) , Applied Materials (Nasdaq: AMAT ) and Intel are doing just OK in 2011, thanks in large part to economy-related headwinds. But those with a long-term view will likely benefit from these shares when investors return to tech stocks. And their super-strong balance sheets are to be considered a key weapon in these challenging times.

Another tech name to watch: chip maker Analog Devices (NYSE: ADI ) , which has seen its shares fall 20% since mid-May. Back then, ADI delivered a better-than-expected fiscal second quarter and raised full-year guidance. The upside is the result of steady research and development spending (at around $500 million per year) that helps freshen the product line-up of chips that go into cars, communications equipment and industrial equipment. The net result: gross margins of 67.6% in the second quarter, a company record.

Thegross margin strength is quickly turning intooperating margin strength. In the last cycle, ADI typically generated 20% to 25% operating margins, but the metric should exceed 37% in the currentfiscal year . Those margin gains, and the cash they produce, is helping management to shrink the share count. ADI has bought back 25% of its stock in the past five years, and another buyback is currently underway. As a final thought, shares have traded between 11 and 34 times forward earnings in the past five years. Thanks to the current sell-off, shares now trade for just 11 times projected fiscal (October) 2012 profits, which is at the bottom of that five-year range.

H&R Block (NYSE: HRB )
I wrote about this tax prep firm last winter , and shares subsequently rallied 40% in the spring toward the $18 mark. Those gains have largely evaporated, and H&R Block is once again a deep value play -- with impressive operating margins to boot.

As is the case with Analog Devices, the downdraft in shares actually took place even as H&R Block was delivering solid financial results. Thanks to favorable comparisons with a very weak fiscal (April) 2010, H&R Block boosted per share profits more than 20% in fiscal 2011, to $1.63. Per share profits in the current year are likely to grow more modestly, perhaps about 10%, as high unemployment levels continue to pressure the tax prep business.

To be sure, H&R Block stumbled badly in the last decade as management made ill-fated forays intomortgage lending and other non-core areas. New CEO Bill Cobb, who took the company's reins in early May, has laid out a much more grounded growth strategy, predicated on moves to buildmarket share in the retail store business, the digitally downloaded software segment and the nascent international tax business efforts.

Even before those moves, H&R Block was a cash cow , generating more than $400 million in free cash flow in fiscal 2011. This helps to support a solid dividend (currently yielding 4%), a steady drawdown in debt, and share buybacks. The company bought back 24 million shares in fiscal 2011 (shrinking the share count by 7%) and expects to continue doing so. You can't blame management for that choice. Shares trade for just four times trailing EBITDA , and 10 times trailing free cash flow.
 
Action to Take --> A tough economy surely calls for a cautious stance. But many stocks are verifiable bargains, sporting peak margins and robust profits. The broader market weakness has punished stocks like Analog Devices and H&R Block, but that simply opens the door for far-sighted value investors who could see a big payoff down the line.


-- David Sterman

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.



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.

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This article appears in: Investing , Basics , Investing Ideas

Referenced Stocks: ADI , AMAT , CSCO , INTC , ISM

David Sterman

David Sterman

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