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Finding Contrarian Plays In A Not-So-Cheap Market

By: Validea
Posted: 2/10/2014 10:10:00 AM
Referenced Stocks: TLK;VZ;HFC;NOV;GME

Good news, bad news: First the bad -- the stock market is no longer cheap. The days of throwing a stone in the air and hitting a bargain-priced stock are over, with S&P 500 P/E ratios in the 16.5-17.5 range and the index's price/book ratio at 2.5.

But now, the good news: None of that means you can't still make plenty of money in stocks. For one thing, just because stocks have hit or passed average valuation levels, that doesn't mean we're headed for doom. A bit traumatized by having two market crashes within the past 14 years, many wary investors seem to forget that, by definition, you're going to be above an average a good deal of the time. The problem starts not when you get to fair value our just beyond it, but when you get way past it, as we did back in the 2000 bubble.

But perhaps more importantly, while commentators -- including, to be fair, myself -- often refer to the monolithic "stock market", what we really have is a "market of individual stocks". And at any given time you can find plenty of undervalued attractive stocks, regardless of where the broader market averages are. Of course, broader market trends can, in the short term, keep the value in those stocks from being recognized. But, with the short term nearly impossible to predict, I'm concerned with the long term, and over the long haul cheap shares of good companies tend to produce strong returns.

So, what individual stocks are looking particularly good and cheap right now? I recently used some of my most contrarian minded Guru Strategies (which are based on the approaches of some of history's most successful investors) to search for some undervalued gems. Among these models were my David Dreman-inspired model (which targets firms that are in the cheapest 20% of the market based on two of the following: P/E ratio, price/book ratio, price/cash flow ratio, and price/dividend ratio); my Benjamin Graham-based model (which requires both the trailing 12-month and three-year average P/Es to be below 15, and the product of the higher of those and the price/book ratio to be no greater than 22); and the Joel Greenblatt-based model (which targets companies with the highest earnings yields, using earnings before interest and taxes and dividing by enterprise value). In many cases, these stocks have some concern or fear hovering above them, making their shares cheap. But they also have the fundamentals and financials that indicate investors are overreacting to those fears. As always, you should invest in stocks like these as part of a broader, diversified portfolio.

Perusahaan Perseroan PT Telekomunikasi Indonesia ( TLK ): "Telekom" is Indonesia's largest telecommunication and network provider, a state-owned enterprise whose offerings include wired and wireless phone service, broadband service, information services, and television services. Emerging market fears have helped keep its price low, part of why the stock gets strong interest from my Dreman-based contrarian model. It considers Telekom ($19 billion market cap) a contrarian play because both its P/E ratio (4.3) and price/cash flow ratio (6.7) fall into the market's bottom 20%. Dreman realized that sometimes, however, a stock is cheap because everyone knows it's a dog, so he also used an array of fundamental and financial tests. This model likes Telekom's solid 22% return on equity, 30% pre-tax profit margins, and 34.7% debt/equity ratio, which is less than a third of its industry average.

Verizon Communications ( VZ ): The wireless giant has taken in more than $120 billion in sales in the past year, has a 32% return on equity, and has grown earnings per share at a 44% clip over the long term (I use an average of the 3-, 4-, and 5-year growth rates to determine a long term rate). But, perhaps in part because some think it paid too much to buy out Vodafone's 45% stake in the firm last year, it trades for just 11.7 times earnings and 3.3 times cash flow, both of which earn it contrarian status, according to my Dreman model. Given Verizon's strong ROE, 4.5% dividend yield, and 24% pre-tax profit margins, the strategy thinks it is worthy of more love.

HollyFrontier Corp. ( HFC ): Shares of HollyFrontier, a Texas-based refiner ($9 billion market cap) struggled over much of 2013, thanks to a combination of shrinking margins and economic and geopolitical concerns. But it has taken in more than $20 billion in sales over the past 12 months and my Graham-based model thinks there's a lot to like about it. Graham was an extremely conservative investor who wanted a company to have a strong balance sheet. The model I base on his Defensive Investor approach requires a company to have a current ratio of at least 2.0 and more net current assets than long term debt. With the current ratio of 2.3 and $1 billion in long-term debt vs $2.5 billion in net current assets, HFC makes the grade. Graham was also known as the "Father of Value Investing", and HollyFrontier's 8.4 P/E (trailing 12-month) and 1.4 price/book ratio indicate HFC is a bargain.

National-Oilwell Varco, Inc. ( NOV ): Houston-based Varco makes oil and gas drilling parts. The $32-billion-market-cap firm is another favorite of my Graham-inspired strategy, thanks in part to its strong balance sheet -- Varco has a 2.5 current ratio and more than three times as much in net current assets as it has long term debt ($9.7 billion vs. $3.1 billion). And Varco is cheap, trading for 13.9 times three-year average EPS and 1.43 times book value.

GameStop ( GME ): GameStop is the world's largest video game retailer, selling all sorts of Nintendo, Xbox and PlayStation games and game units, as well as a variety of online and computer games. It has more than 6,000 stores in the U.S. and 14 other countries, and a $4 billion market cap.

Many feared GameStop's store-based model would spell big trouble as the gaming industry evolved, but the firm has held up fairly well in recent years. Last month, after it announced disappointing holiday sales, investors rushed for the door, however. My Greenblatt-based model thinks they were too hasty. It likes GameStop's stellar 18.8% earnings yield, which is the 20th-best figure in the market -- when valuations (and expectations) are that low, a company doesn't need to excel for its shares to rise; it just needs to do a little bit better than terrible. GameStop's 88.3% return on capital indicates it should be able to do that, according to this model.

I'm long HFC, NOV, GME, and TLK.