This Master Of Hidden Value Stocks Picks His Top 5

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Every value investor envies legendary money manager Mario Gabelli's genius -- and for good reason.

Gabelli leads GAMCO Investors, a $36 billion global investment firm known for bringing its clients 16.3% annualized returns since its founding in 1977. He was named the 2010 Institutional Investor "Money Manager of the Year" and has a net worth of more than $1 billion, according to Forbes.

Gabelli uses a bottom-up, value-driven approach to identify bargain-priced stocks, then looks for catalysts that may unlock the company's hidden value. He looks for industry trends, regulatory changes, merger opportunities and spin-offs, for example.

Gabelli shared his top stock picks for 2013 in February at a Barron's Roundtable. Most of his favorites are thought to be ripe for a merger or spin-off this year. Here is a closer look at five of Gabelli's top picks.

1. Post Holdings ( POST )

This leading cereal maker was spun off from Ralcorp Holdings in 2012. Post has a 10.5% share of the $10 billion U.S. cereal market and owns brands such as Grape Nuts, Raisin Bran and Shredded Wheat.

Gabelli likes the stability of the cereal business and thinks Post is a strong cash flow generator with good pricing power. He also considers Post CEO Bill Stiritz a savvy deal-maker -- Stiritz negotiated the sale of Ralston Purina to Nestle in 2001.

Improved volume and higher selling prices resulted in 8% growth in Post's sales to $237 million for the first quarter of 2013 compared to the same quarter last year. Meanwhile, cash flow climbed 15% to $52.5 million. Earnings per share (EPS) fell 16% to 31 cents due to costs surrounding the separation from Ralcorp, but Gabelli thinks the company will earn about $1.50 this year, which could grow to $3 in the next three to four years.

Post shares are priced at only 1.1 times book value. This is a steep discount to competitors Kellogg ( K ) and General Mills ( GIS ) , whose shares trade at price-to-book value multiples of 9.5 times and 4.4 times, respectively.

2. Patterson Companies (Nasdaq: PDCO)

Patterson supplies dental products and imaging equipment to some 185,000 U.S. dentists. The dental market benefits from an aging U.S. population that will require more dental care.

In addition, Patterson owns a veterinary products business that serves a $3 billion market. Patterson trades at a 10% lower price-to-earnings (P/E) ratio than its main dental products competitor, Henry Schein (Nasdaq: HSIC) and a 30% lower P/E than its principal veterinary products competitor, MWI Veterinary Supply (Nasdaq: MWIV) , making it attractive in both industries. For these reasons, Gabelli sees Patterson as a likely candidate for a takeover or split-up.

Patterson increased sales 3% during the first nine months of fiscal 2013 to $2.67 billion from one year earlier; EPS improved 5% to $1.41. Analysts predict 6% earnings growth this year, and rising another 10% next year.

The company generates more than $300 million in cash flow annually, but uses only $30 million for capital spending, leaving plenty of cash to return to investors. Earlier this month, Patterson authorized a 25-million-share repurchase and hiked its dividend 14% to a 64 cents annual rate yielding 1.7%.

3. Smithfield Foods ( SFD )

Smithfield is the world's largest pork processor and hog producer and owns the Eckrich, Farmland and Armour brands. Breakfast sausage is a $4.6 billion U.S. market, growing about 5% a year.

Smithfield's sales were flat at $9.9 billion during the first nine months of fiscal 2013; EPS fell 40% to $1.03 due to losses in the hog production business.

Investors are pushing for a breakup of the company. According to Goldman Sachs, separating Smithfield's pork processing, hog production and international operations could yield a breakup value as high as $48 a share, or nearly twice the current share price. Continental Grain has issued an offer that Smithfield's board is reviewing.

4. Hillshire Brands ( HSH )

Another takeover candidate identified by Gabelli is Hillshire Brands ( HSH ) , which was spun off from Sara Lee in 2012. Hillshire is a market leader in the breakfast sausage, lunch meat and hot dog categories. Several companies were bidding to acquire Hillshire from Sara Lee before the spin-off.

Hillshire's EPS rose an impressive 49% during the first half of fiscal 2013 to $1.10 on a 2% rise in sales to $2 billion. Management has updated full-year EPS guidance to a range of $1.60 to $1.70, up from $1.40 to $1.55. Hillshire is priced at a P/E of 6, while competitors Kraft Foods (Nasdaq: KRFT) and Hormel (HRL) are each priced at a P/E of about 20, making Hillshire that much more interesting. Hillshire also pays a 50-cent annual dividend and yields 1.5%.

4. Graco, Inc. (GGG)

Graco manufactures industrial pumps, mixers and meters. The housing recovery has helped this company, which produces mixers and applicators for painters. Graco also benefits from the oil and gas industry -- its pumps and injectors are used on drilling rigs. Although Graco's sales rose 13% to $1 billion in 2012 from the previous year, EPS improved by just 4% to $2.42: Expenses were incurred due to its 2012 acquisition of businesses from Illinois Tool Works (ITW) . Gabelli thinks Graco's earnings will double within four years as the housing market improves and costs from the Illinois Tool Works acquisition are gradually absorbed. Graco also pays a $1 annual dividend yielding 1.7% and has been growing its dividend by roughly 5% a year.

Risks to consider: Rising grain prices could hurt Post's profit margins and increase feeding costs for Smithfield's hog production operations. Smithfield could also be affected if budget cuts force the U.S. Department of Agriculture to furlough some meat inspectors later this year.

Action to take --> I think Graco is the best of these five picks because of its business model and benefits from the housing market recovery. I also like Patterson for its growing markets, rich cash flow and dividend growth. Post, Smithfield and Hillshire are bargain-priced but dependent on a catalyst event such as a takeover offer to unlock value.

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

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

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