Markets & Finance

Left Behind: Quality Stocks That Missed the Rally


Pros at the fifth annual Value Investing Congress agreed that the rally has left behind some select stocks, but some names won't pay off for a while

With the Standard & Poor's 500-stock index up 60% from its March lows, should value investors lay low and hope for a double-dip recession? The rapid runup in stock prices—and the lack of evidence pointing to a major correction in the wings—no doubt has caused some sidelined investors to lament having missed out on a slew of great bargains.

But maybe they shouldn't fret. There are still stocks that the rally has left behind—mostly due to company- and industry-specific issues—that present tantalizing buying opportunities. Be warned, however: Some names won't pay off for a couple of years and will require patience.

At the fifth annual Value Investing Congress, held in New York on Oct. 19 and 20, there was no shortage of recommendations of stocks that haven't benefited much from the rally. The ideas ranged from companies slammed for misunderstood capital structures to ones poised for future outperformance based on management changes.

Despite the reputation most value investors have for picking stocks based on careful examination of individual company balance sheets, business strategies, and market opportunities, speakers at the conference gave a fair amount of attention to the extraordinary macroeconomic circumstances that may make bottom-up stockpicking a less effective strategy than in the past.

Still, it was assorted bottom-up strategies—not the gloom-and-doom warnings of how a renewed housing market slump and runaway inflation could stifle an economic rebound—that were the main draw for investors.

Core-Mark: Convenience Retail Distributor

Kian Ghazi, managing partner and portfolio manager at Hawkshaw Capital Management, which he co-founded in 2002, looks for stocks that are fairly valued on current earnings, as opposed to the future earnings the market is projecting based on an economic recovery. Ghazi is a proponent of bottom-up stockpicking based on his own investigative research. With a bias toward companies that have high-quality, one-of-a-kind franchises and historic returns that indicate a competitive advantage, he asks questions like "Who would miss the company if it was gone tomorrow?" and "What could cause the stock to drop 30% and not cause investors to lose confidence in it?"

One of his current picks is Core-Mark Holding (CORE), the second-largest distributor to U.S. convenience stores, behind McLane, which is owned by Berkshire Hathaway (BRKA). At 28.82, the closing price on Oct. 21, the shares trade at 7.2 times estimated 2009 earnings.

Convenience stores, notes Ghazi, are generally recession-resistant because of the habit-forming merchandise they sell. While he weighs risks such as an accelerating decline in cigarette sales and a move to self-distribution by its big customers, Ghazi thinks the stock is worth 45 to 50.

He approves of the company's efforts to increase sales of fresh food such as sandwiches, salads, and fruit cups, which provide gross margins between 15% and 25%, compared with the 4% margin on cigarettes. Cigarettes account for 30% of all convenience-store sales. West of the Mississippi River, where it dominates in market share, Core-Mark serves a more densely concentrated store base, which helps it stretch fuel costs. As the company's fresh-food offerings increase, fuel costs will rise since perishable food requires a second delivery each week, but margins will rebound as Core-Mark layers in additional customers for its fresh foods in the future, Ghazi predicts.

LabCorp, No. 2 in the Clinical Test Market

Laboratory Corp. of America Holdings (LH), the No. 2 player in the clinical testing market, behind Quest Diagnostics (DGX), also has a compelling valuation, according to Zeke Ashton, the founder and managing partner at Centaur Capital Partners. The stock trades at less than 11 times free cash flow per share, with free cash flow projected at $670 million this year. Over the past seven years, free cash flow has ranged from 13% to 15% of revenue—and that's understated because the company has increased capital spending in recent quarters to attract additional customers and expenditures will be lower in the future, says Ashton.

Together, Quest and LabCorp control 66% of the clinical test market, with hospitals accounting for the other 34%. Ashton likens the two companies' market dominance to Coke (KO) and Pepsi (PEP) in the beverage industry. "We think LabCorp is better run, so that's where we go," he says.

LabCorp runs about 340,000 lab tests each day and has expanded its margins with the more than doubling in sales from $2.1 billion in 2001 to $4.5 billion in 2008, says Ashton. The excess free cash flow has also enabled the company to slash its share count by 26% in four years and it continues to buy back more shares.

Its acquisition in mid-2009 of Monogram Biosciences will allow the company to expand into more esoteric markets with gene-based testing for infectious diseases such as HIV and hepatitis C.

The stock is up almost 29% since Mar. 9. Ashton believes it's lagged the market due to uncertainty around the government's health-care reform efforts. The Senate Finance Committee proposal that was recently passed initially included a provision that called for a $750 million annual tax on clinical labs, but that was struck from the bill in September. In exchange, the lab companies agreed to a 1.75% additional reduction of the fees they'll be allowed to recover for Medicare patients between 2011 and 2015, says Kevin Ellich, an analyst at RBC Capital Markets. Clinical lab fees covered by Medicare make up roughly 12% of total revenue for both LabCorp and Quest, he says.

With its test volumes likely to be down from a year ago due to rising unemployment and expiring Cobra coverage, LabCorp's shares may take another hit when it reports third-quarter earnings on Oct. 22, but any dip in the price would be a good buying opportunity for late-to-the-game investors, says Ellich.

J.M. Smucker's Sales Lift

One of the top holdings in Alexander Roepers' value portfolio at Atlantic Investment Management is J.M. Smucker (SJM), which doesn't look very cheap at first glance. But it's one of a handful of stocks that meet his rigorous criteria, which include predictable and recurring revenue and cash flows through an economic cycle, a market cap of $1 billion to $20 billion, and no vulnerability to technical obsolescence, product liability, or government intervention.

The company, which makes Jif peanut butter, Hungry Jack pancake mix, Borden's canned milk, and many other brand-name foods, has better sales in a weak economy as people eat at home more, says Roepers.

The shares came under some pressure in the first quarter due to a salmonella outbreak in 42 states that was linked to tainted tubs of peanut butter made by the Lynchburg (Va.)-based Peanut Corp. of America. But Smucker probably benefited from the scare once concern abated because consumers were more inclined to trust familiar brands such as Jif and Skippy when they started buying peanut butter again, he says.

Smucker is currently trading at 14 times estimated earnings of $3.83 a share for fiscal year 2010. The stock isn't nearly the bargain it was when Roepers first bought 2.8 million shares at 37.54, but even 50% higher at 53.88, where it closed on Oct. 21, he believes it still has more room to run. His 12-month price target is 74 based on 12 times enterprise value to projected EBIT for fiscal year 2011. He also believes Smucker is a takeover candidate.

Starbucks' Growth Outlook

Starbucks (SBUX) is an example of a company that can be revived in turnaround after a management change. Despite what some see as a misstep in its September launch of Via, an instant coffee product that could potentially drain sales of brewed coffee from its retail stores, Lloyd Khaner, a general partner of hedge fund Khaner Capital, likes the operational changes that returned CEO Howard Schultz is making.

At 20.34, its closing price on Oct. 21, Starbucks is up nearly 150% from Mar. 9, but Khaner sees more growth ahead. He expects same-store sales to start increasing again in fiscal year 2010 and believes the company can generate $500 million to $750 million of free cash flow a year for the next three years, which will help it buy back shares and pay down debt. He predicts it will be ready to open new stores in China in three years and in India sometime after that.

Value investors need to be in it for the long haul and prepared for prolonged periods of losses, says Joel Greenblatt, a managing partner at Gotham Capital, a hedge fund he founded 24 years ago. His back-testing research showed that bad periods added up to just short of four years out of a 10-year period from Oct. 1, 1999, to Sept. 30, 2009. "People lose confidence in [the market] over the short-term horizon, but if you do something that's systematic and disciplined, it will pay off over the longer term," he said.


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