Show Me the Bargains Cheap stocks are still scarce after last year's market rally, but these top managers say they've spotted some opportunities
(MONEY Magazine) – For months, we kept hearing it. It's all too expensive. There's nothing left to buy. Some of the best bargain-minded stock pickers we know were telling us that since last summer they had, in essence, stopped picking stocks. They were mostly just adding to the same handful of persistently undervalued companies because nothing new was passing their valuation screens.
But in March the bull market waned, with the S&P 500 eventually dropping back to where it started the year. "I think we're in the midst of a pretty significant correction right now," says Ariel fund manager John Rogers. "All of a sudden you see opportunities starting to creep in." With that in mind, MONEY's Tara Kalwarski and Cybele Weisser thought it would be a good time to check in with the value guys to see what stocks, if any, they like now.
John Rogers: Looking beyond small caps
In his year-end shareholder letter, Rogers wrote, "Our new-idea drought has now persisted for nine consecutive months, the longest it has ever been." He added just one stock, the scandal-tarnished money manager Janus (JNS), to his flagship Ariel fund in 2003.
WHAT HE LIKES NOW These days, Rogers, who normally favors small-caps for the Ariel fund, sees more values in "mid-cusp" companies, or former small-caps just on the verge of becoming midcaps, with market capitalizations of $2 billion to $2.5 billion. "That's where we've had to go look for ideas because of the dearth of high-quality small companies," he says. One example: the $2.2 billion credit-card and checking services provider Certegy (CEY), which Ariel assistant portfolio manager John Miller says is gaining market share in its check-fraud detection business. At a recent $34, with a P/E of 20 (based on estimated 2004 earnings), Miller says Certegy is trading at a discount to its intrinsic value and could hit $45 a share. Rogers also recently picked up Argosy Gaming (AGY), a $1 billion company that operates riverboat casinos. It trades at 16 times expected earnings and is ideally located in Illinois, where there is a limit on the number of gaming licenses.
For his Ariel Appreciation fund, which primarily holds midcap stocks, Rogers likes Schering-Plough (SGP), which had a decline in sales following the expiration of its patent on blockbuster allergy drug Claritin. But with several new drugs in its pipeline, the company should see a minimum 15% compound annual growth rate through 2006, Miller says.
The Clipper crew: Standing on the sidelines
The team at Clipper adds only stocks that sell for at least a 30% discount to the managers' estimate of fair value. (They base that figure on private market transactions and discounted cash flow valuations.) Few companies are that cheap lately. "The fact is, we sold a hell of a lot more than we purchased last year," says co-manager Michael Sandler. Like Rogers, they only bought one new stock during the rally. It was hospital company HCA (HCA), which they purchased in June.
WHAT THEY LIKE NOW Clipper certainly has plenty of money to put to work. Recently, the fund was 30% in cash and Treasuries, compared with just 6% in early 2003. Sandler says he thinks that some of the fund's larger holdings are very cheap, including home mortgage heavyweights Fannie Mae (FNM) and Freddie Mac (FRE). Both fell last year on accounting concerns at Freddie but will still benefit from the continued growth in American home ownership. Their current P/Es are at the low end of their historical range.
Bob Torray and Doug Eby: What value drought?
Although the Torray Fund, like Clipper, qualifies for Morningstar's large-cap value category, managers Bob Torray and Doug Eby don't demand the same rock-bottom prices. "We've found that it's difficult to make money trafficking in weak businesses," says Eby. "And weak businesses in general tend to have very low P/Es." So they're willing to pay a little more if it snags them a stronger company. Eby says he and his partner have had little trouble finding fresh names to buy.
WHAT THEY LIKE NOW The fund added e-commerce and payment-service powerhouse First Data (FDC) in the second half of '03, when it was trading at 16 times earnings, near its historic lows. The stock slumped last year because analysts were concerned about the growth prospects of its Western Union unit. But Eby argues that Western Union's money-transfer business will continue to generate "phenomenal" cash flow for the company. Eby and Torray also like First Data's recent purchase of debit-card merchant Concord. "This is a smart management team that makes acquisitions based on long-term strategic factors," says Eby. First Data has since climbed 20% to $42, but he reckons it could hit at least $50.
The managers also like Cardinal Health (CAH). The company, which had been growing at 22% a year, lowered its growth target to the mid-teens last year because of lower margins in its core drug-distribution business. But Eby and Torray say that growth rate merely brings Cardinal in line with its peers, and that the company will still benefit from the overall growth in pharmaceutical sales. They believe drug companies can grow unit volume at an annual rate somewhere in the mid-teens in the coming years. "Plus, the company is diversified into non-pharma distribution," says Eby. "And it expects to generate $5 billion in free cash flow over the next three years." At $67, Eby says, Cardinal's shares have room to rise.
The Tweedy Browne team: Looking abroad
The five-member management team of Tweedy Browne's American Value fund was unable to come up with a single U.S. company that met its investment criteria in 2003. The only company they added to American Value last year was Amsterdam-traded Heineken Holding, whose sole asset is a majority stake in Dutch brewer Heineken. "The premium-beer segment is growing around the world," explains Tweedy Browne co-manager Tom Shrager, who adds that the stock is currently trading at a 40% discount to their estimate of what it's worth.
WHAT THEY LIKE NOW About 10% of the fund's assets are now in cash--"higher than it's been in a while," according to co-manager Bob Wyckoff. Like many of their peers, the managers have mostly been adding to current positions, particularly Dutch banking giant ABN AMRO (ABN), which recently traded at just nine times earnings. In December 2003 they also added to their position in timber company Rayonier (RYN), which owns 2.2 million acres of timberland in the U.S. and New Zealand, and should benefit from the continuing commodity boom and a weaker U.S. dollar. Rayonier, a real estate investment trust, has a meaty 5.2% dividend yield. The stock is up 60% since last year, but at a recent $43, the Tweedy Browne team thinks it trades at as much as 12% below its true value.