Examples of Bargains in Pricey Markets

While volume is FAR lower than it was during the first three weeks of January 2011, the S&P500 managed to climb another 2% last week. The lack of volume makes the price appreciation very difficult to accept as a solid foundation for further gains. It’s akin to climbing up the side of a tall building using scaffolding made of balsa wood: can you climb higher and higher? Sure. But anyone with a brain would be concerned about the flimsy structure underpinning the climb. And to add more risk, complacency has fully set in—the volatility index is back to “what, me worry?” levels, suggesting that traders have removed a great deal of insurance protecting them from downside moves.

The US equity markets are quickly moving into a very fragile condition—the slightest “disturbance” could set off a huge wave of selling, selling with little near-term bullish support that would break the fall.

On the macro front, the news flow was light due to the holiday shortened week.  Empire State manufacturing, although still very weak by historical standards, did beat estimates. But industrial production missed. Both headline producer prices and core figures were lower than expected. Consumer prices were slightly lower than expected. So on the inflation front, there seems to be very little to be worried about—in the most recent month to month comparisons. In housing news, the results continue to disappoint: both existing and new home sales were lower than predicted. And more importantly, median prices continue to grind lower. While initial jobless claims were better than expected, the Philly Fed survey missed.

Last week, we took the temperature of today’s markets and investor psychology. The verdict was that prices and spirits are on the high side.

The problem is that most investors would simply shrug their shoulders, declare there’s nothing they can do about high prices, and simply go with the flow by staying broadly invested in stock markets.

And that’s exactly how these investors—most individual and even institutional investors—unknowingly assume huge risks of big losses in the near future. Instead of employing tactics to guard against price drops, they compound risk by continuing to buy more stocks at inflated prices, specifically at prices that are above intrinsic values.

So what should an intelligent value investor do?

First, after recognizing the frothy price environment, one could sell down a 100% invested portfolio to increase the cash percentage. Another, tactic for the smaller investor would be to make sure that carefully considered stop orders are put in place to protect unrealized gains from the last two years.

Third, the intelligent investor must be prepared to look for bargains outside of the mainstream large cap pools like the S&P500.  This way, the investor will never be temped to break the cardinal rule of value investing—buying a stock at prices below its true value.

Where can you find such bargains today, at a time when the S&P500 is more than fully priced?

In the US, you’ve got to dig through the small to mid cap firms in the Russell 2000. For example, you could consider a stable, unglamorous medical products maker called Invacare.  Down from $34 just six months ago, you can today buy shares at about $16, which represents an astoundingly cheap 4 times free-cash-flow valuation.  This is about 7 times projected earnings, and only 8 times EBIT for the entire enterprise value. Why did prices fall so much? The firm suffered a technical problem at one of its wheelchair manufacturing plants. Most likely, this is a temporary setback, creating a temporary hit to price (not a permanent hit to value) resulting in a short-term opportunity to buy shares at prices about 50% below true value. Even if share prices were to double, this would bring price-to-free-cash-flow up to only 8……still not over-priced by most standards today.

Other similar bargains abound…..but in Europe, for example, which has taken a beating in market prices over the last six months. Today, large cap, stable drug and telephone companies can be purchased at price-to-free-cash-flow multiples that are near 5. That’s cheap. In many cases, only months earlier, prices were 100% higher.

The bottom line is that there’s NO reason to break the value discipline. In today’s frothy US stock markets, it’s much harder to find screaming bargains. But they do exist. It simply means that an investor must look harder and more widely to find them.

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