Three Buys for a Cautious Market

10/15/2013 9:00 am EST

Focus: STOCKS

Dennis Slothower

Chairman and CIO, Alpine Capital Management

Stocks are trading at a P/E ratio of about 24, which is higher than the long-term P/E of 16. There are those who say that the market is still reasonably valued, but that's not a position I feel comfortable taking, cautions Dennis Slothower, Editor of Stealth Stocks.

If earnings continue to deteriorate, we could quickly see stock prices fall, and the current P/E will plunge to its long-term average of 16. This brings us to what is coming ahead in October with the announcement of third-quarter earnings.

Should earnings disappoint, which looks like a given to me, especially with oil prices above $100, the earnings component in the P/E ratio will head even higher.

Oil prices trending above $100 a barrel for more than a quarter is damaging consumer spending. To support the stock market when P/E ratios are soaring will likely prove a huge challenge for the Fed...even with the current QE bond purchases of $85 billion per month.

This makes it a little more challenging to find stocks that are attractively priced. Stocks fairly priced can suddenly become very expensive if earnings get thumped.

It is one thing to see a stock appreciate with the market recognizing value and bidding up prices to higher multiples supported by real growth. But it's quite another to have a company's P/E ratios spike because earnings collapse beneath it.

That is why I closely follow the impact GDP growth and oil prices will have on corporate earnings. If earnings growth continues to shrink next year, stocks will become very expensive by historical standards.

Despite our concerns, there are still bargains in the stock market. Our principal objective is to earn excess returns by uncovering undervalued, competitively advantaged businesses.

While the stock market, as a whole, is likely to become overvalued given the Fed's recent decision to prolong its bond purchases, our objective is to remain on the hunt to identify great companies selling at a discount. During times when the stock market rises, it becomes a bit harder.

Several of the stocks in our portfolio have become even more attractive while the stock market discounts their future growth:

  • Delek Holdings (DK), a petroleum refiner, has a P/E ratio of 4, pays a 2% dividend, and has a 30%+ return on equity.

  • HollyFrontier (HFC), also a petroleum refiner, has a P/E ratio of 5.5, pays a 3% dividend, and is growing revenue by more than 40%.

  • CF Holdings (CF), one of the largest fertilizer companies in the world, has a P/E ratio of 8 and a rock-solid balance sheet.

We are in a point in the economic cycle where it is crucial to own stocks currently trading below the underlying worth of the business.

That can mean we end up owning some ugly ducklings that aren't popular at this time. But do keep in mind that our goal is not to pick the popular stocks...just the ones that will make money.

The stock market looks vulnerable at this juncture, and any sell-off will give us the opportunity to add financially solid companies at even bigger discounts.

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