Have You Heard of These 2 Value Stocks?

05/03/2012 11:15 am EST

Focus: STOCKS

There are plenty of high-tech ways to pick stocks and time markets, but maintaining a simple value approach is still a great way to find the market's best stocks, writes J. Royden Ward of Cabot Wealth Advisory.

One of the best ways to make money is to ensure that you don't lose money—or at the least, you don't lose your shirt.

When I recommend a stock to buy, I always make sure the company is solid. A couple of quick ways to test the quality of a company are to check the company's ability to pay dividends and to check its balance sheet. Today I'll look at balance sheets—I discussed dividends in last month's Cabot Wealth Advisory.

I'm not an accounting professor, so I'll keep this simple. Every public company issues a balance sheet whenever sales and earnings are reported, which in the US is always quarterly. Every balance sheet is divided into two sections:

  • Assets
  • Liabilities and Shareholders' Equity.

One of the best ways to ascertain a company's quality is to compare the book value per share to the stock's current price. I find that a lot of investors are unfamiliar with book value and book value per share, so, become familiar with these terms.

Book value is shareholder's equity or retained earnings, which is a number found near the bottom of a company's balance sheet. Book value per share is simply the shareholder's equity or retained earnings divided by the number of common shares outstanding.

Is book value per share important? By itself, no. But when compared to the company's stock price, it's enormously important. In short, quality companies with low price-to-book value per share ratios (P/BV) have outperformed companies with high ratios for the past three-, five-, and ten-year periods.

I recently scoured my databases to find the best companies with low P/BV ratios. I found 200 companies in my database of 1,000 have P/BV ratios of 1.2 or lower. I used several additional criteria to narrow the list of 200 companies by also requiring Standard & Poor's Earnings/Dividend ratings of B+ or better, low price-to-earnings (P/E) ratios, dividend yields of 1% or higher, and good earnings prospects for the next 12-month and five-year periods.

My search turned up investment choices quite different from companies appearing in most other investment advisories. I discovered two lesser-known companies with low price-to-book value ratios selling at bargain prices.

Fred's (FRED)
Founded in 1947 in Memphis, Fred's sells discount merchandise from 701 stores in 15 states in the Southeast and Midwest.

Fred's also offers a large selection of generic drugs, which are in high demand and highly profitable. Stores offer household goods, pharmacy items, food, pet supplies, clothing, and linens. The average store size is modest at about 14,400 square feet.

US consumers continue to seek bargains when shopping for food, clothing, and household items, even though the economy is improving. Major retailers are aggressively cutting prices to compete for each retail dollar.

Merchants selling luxury goods and high-end merchandise are producing solid sales, but the stock prices of high-end retailers, such as Saks (SKS), Tiffany's (TIF) and Coach (COH) are too high. Likewise, the stock prices of discount and dollar store companies, such as Ross Stores (ROST), TJ Maxx (TJX), Dollar General (DG), and others enjoying strong sales are too high to buy right now.

Enter Fred's, which is a smaller discount retailer with sales of less than $2 billion, but whose stock price is very reasonable. Same-store sales have been flat during recent months, but I expect much better sales growth during the next several quarters as a result of 26 new stores opening in 2011 and 413 stores undergoing renovations during the past two years.

I expect sales to increase 7% and earnings to rise 12% during the next 12 months. The retailer has added pharmacies to half of its stores and is working to do the same in most of its remaining stores. In addition, Fred's will continue to open many new stores and renovate existing stores.

FRED shares are undervalued at 1.13 times book value and at 13.8 times forward earnings per share. The Standard & Poor's Earnings/Dividend Rank is B+, and the dividend yield of 1.7% is decent. I expect the strong demand for merchandise offered at low prices to continue during the next several years.

I advise buying FRED at or below $14.72 and selling when the stock price hits $21.74. FRED shares are low risk.

Ingles Markets (IMKTA)
This is a leading supermarket chain with operations in six southeastern states. Founded 49 years ago in Asheville, North Carolina, the company generates $3.6 billion in sales from 203 supermarkets, located typically in smaller towns and cities.

In addition, the family-run business owns and operates 71 neighborhood shopping centers, 59 of which contain an Ingles supermarket. Ingles also operates 74 in-store pharmacies and 70 on-site gas stations.

Ingles is building a new distribution and warehouse center in Asheville to replace its outdated (and only) facility. The new center will be completed soon, and will increase efficiency and add to profitability in 2012.

The company is expanding its selection of private-label items under the Laura Lynn name. Private-label goods are noticeably more profitable. The company is enjoying a surge in demand from consumers who are opting to buy groceries and cook at home rather than spend extra money to dine at restaurants.

The transition to the new distribution facility and higher food costs will hold back earnings growth in 2012, but I expect 14.5% growth in future years. Cash flow of more than $5 per share is more than enough to expand Ingles' store count, and at the same time, pay down the high debt load to reduce interest expense.

The price-to-earnings ratio (P/E) is realistic at 9.1 times current EPS, and the 3.8% dividend yield and price to book value ratio (P/BV) of 0.87 make Ingles Markets a very attractive investment opportunity.

IMKTA shares are medium risk. The Standard & Poor's Earnings/Dividend Rank is B+.

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