Hunting For Deep Value Gems

By Ryan Barnes | July 12, 2010 AAA

As part of an ongoing look at some screens on the S&P 500, today we're sifting through the index's 500 members for some deep value stocks. These are companies trading for very low P/E multiples, but still sporting decent growth prospects and other attractive characteristics. At a time when the broad market is struggling to find its footing, deep value hunting can be a fun and rewarding exercise. Socking away a couple of stocks trading for rock-bottom prices are a great counter-balance to a portfolio that is heavy on growth stocks.

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The Criteria
In today's screen, I filtered for stocks that had forward P/Es under 10 and traded for less than 10 times free cash flow. Flipping these ratios around, we're looking for companies with earnings yields in excess of 10%, much better than you'll find on all but the riskiest of bonds.

To make sure I wasn't just finding market duds or outcasts, I also filtered for companies that had at least 15% annualized earnings per share growth the past 5 years, and have PEG ratios less than 1.0 - meaning they have growth expectations grander than their P/Es reflect. (For more, see The 4 Basic Elements Of Stock Value.)

Only 10 stocks made it through the hoops. One thing they almost all have in common was that they've had a recent slide; this pushes down valuation measures and usually belies poor investor sentiment. Since nobody wants to reach out for a falling knife, below are three companies that still have a good long-term thesis behind them.

L-3 Communications Holdings (NYSE:LLL) is a defense & aerospace contractor with a high-tech focus. Main business segments include global intelligence, surveillance and reconnaissance (ISR), aircraft modernization & maintenance, and communications/IT services. In 2009, 83% of the company's $15.6 billion in annual sales came via the U.S. government, which provides stability (as in a $10 billion order backlog), but also highlights why some investors have soured on the stock of late. Shares were down over 20% in the last quarter over fears of budget cuts and sluggish sales, which were flat in the most recent quarter. (Are all the ratios making you see red? Check out Investopedia Video for easy-to-understand explanations of ROE, ROI, EPS and much more)

But the reality is that we live in a world that demands strong defense, and L-3's focus on modern defense equipment and strategies should ensure them a solid piece of the defense budget pie for years to come. The company recently instituted a dividend, and while the yield of 2.2% is good on its own merits, the payout ratio is less than 20% leaving plenty of room for future hikes. The recent weakness could be a good opportunity to pick up shares of this long-term performer (just two down years in the past decade) for a meager 9 times earnings.

Goldman Sachs (NYSE:GS) - One could easily make the case that Goldman has become the poster child for excess - even arrogance - in the past few years, but the fact remains that the company simply mints profit in good times and bad. Goldman booked $3.5 billion in net income during the first quarter, nearly double what they earned a year ago. While investment banking and advisory revenues were down over 25%, Goldman more than made up for those declines in their fixed income, currency and internal trading division.

Goldman's current P/E is a paltry 5.5, revealing investor concern over how the profitability of the company will be impacted by recently passed regulations limiting financial leverage and proprietary trading desk activity. The "investment" bank is also in the SEC's cross hairs over events preceding and during the financial crisis - a storm cloud that could linger for quite some time. Fears of fines, penalties and litigation are never positives for a stock, but investors should keep their eyes on GS shares as the SEC dance progresses. Love 'em or hate 'em, Goldman's got ingenuity in spades - their operating margin of 47% crushes rivals like JPMorgan Chase (NYSE:JPM) and Morgan Stanley (NYSE:MS) (31% and 22%, respectively). Financial markets are nothing if not fluid, and Goldman has proven its ability to both adapt and thrive.

GameStop Corp (NYSE:GME) - The #1 brick and mortar video game retailer has been on a multi-year backslide, with shares down nearly 70% from their peak in 2007. The basic bear argument is that GameStop is in a death spiral brought on by online content distribution and uber-competition from the likes of Wal-Mart (NYSE:WMT) and Amazon (NASDAQ:AMZN). Investors are worried that about the possibility that gamers will have nearly all their software needs met online, rather than by physical delivery.

Adding to recent share weakness was a poor 2009 for video game sales - total units were down 8% amidst slowing hardware sales and a weak economy, which has also put the brakes on a major push for a new console cycle. But while it seems that the stars are aligned against GameStop, the company is quietly growing sales, earnings and cash flow. Since the stock peaked nearly three years ago, sales are up over 30%, and operating income has doubled. GameStop has pulled this off by growing its used game business, which surprisingly carries with it double the gross margins of new game sales. It seems unfair then that shares trade for just 9 times earnings, especially considering that net debt is 80% less than three years ago and shareholder's equity has doubled.

Parting Thoughts
By sitting down for a bit of extra homework, investors can round out a portfolio with some value stocks that still have enough growth traits to participate in an extended market rally and/or economic recovery. These three are a good place to start. (To learn more, check out The Value Investor's Handbook.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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