Working Within the System

 | Mar 27, 2012 | 2:00 PM EDT
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My recent conversation with Henry Carstens of Vertical Solutions started me thinking again about a test we ran a few years ago. We bought S&P 500 stocks that traded below book value with relatively low levels of debt on the books and held them until they either doubled in price or went to zero. The system handily beat the market for a long period and had never had a down year. The list of stocks we produced in July 2008, just as the stock market went into a tailspin, has been a tremendous performer, to say the least. Although the timing was unfortunate, the system has produced a seven-stock portfolio that is 80% higher today, not including dividends. I revisited the test in a column last September, as the market was starting to fall down around us. That list of stocks has matched the market before dividends since then, rising by about 15%, not including dividends.

This morning I ran a screen for stocks that fit that approach in today's market. Although we had experienced a nice rise in the overall market in the past few months, there are still a few candidates for purchase based on this mechanical approach. I came up with seven stocks that have decent balance sheets, trade at a discount of 10% or more to book value and were in the index. Four of them were insurance companies: Lincoln National (LNC), Unum (UNM) and XL Group (XL). These companies and their stock price probably have a great future, but I'm lukewarm on insurance companies, as they have had a strong run recently. I prefer to buy these in a down market.

Harford Financial Services (HIG) is more of a special situation. Under pressure from activist investors, including fund manager John Paulson, the company has announced that it will put its annuity business in run-off mode and sell several of business units. Selling the life insurance and retirement plan business will allow the company to focus on property and casualty, mutual funds and group benefit lines. Getting out of the variable annuity business is a wise decision on the part of Hartford, and the tighter focus should lead to a rising bottom line and better valuation for the stock. Trading at just 40% of tangible book value, this stock could double and it would still be slightly undervalued. It is wise to move slowly on any insurance stock right now, but you can start buying this one even after the recent price improvement.

There is one stock on the list that poses a bit of a conundrum for me. I am not bullish on the near-term prospects for solar energy but shares of First Solar (FSLR) are cheap. Solar is part of the long-term energy solution in the U.S., but it is not yet the end-all, be-all answer many had hoped it would be. Many solar stocks have fallen back to earth in the past year, including First Solar. The company lost its cost advantage when polysilicon prices were much higher. Now that prices have fallen, it's losing ground to Chinese competitors. Industrywide, there are excess supplies of solar panels and government subsidies for solar installations are declining rapidly across the globe. It is an ugly picture for the company. The stock is trading at 60% of tangible book value, however, and has a little more than a third of its market capitalization in cash with very little debt on the books. I need to consult with some energy savvy friends to ascertain the outlook for this company, but it is very cheap at this level. I'm not a fan of solar stocks, but I am a fan of cheap.

The remainder of our portfolio is rounded out by an energy stock and a bank. Zions Bancorp (ZION) has risen by 35% year to date, but still trades at just 70% of book value. Credit conditions are improving and Zions is over-reserved with 130% of reserves to nonperforming loans. Although I wish Zions wouldn't just yet, odds are that those excess reserves will be released and push earnings higher throughout 2012.

WPX Energy (WPX) is yet another energy company that has seen its stock price affected by low natural gas prices. At 70% of tangible book value, the shares look cheap and should rebound when natural gas pricing improves.

Looking for cheap stocks that aren't overleveraged in the S&P 500 has been a winning approach for investors. This is an approach that allows us to benefit from the natural bullish bias of black boxes and short-term traders by buying amid the short-term difficulties of specific companies.


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