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  1. Home
  2. / Investing

3 Cheap Stocks on Their Best 'Behavior'

Combining valuation and behavioral investing concepts results in a short list these days.
By TIM MELVIN Mar 03, 2016 | 01:00 PM EST
Stocks quotes in this article: URI, CF, RWT

I recently came across a Bloomberg article on economist Richard Thaler and the success of a fund managed using his behavioral investing theories. The Undiscovered Managers Behavioral Value Fund (UBVAX), which has beaten its peers handily over the past three and five years, looks for beaten-up stocks with potential for a turnaround.

Lead portfolio manager Dave Potter uses the theories developed by Thaler to select stocks for the fund. He told Bloomberg, "We're looking for the companies that say not only is our stock so cheap that management is buying it, but the company itself is going to forgo an M&A opportunity or capital expenditures and use cash to reduce the share count."

That sounds like a pretty sensible approach to me. Last night I ran a screen looking for companies whose stocks had fallen at least 30% in the past year, had repurchased at least 5% of their shares and had insider buying in the past several months. It is a pretty short list right now, but there are some interesting candidates for patient, long-term investors.

United Rentals (URI) has seen its stock price drop by more than 40% in the past 12 months on declining demand from oil companies for its fleet of construction and industrial equipment. The Connecticut-based company had decent results for the year, as demand from other industries was fairly strong, but it fell short of Wall Street expectations for the fourth quarter and guidance for 2016 was lower than many had hoped.

URI now trades at 8x earnings and has an EV/EBIT ratio of just 7 so the stock is getting pretty cheap. Three directors have been buying back stock in the past two months and the company repurchased $750 million of its shares in 2015 and expects to continue buying this year.

CEO Michael Kneeland said on a recent conference call that United Rentals will use its strong free cash flow to pay down debt and buy back stock. The company had about $890 million left on the current repurchase authorization at the end of 2015.

CF Industries (CF) manufactures and distributes nitrogen fertilizers and other nitrogen products around the world. Fertilizer demand is down as a result of the weak global economy. CEO Tony Will recently described the current climate as "some of the most difficult market conditions seen in a decade." Despite this, the Illinois company has remained profitable and the stock looks cheap at 11.9x earnings and an EV/EBIT ratio of 7.6.

There has been strong insider buying in the past few months, including by Will, and although the company took a break in the fourth quarter, it repurchased 8.9 million shares for a total of $527.2 million in 2015. The dividend was lowered in 2015, but the stock still yields around 3.35%.

It may take some time but demand for food and the fertilizer needed to grow it will firm and CF Industries stock should trade a lot higher five years from now. Investors will likley be well rewarded for their patience.

Shares of mortgage REIT Redwood Trust (RWT) have bounced off lows reached in February but are still down more than 30% in the past year. In late February, the company beat Wall Street expectations for the fourth quarter and announced a new $100 million stock repurchase authorization. The company has already fully executed the $100 million buyback plan authorized in the third quarter of 2015 so it is being fairly aggressive about buying back stock.

RWT is currently trading at about 85% of book value and yields around 9%. Management has said they expect to see meaningful improvement in earnings for 2016 so that distribution rate could climb during the year. Two insiders, including CEO Martin Hughes, have been buyers of the stock in the past week.

Mortgage REITs have been battered in the past year but if rates remain fairly stable they could stage an impressive recovery in 2016.

The Undiscovered Managers Behavioral Value Fund has earned solid results using Thaler's theories, which combine valuation and behavioral investing concepts. We should be able to do the same.

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At the time of publication, Melvin had no positions in the securities mentioned.

TAGS: Investing | U.S. Equity

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