I spend a great deal of my time wandering around the markets looking under rocks for ideas cheap enough to present a solid long term opportunity. It is no secret that this has become increasingly difficult over the past few years as markets have gone higher. Outside of the small banks, there simply have not been many stocks that are cheap and even fewer that are cheap and safe.
Over the past weekend while watching a bunch of baseball, running screens and reading Ace Atkins' latest novel, I also turned over a few more rocks. As part of that process I ran across a list of industry groups ranked by Shiller P/E and decided to look for the cheapest stocks in the cheapest industry groups. (The Critically Adjusted Price-to-Earnings Ratio (CAPE ratio), devised by Robert Shiller, compares the 10-year average of inflation-adjusted earnings to price, and it is often viewed as more reliable than simple P/E.)
The lowest-ranked sectors are oil and gas drilling, coal and integrated oil and gas. So, I put those three groups into my trusty screener and almost all of them are cheap. However, then we add in some safety factors and look for a company's ability to survive until it can thrive again when energy prices move higher in the future.
If I use my strictest safety criteria -- and that's the only one I am willing to use today -- and price-to-book value as the valuation measure, there are no stocks that pass the "screen test." If I use enterprise/EBIT as my measure, then just Exxon Mobil (XOM) and Chevron (CVX) make the grade as stocks both cheap and safe enough to consider owning. A quick check also tells me that both pass the Novy-Mark quality test, with gross profits that are more than one-third of total assets used to produce the profits.
These two energy giants are the only energy names I would be willing to buy among integrated oil companies or drillers at current prices. It is no secret that I have taken a real beating in energy and coal stocks over the past couple of years. If not for my preference for small position sizes and the fact that the majority of my portfolio is in small banks I might be up on a ledge somewhere. Although I am confident that oil will recover at some point, I have no idea when that will happen and there will continue to be casualties along the way. If you must play energy, however, high-quality industry leaders with a strong financial position make the most sense to me.
The next cheapest industry group is specialty insurance, which includes companies that write reinsurance, bond insurance and workers' compensation insurance. The cheapest stock in this sector is Assured Guaranty (AGO), trading at 70% of book value. The story here is pretty simple. If Puerto Rico straight out defaults this company is in trouble. If Puerto Rico restructures or does a swap of some sort to reduce debt then this bond insurer comes out OK and the stock will do very well.
AGO stock is a bet in my eyes and if I needed to be involved I would structure it using a straddle of January 2017 puts and call. A quick eyeball shows that a careful trader could get a pretty interesting bet using the 20 puts and 30 calls that pays off if the stock collapses or the cloud of default liability is lifted over the next 18 months. Perhaps Real Money's Tim Collins could chime in on that one.
The second cheapest stock in this group is Blue Capital Reinsurance (BCRH). Blue Capital, which sells collateralized reinsurance in the property catastrophe market, is trading at 81% of book value. The company is doing very well right now and all of its assets are in cash or short-term instruments so there is none of the market risk that other reinsurers have in their portfolios.
Blue Capital returns most of its profits in the form of dividends and the stock currently yields over 7%. Also, it just paid a special dividend of $0.66 per share so management is focused on returning profits to shareholders.
Next on our list, at 89% of book value, is a reinsurance company that does take market risks with its assets. The investment portfolio at Greenlight Capital RE (GLRE) is overseen by hedge fund manager David Einhorn, who has a strong track record when to comes to managing money.
According to Greenlight's website, the largest disclosed long positions in its investment portfolio are Apple (AAPL), CONSOL Energy (CNX), General Motors (GM), gold, Micron Technology (MU) and SunEdison (SUNE); its investment portfolio is approximately 104% long and 83% short. I imagine that the short book contains some of the fracking-related names that Einhorn has talked about at recent investment conferences, so the company should be benefiting from what is going on in that sector right now.
Buying the cheapest stocks in the cheapest sector makes a lot of sense but as with every list we look at of late the pickings are slim.