This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Oil Prices Whiplash
On Tuesday, I warned investors to avoid oil stocks:
“If history is a guide, oil’s outperformance won’t last forever. Much like the commodity rush of 2013 to 2014, today’s commodity boom can end in the blink of an eye. And when it does, you want to be sure you’re not holding the bag.”
Barely a day later, oil would retreat from $120, putting oil stocks on the back foot.
For energy companies and other “value” stocks, simple valuation metrics such as P/E and EV/EBITDA ratios no longer guarantee results. Even a low price-to-book (P/BV) value — a metric that Fama and French famously used in their 1992 paper — generated no discernable alpha between 2013 and 2022.
So much for an easy win.
But I have good news. And it’s not just for my vocation.
It turns out that investors can still profit from value stocks throughout business cycles:
- Rising Demand = Low P/E Companies. Cheaper companies performed remarkably well when consumers were rushing to buy (i.e., 2013, 2018, 2021).
- Falling Demand = High P/E Companies. More expensive firms did better during belt-tightening (i.e., 2015, 2020).
The price-to-sales metric also shows solid results. $10,000 invested in the lowest quintile of P/S stocks would have turned into $63,060 over ten years, compared to $43,870 in all other stocks.
In other words, those who pick their value-stock battles can still outperform.
And today, we’re going to consider three cheap stocks that could rise 2x over the coming year.
Value Stocks and Cyclical Demand
My quantitative Profit & Protection system helps us avoid “value traps,” the dreaded prospect of buying cheap stocks and seeing them go nowhere (or more commonly, watching them get even cheaper).
Today, there’s no better place to find such traps than in auto stocks.
Since March, rising oil prices and financing costs have dented automotive demand. The Mannheim used vehicle index has fallen from a 236.3 peak in January to 222.7. And used car site Carvana (NYSE:CVNA) has (thankfully) stopped sending me ads to try buying my car.
Meanwhile, another group of cheap stocks are gaining fast: healthcare, consumer staples and telecom.
Stocks in these conservative sectors have historically outperformed during recessions, making them the cheapest “no-brainers” to buy today.
Telecom: Millicom International
TIGO is admittedly a “slow-burn” company rather than an overnight get-rich-quick stock. Most Latin American telecom markets are oligopolies that resemble slow-moving Amazonian sloths. 5G networks only have around 7% penetration on the continent, and a mere 9.9% of the population has access to high-quality fiber connections at home.
A hypergrowth market, this is not.
But Millicom and other Latin American telecoms are starting to change that.
In Guatemala, Millicom (also known as Tigo) now plans on adding 1 million new homes per year to its cable network. And data services is an area with healthy growth potential. Analysts at Morningstar expect the firm to grow revenues by 4% annually towards the end of the decade.
The competitive landscape is also ideal for value investors. Millicom has a duopoly in its Guatemalan home market, while Colombia is largely a three-way race (Tigo also leads in smaller markets like El Salvador, Honduras and Paraguay). Analysts expect the telecom to earn 7% return on equity (ROE) in 2023, a fair amount in an industry with sky-high capital investments.
Most importantly, TIGO shares are cheap. At a time when most low-volatility stocks are at a premium, Millicom is the rare investment that retains multiple expansion potential. A return to a more “typical” valuation would give the stock a 125% upside from today’s levels.
The Profit & Protection system shows that it’s not enough to buy a company for a low P/E ratio. But once you factor in other cyclical elements, the attractiveness of companies like Millicom quickly becomes clear.
Healthcare / Cons. Staples
Bausch is a rebrand of the embattled Valent Pharmaceuticals, a firm that gained notoriety in 2015 after hiking the prices of essential drugs. Under the new guidance of CEO Joseph Papa and activist investor John Paulson, the company now looks more like a stable Johnson & Johnson (NYSE:JNJ) than a pharma version of “barbarians at the gate.”
It’s not the first company to have survived a near-death experience. Savvy marketers renamed WorldCom’s assets to MCI, which Verizon (NYSE:VZ) eventually acquired in 2006. And GE’s insurance arm lives on as Genworth Financial (NYSE:GNW).
Bausch, however, joins the Profit & Protection list because of its highly stable Baush+Lomb eyecare business, which makes up 55% of revenues.
B+L’s consumer business — which includes Biotrue and ReNu lens solutions — is a downturn-resistant industry with high margins. Consumers might forego a new set of glasses in a recession, but contact lens solution is far harder to substitute.
Bausch+Lomb’s surgical business (15% of sales) also has recession-resistant characteristics. Cataracts don’t disappear during downturns and B+L is a leader in the optical surgery business.
These elements (as well as a mix of drugs from its pharma and Salix segments) have given BHC a stable source of revenue during market ups and downs.
Like most low-priced firms, however, BHC does have its issues.
- Legal liabilities. Although most analysts project less than $100 million in legal liabilities, BHC still remains in legal limbo over several lawsuits from its 2015 to 2016 crisis period.
- Drug pipeline. Several of the company’s drugs, including Xifaxan and Prolensa, will lose patent protection through 2028. BHC has no clear candidates to replace these revenue drivers.
- Debt load. The firm’s $23 billion in long-term debt is unsustainable. BHC will need to offload more of its asset portfolio in order to pay down debt.
Nevertheless, BHC’s sub-$10 price makes it a tempting play. A fair value of $25 gives a healthy 150% upside, while its 90% ownership of publicly-traded Bausch + Lomb Corp (NYSE:BLCO) gives it significant downside protection.
In theory, its BLCO stake of $5.3 billion exceeds its current market cap of $3.5 billion, a fact only made possible by the parent company’s large debts.
More on this tomorrow.
Low P/S Moonshots
Meanwhile, former Moonshot Investor readers might also ask, “What about ultra-low P/S stocks that can go 5x or 10x?”
And that’s where a gamble on Bed Bath & Beyond (NASDAQ:BBBY) comes into the mix. Though it doesn’t quite make the core Profit & Protection portfolio, BBBY has many elements that my quantitative system favors: a rock-bottom 0.09x price-to-sales ratio, a sky-high 73% EPS growth rate in 2024 and revenue shrinkage last year that seems to ask, “how much worse can things get?”
In other words, it’s a cheaply-priced turnaround play that could go 3x to 5x overnight.
From a risk-blind standpoint, BBBY is a steal at its current sub-$9 price. My estimated fair value for the company is around $15, a 67% upside, and a hoard of Reddit investors could easily send shares up 200% or more. Activist investor Ryan Cohen has a history of whipping up a frenzy.
But hazards surrounding the potential upside are too great to ignore. A traditional 2-stage discounted cash flow (DCF) model using current estimates pegs BBBY’s value at $0, suggesting that the potential for total loss outweighs any potential gains. This is not an investment for the faint-hearted.
Bond markets also seem to agree. The retailer’s 2024 bonds trade at 71 cents on the dollar, down from par as recently as March 11. Much like other failed retailers from Sears to JC Penney, Bed Bath & Beyond will find that turning its ship around will take a Herculean effort.
I would reconsider BBBY for the Profit & Protection “buy” list if prices dropped below $3. But for the most risk-seeking of investors, a $9 entry price could still yield 2x gains if Reddit investors have it their way.
The First Principles of Investing
When I first started on Wall Street years ago, I wanted to find that one thing that could help me outperform the market every time.
Legendary investors like Ben Graham made it seem so easy — couldn’t you buy companies under their book value and be done with it?
But much like exercising to a Jack LaLanne or Jane Fonda workout, beating the market took as much work as getting in shape.
Not only did I have to put in the hours…
… I also needed to know why certain things worked.
It wasn’t enough to know that low-P/S companies do well (or why Jack LaLanne went with a high-protein, primarily vegetarian diet).
I also needed to know why. That way, I can start or stop doing things based on context.
My quantitative Profit & Protection model goes a long way to solving these issues. By layering multiple rounds of checks and balances, cheap stocks like Bed Bath & Beyond are elevated because of their turnaround potential, but handicapped because of their enormous financial risks. It’s how I found winners like Hertz (NASDAQ:HTZ) back when it was still trading for under $2 in bankruptcy.
But identifying high-quality cheap stocks still involves knowing why an investment should outperform. And tomorrow, I’ll cover two perfectly-positioned stocks with just those characteristics.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.