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The hallmark of a mispriced stock is misperception. Stocks that are properly understood by investors tend to have stock prices that approximate value. Not so for stocks where perception is faulty. It is fair to say that, generally, the greater the misperception, the greater the odds that there will be a wide gulf between price and value.
For overvalued stocks, misperception typically involves excess enthusiasm that is evidenced by unrealistic and/or unattainable expectations.
For undervalued stocks, misperception frequently involves excessive pessimism. For skilled value investors, this is the sweet spot in investing. That is, when there is excessive negativity, there is often a large potential reward coincident with low risk.
Here are five undervalued stocks that meet this test. They are heavily discounted by the market because of widespread misperceptions. I have been buying these stocks because they represent high-reward, low-risk opportunities.
■Commerce Bank (CBH). At about $36 a share, the stock price of Commerce is woefully mispriced. It is mispriced because the stock quote is predicated on a continuing yield curve inversion – inversions occur when short-term interest rates are higher than long-term rates. The current inversion severely pinches profits at Commerce because of its heavy investment in fixed-income securities. History shows, however, that inverted yield curves are a transitory phenomenon.
The best way to value Commerce is to calculate its earnings per share based on a normalised yield curve. To be sure, the yield curve won’t steepen dramatically in the next month or two. But if it reverts to a more normal slope over the next couple of years, the net income of Commerce will at least double. That would make my calculation of value, at $73 a share in 2008, an easily achievable target.
■1-800-Flowers.com (FLWS). By my calculations, this $6 stock will be worth $11-$12 by the end of 2007. The company has changed its focus from top line (revenue) growth to bottom line (earnings) growth. Expect the operating leverage in this model to be unleashed over the next several quarters as improved efficiencies and rapid expansion of its high-margin Bloomnet business drive earnings much higher. Annual earnings per share should exceed 50 cents by next year.
■Gateway (GTW). My estimate of value for this computer maker is $3-$3.50 a share, much higher than the current mispriced stock quote of about $1.90. With some modest operational improvements, value will easily exceed $5 a share. It doesn’t require anything heroic. Taking operating margins to the 4-5 per cent neighbourhood, which is well below other PC makers, will justify a price in excess of $5 a share.
The market has, in effect, granted buyers of Gateway stock a “free option” on operational improvement. The stock is priced as if current struggles will continue in perpetuity. With a strong balance sheet and a new management team that is focused on profitability, my bet is that an upturn is around the corner.
■Georgia Gulf (GGC). This leading chemical company recently acquired Royal Group. Before the acquisition, Georgia Gulf’s enterprise value (equity plus debt) was $1.2bn. After paying $1.55bn for Royal Group, the combined company’s enterprise value is $2.2bn. The market has priced the stock of Georgia Gulf as if one plus one equals a lot less than two.
A contributing factor to a depressed Georgia Gulf stock price is that its end markets are tied to housing and construction. Because of an anticipated decline in its end market, earnings estimates have come down for 2007 and the stock has been hammered. Investors that can look past a cyclical economic decline can take advantage of the fire-sale Georgia Gulf stock price.
By my calculations, when the end market for Georgia Gulf is healthy again – perhaps in 12 to 24 months – this $19.50 stock will be worth in excess of $50 a share.
■Blockbuster (BBI). The market is not paying close attention to the dramatic improvement at Blockbuster. Operationally, the company has already turned the corner.
The company generated $130m in free cash flow in the first nine months of the year – compared with a huge cash flow deficit in 2005. On a year-over-year basis, improvement in cash is impressive, growing to $255m from year-ago levels of $65m. So is the improvement in debt, declining to $995m from year-ago levels of $1.27bn.
Early indications are that Blockbuster’s “Total Access” programme is a success. Blockbuster is leveraging its store base to deliver films to subscribers faster than Netflix. And its cost to acquire subscribers is materially lower than Netflix. Assuming a continuation of recent operational improvements and growth in its Total Access programme, my calculation of value for Blockbuster is $11.50 a share. That is much higher than the recent quote of $5.75.
Arne Alsin is a portfolio manager for Alsin Capital and the Turnaround Fund firstname.lastname@example.org