Despite a bumpy start to 2012, we are starting to see a renewal in corporate activity, much of which can be attributed to business sentiment being on the mend. This I believe has created an opportunity to closely examine the market to find those stocks that are still undervalued as they have fallen out of favor with investors. In this article I have analyzed five stocks that I believe are cheap stocks, which are in plain sight to determine if they are worthwhile investments. After applying this analysis I have found five stocks; ERIE, PRA, TCO, KMB and ACE that I believe are cheap stocks hiding in plain sight that will perform strongly in 2012. As always use my analysis as a starting point for conducting your own due diligence prior to investing.
Erie Indemnity Company (NASDAQ:ERIE)
Erie is the attorney for the Erie Insurance Exchange in Pennsylvania and the company provides sales, underwriting, and policy issuance services to the policyholders of the Erie Insurance Exchange. It operates 25 field offices in 11 Midwestern, Mid-Atlantic, and Southeastern states and the District of Columbia. It currently has a market cap of $4 billion and is now trading at around $78 with a trailing PE of 28. It has a 52 week trading range of $62.62 to $81.41.
At this price I believe the company is undervalued and this is a reflection of the negative sentiment investors have been expressing toward financial and insurance stocks since the U.S. debt crisis. This softness in demand for investments in the insurance sector has been further driven by increased business and consumer cost cutting on non-essentials and renewed economic fears driven by the European debt crisis. However, in my opinion the company should see a major improvement in its stock price during 2012 and now I will explain why.
Based on the numbers Erie’s outlook isn’t that great, for the third quarter 2011 it saw a 38% drop in earnings to $756 million and a 10% drop in net income to $47 million. For the same period its balance sheet also weakened with cash and cash equivalents dropping a massive 30% to $76 million, although long-term debt remained steady at nil.
When we review and compare the company’s key performance indicators to its competitors its growth potential during 2012 appears to be even more dismal as the table below highlights.
|Arthur J Gallagher (AJG)||1.92||7%||12%|
|Marsh & McLennan (MMC)||1.53||5%||14%|
Erie’s PEG at best indicates that it has dismal growth prospects and these are certainly worse than either Arthur J Gallagher or Marsh & McLennan. Furthermore, despite all three companies having a similar profit margin Erie’s return on equity is the lowest of the three and is a poor 3%, which further bodes ill for future income growth.
I also don’t like Erie’s debt to equity ratio of 1.52, which indicates that the company is more reliant upon debt than equity to funds its operations. Overall, I have a preference for investing in companies that rely upon equity to find their operations as this means they are less exposed to increased interest costs should interest rates rise and have less problems with managing debt covenants should their stock price come under pressure.
It is predicted that 2012 will continue to be a difficult year for insurers such as Erie to grow their businesses as the U.S. and European countries are still struggling to jump-start their economies and as the flow on effects of the European sovereign debt crisis continue to ripple across the global economy.
However, the economy is not the sole obstacle confronting insurers; the industry is also facing the fundamental need to change how it does business to meet rapidly evolving consumer expectations in terms of products, distribution, service and technology. Overall this can explain Erie’s poor fourth quarter 2011 financial results and indicate that Erie will find 2012 to be just as difficult.
Despite the negative industry outlook and Erie’s less than spectacular fundamentals the company does have some positive aspects. I quite like Erie’s handy dividend yield of around 3%, which while not spectacular, does provide a nice earner for income hungry investors and it is highly likely that Erie can continue to sustain this dividend with a payout ratio of 72%. There are also a number of positive aspects surrounding Erie’s ongoing business as in December 2011 the company decided to maintain the current management fee rate paid to it by the Erie Insurance Exchange at 25 percent. I also quite like the fact that the company’s board approved the increase of its dividend by 7% for both class A and class B shares in the same period. A further highly appealing aspect regarding Erie is that the company is rated by Wards as one of the top 50 insurers in the U.S and has an A+ (superior) rating from A.M. Best.
Finally at current trading prices Erie appears to be unfairly discounted by the market, firstly because it has a book value per share of $125, which at its current price, means it is currently trading at a 37% discount to its book value per share. Secondly it has an earnings yield of 4%, which is roughly double the current risk free rate of ten year treasuries which represents a small but solid risk premium over the risk free rate of return. Accordingly, despite Erie’s poor performance indicators I do believe that company has been unfairly valued by the market and at its current price represents a solid investment opportunity for 2012.
ProAssurance Corporation (NYSE:PRA)
ProAssurance is a specialist medical and professional liability insurance provider to the health care service, legal service, and other professional service providers in the United States. It primarily offers its products to physicians, dentists, chiropractors, optometrists, and allied health professionals. The company markets its products through an internal sales force, as well as independent agents.
The company has a market cap of $2.5 billion and is trading at around $83 with a trailing PE of 10. It has a 52 week trading range of $58 to $85.04. At its current price I believe that ProAssurance is relatively cheap and will continue to grow in value through 2012 and now I will explain why.
ProAssurance’s numbers are particular strong, as for the third quarter 2011 the company reported a 7% fall in earnings to $166 million and a 20% drop in net income to $44 million. However, the company reported a stronger balance sheet in this period with cash and cash equivalents rising by a solid 24% to $126 million and long-term debt dropping by 3% to $49 million.
I also feel that ProAssurance’s key performance ratios indicate that the company has solid growth prospects, even more so when compared to its competitors as the table below highlights.
|American Financial Group (AFG)||1.31||9%||7%|
|American National Insurance Company (ANAT)||0.60||8%||5%|
ProAssurance has a very favorable PEG ratio, which indicates solid growth prospects and when this is combined with its solid profit margin and solid return on equity the company in my opinion can only continue to grow net income and deliver strong investor returns through 2012. This is further confirmed by its extremely conservative debt to equity ratio of 0.02, which indicates an almost debt free balance sheet and in my view only makes the company an even more compelling investments.
Another highly appealing aspect is that Fitch have confirmed ProAssurance’s rating as A with a stable outlook, which bodes well for the company’s future financial outlook. The company is also preparing to expand nationally through the opening of two new processing centers to enhance its claims and underwriting abilities, which indicates that business is growing creating additional revenue.
I also believe that ProAssurance at its current price is undervalued by the market for two reasons. Firstly the company has a book value per share of $66, which means that at its current trading price, it is trading at a modest premium to its book value per share of 26%. Secondly with an earnings yield of 9.5%, which is more than triple the risk free rate of ten year Treasuries, the company is undervalued. In my opinion, despite trading at close to its 52 week high, now is a great time to jump on board with ProAssurance as its business continues to grow momentum, which will see it hit new stock price highs and deliver solid investor value.
Tractor Supply Company (NASDAQ:TSCO)
Tractor Supply operates around 1,043 retail farm and ranch stores in the United States, selling a selection of merchandise, including equine, pet and animal products, agricultural and rural products, hardware, tools, seasonal products as well as gifts and toys. It has a market cap of $6 billion and a 52 week trading range of $49.02 to $87.13 and is currently trading at around $85 with a trailing PE of 28.
Tractor Supply should have seen its earnings affected by the current economic downturn as it is reliant upon discretionary consumer spending to grow earnings. Yet for the fourth quarter 2011 it delivered solid financial results with a solid 27% increase in earnings to $1.2 billion, and even better a 65% increase in net income to $71 million. Overall this saw the company report a 2011 net income of $223 million, which is a 33% increase on its 2010 net profit and the third consecutive year that net income has risen.
Tractor Supply’s key performance ratios indicate that the company has solid growth prospects and I have set these out in the table below in order to compare them to some of its major competitors.
|Tractor Supply Company||0.81||6%||24%|
|Pet Smart (PETM)||0.75||4%||24%|
Tractor Supply has a very favorable PEG ratio and when this is combined with its solid profit margin, for a specialty retailer, and strong return on equity the company in my opinion can only continue to grow net income and deliver strong investor returns through 2012. As the table indicates the company’s fundamental indicators also indicate that it has better growth prospects than its competitors. I also quite like the company’s extremely conservative debt to equity ratio of 0.1, which indicates a strong balance sheet and bodes well for net income and dividend stability.
Finally Tractor Supply has an earnings yield of 3.6%, which is only marginally higher than the risk free yield of ten year Treasuries. Normally as a value investor I would be seeking a stock with a much higher earnings yield, therefore giving me a substantially greater risk premium as my reward for investing.
However, all of the numbers and fundamental performance indicators for Tractor Supply show that the company should be able to substantially grow EPS over the short to medium term. On the back of improving sales trends, Tractor Supply is expecting earnings in the range of $3.38 to $3.46 per share for the fiscal year 2012, which represents year-over-year growth of 12% to 15%.
The added sweetener with Tractor Supply is that even though its dividend yield of 0.6% is nothing to write home about, with a payout ratio of only 14% it is quite sustainable and this gives investors an additional predictable return on their investment.
Overall Tractor Supply has extremely solid fundamental performance indicators and it delivered a solid financial performance in 2011, in what can only be described as difficult operating circumstances. I also believe that Tractor Supply’s solid performance metrics show a company that based on current earning yields is undervalued and well positioned to take advantage of any uplift in the economy.
Kimberly-Clark Corporation (NYSE:KMB)
Kimberly-Clark manufactures and markets health care and personal care products worldwide and has a market cap of $28 billion. It has a 52 week trading range of $61 to $74.25 and is now trading at around $72, with a trailing PE of 18.
Kimberly-Clark saw a 3% drop in fourth quarter 2011 earnings to $5 billion and a 7% drop in net income to $401 million. For the same period Kimberly-Clark’s balance sheet strengthened with cash and cash equivalents dropping 39% to $764 million and long-term debt remained steady at $6 billion.
I also feel that Kimberly-Clark’s key performance ratios indicate that the company has some growth prospects and overall it is performing on par with its competitors as the table below highlights.
|Procter and Gamble (PG)||1.83||12%||16%|
Despite Kimberly-Clark’s high PEG, which doesn’t bode well for future growth prospects, it is in the same ball park as both Colgate-Palmolive and Procter and Gamble. I quite like its solid return on equity and profit margin. Although in the case of its profit margin it is lower than its competitors such as Colgate-Palmolive and Procter and Gamble.
I am not overly enthused by Kimberly-Clark’s debt to equity ratio of 1.16, although this is primarily due to my preference for investing in companies which use equity to fund their operations rather than relying on debt. However, even though it indicates that Kimberly-Clark uses debt as the predominant means of funding its operations it is not overly leveraged.
A tantalizing aspect off investing in Kimberly-Clark is its solid dividend yield of 4%, which is the fifth highest in its industry and higher than the return of ten year Treasuries and the U.S. inflation rate for January 2012 of 2.93%. Furthermore this yield is set to improve as the company has recently stated that subject to board approval, it plans to increase its annual dividend at a "mid-single digit rate." From this I would assume an increase in dividend to around $2.94 a share, up from its current dividend payment of $2.80 a share.
Finally at current prices I believe the stock is undervalued as it has an earnings yield of 6%, which is more than double the risk free rate. This represents a healthy risk premium for a company operating in the consumer staples sector. Overall the earnings outlook for Kimberly-Clark is quite solid due to its strong market position in non-cyclical paper, health and hygiene-related consumer products. It also has a portfolio of established brands all of which are consumer staples, which have relatively inelastic demand. Therefore, despite Kimberly-Clark reporting some disappointing financials in the fourth quarter 2011, I believe the stock is moderately undervalued by the market once its increased dividend yield is taken into account.
Ace Limited (NYSE:ACE)
Ace is one of the largest property and casualty insurers listed in the U.S. and the company provides a range of insurance and reinsurance products worldwide. It has a market cap of $25 billion and a 52 week trading range of $56.90 to $74.50. It is currently trading at around $74, with a trailing PE of 16.
For the fourth quarter 2011 ACE reported a 6.5% rise in earnings to $4.6 billion and a 2500% rise in net income to $750 million. For the same period its balance sheet weakened with cash dropping by 20% to $614 million. However, insurance policy liabilities in this period dropped by 3% to $48 billion and long-term debt remained steady at $3.7 billion. Its overall net profit for 2011 was $1.6 billion which was 49% lower than 2010. Much of this drop in annual profit can be attributed to the spate of natural disasters around the world in 2011 which saw Ace's pre-tax catastrophe losses soar to $155 million, primarily due to losses from the floods in Thailand.
Ace’s key performance indicators indicate that the company has moderate growth prospects and overall are superior to two of its main competitors as the table below shows.
|American International Group (AIG)||3.54||13%||7%|
|The Travelers Companies Inc (TRV)||1.91||5.6%||5.7%|
As we can see from the table above despite Ace’s PEG despite being less than optimal does indicate that the company has some growth potential and it is substantially better than either AIGs or the Travelers Companies. In addition, it does have a solid profit margin of 9.4% and a moderate return on equity of 7%, which in my opinion indicates that it is able to cost effectively translate earnings into net income. In addition, these earnings should grow as the U.S economic recovery gradually gains momentum despite the ongoing fallout from the European debt crisis.
I also find Ace’s debt to equity ratio of 0.4 very appealing as this indicates it has a solid balance sheet with the company predominantly using equity to fund its operations. This bodes well for net income and dividend stability as any rise in interest rates won’t see additional cash flow being allocated to managing debt. It also means the company is not only strongly positioned for future growth, but is capable of weathering any further economic headwinds should they arise.
With insurers facing a challenging 2012, it would seem obvious to state that Ace is not a worthwhile investment. However, I believe the contrary, as at its current price those investors who invest now should see a solid long-term return as the economy improves and the company is able to shake off its current catastrophe losses.
I also I believe that based on its fundamentals Ace is unfairly valued by the market for two reasons. Firstly the company has a book value per share of $71.89 and at its current price the company is trading at very low premium to its book value per share of 3%. Secondly it has an earnings yield of 6.3%, which makes it appear to be marginally undervalued by the market when compared with the risk free yield of ten year treasuries. This should give investors a moderately comfortable risk premium over the risk free rate of return.
About the author:
I fundamentally analyze every business from the top down.
In my personal life, I have a strong Jewish faith and enjoy playing Scrabble and entrepreneurship.