7 Stocks at Bargain Prices

Their shares didn't deserve to be clobbered. Jump in before the herd realizes its mistake.

EDITOR'S NOTE: The story was posted in May, so the stock prices quoted below may have changed. Click on the stock symbols to get current prices.

Whenever investors rush to the exits, stocks of good companies tend to get trampled along with the bad. And there has been quite a stampede out of stocks since last October. Between then and mid April, Standard & Poor's 500-stock index declined 15%; at one point, the benchmark was 18% below its peak.

After sifting through the wreckage, we think we've found seven companies that don't deserve the drubbing they've gotten. All of them have obvious competitive advantages that seem to have been overlooked because of the gloomy short-term outlook in their businesses.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

In spotlighting these seven, we are mindful that cheap stocks can always get cheaper. But we have narrowed our list to those that have the financial wherewithal to withstand a prolonged downturn, if it comes to that. When investors sense a recovery is on the way, these stocks' advantages will become obvious and they won't remain bargains for long. The seven are listed in order of market value, starting with the biggest.

Apple of my eye(pod)

With some 85 million iPods in circulation, is the market for Apple's franchise product tapped out? Investors seem to think so. They've pushed the shares down 27% since their late-2007 peak of $202.

But Apple devotees appear to be trading up. Although iPod sales were up just 5% in the December quarter, at 22.1 million units, iPod revenues were up 17%, to $4 billion, as buyers moved to more-expensive versions, such as the Touch, which incorporates wireless Internet browsing.

What's more, Apple expects to sell ten million iPhones this year. Although Apple tracks their sales separately, iPhones are essentially iPods with phone service. Viewed in that light, there's plenty of life left in the iPod franchise as Apple adds new capabilities. "Apple has established a whole range of digital-media products with the potential to communicate with one another," says Michael Lippert, manager of Baron iOpportunity fund, which counts Apple among its top holdings. "Who cares what the differences are in terms of labels?"

Lost in the iPod fuss is the renewed growth in sales of Apple's desktop and laptop computers. Their revenues were up 47% during the October-December quarter compared with the year-earlier period. With just a 3% share of the market for computers, Apple, based in Cupertino, Cal., has plenty of room to grow here, too.

The stock (symbol AAPL) trades for 28 times estimated calendar '08 earnings (Apple's fiscal year ends in September). But remove the company's $18.5-billion cash hoard -- equivalent to $20 a share -- from the equation, and the price-earnings ratio falls to 24.

In addition, Lippert notes that earnings are depressed by Apple's decision to count most iPhone expenses when the sale is made but stretch out recognition of the revenue over two years. Deferred iPhone revenue (including deferred AppleTV revenue) was $1.4 billion during the October-December quarter, up from $636 million the previous quarter. Apple looks even cheaper when earnings are adjusted for this accounting maneuver, Lippert says.

More than a rater

Through its ownership of bond-rating behemoth Standard & Poor's, McGraw-Hill has been dragged into the middle of the subprime-mortgage mess, and its shares (MHP) have plunged 50% since June 2007. S&P and other bond raters are under fire for vouching for the safety of complicated mortgage securities that later plummeted in value.

[page break]

Critics say the root of the problem is a system in which those with the most to gain from a favorable rating -- the bond issuers -- are the ones paying for the ratings. Any reform of the system would have a major impact on S&P. Meanwhile, few new mortgage securities are being issued, and S&P's profits are suffering as a result.

But the chance that new laws or regulations would force bond raters to change their business models is small. And the status quo favors S&P, which rates $32 trillion worth of debt in more than 100 countries and has an unassailable position.

Concerns about S&P's near-term performance, however, are real. The financial-services firm accounts for 45% of McGraw-Hill's revenues and three-fourths of its operating profits. In March, McGraw-Hill, which is headquartered in New York City, warned that it wouldn't hit its 3%-to-5% target for full-year earnings growth.

But while the uncertainty is unsettling, it should be put in proportion. S&P's business of rating new securities accounts for only some 15% of McGraw-Hill's total revenues, according to analyst Wendy Walker, of Argus Research. And the long-term outlook is solid. "There will always be new investment products that need to be rated," says Robert Millen, co-manager of Jensen fund, which owns McGraw-Hill shares.

S&P has other businesses, including research, data and the licensing of its stock-market indexes. McGraw-Hill is also a dominant player in textbooks, and its media division includes such well-known brands as BusinessWeek magazine and J.D. Power and Associates, which conducts customer-satisfaction surveys.

McGraw-Hill shares sell for just 13 times this year's expected earnings, and they pay a dividend, currently at a rate of 88 cents a year, that has risen an average of 10% annually over the past 34 years (the stock yields 2.4%).

Transportation supplier

Trinity Industries is the nation's largest manufacturer of railcars, an industry that is leveling off after several years of explosive growth. The slowdown is evident in Trinity's backlog of orders, which slipped to $2.7 billion at the end of 2007, down from $2.9 billion a year earlier.

But given that nearly half of the nation's railcars are at least 25 years old and their average life span is 35 years, it's only a matter of time before demand picks up again. You'd hardly know that from Trinity's stock (TRN), which is down 50% from its 52-week high.

Meanwhile, Trinity, a member of the Kiplinger Green 25, has several other lines of business that are doing well. It is the nation's largest manufacturer of inland barges (the order backlog for these has almost doubled over the past year, to $753 million), and its construction-products group, a play on rising infrastructure spending, sells more highway guardrails and crash cushions than anyone else. It also makes towers for wind-powered turbines, a business that has seen revenues leap from $11 million in 2004 to an expected $380 million this year.

Eric Marshall, co-manager of the recently launched Hodges Small Cap fund, says one of the reasons he likes Dallas-based Trinity is that one-third of its business is not tied to railcar manufacturing. The non-railcar businesses "will contribute to growth even though '08 won't be a great year for the railroad business," he says.

At $25, the stock now trades at just seven times expected 2008 earnings -- well below Trinity's historical P/E. That may be due in part to concerns that Trinity's growing railcar-leasing business uses a lot of borrowed capital at a time when the credit markets are in turmoil. But the company has a solid balance sheet, hasn't missed a dividend payment in 44 years and could even repurchase up to $200 million of its shares this year and next.

[page break]

Fingerprint matcher

Cogent Systems is one of a handful of suppliers of automated systems that capture and analyze fingerprints and other physiological identifiers. Its technology can sift through six million fingerprints per second and find matches with a high degree of accuracy. That has made it a top supplier to the U.S. Department of Homeland Security and a leading candidate to update the FBI's database of 60 million fingerprints.

The market for such identification systems is expected to more than double, to $7.4 billion, by 2012 as governments tighten border security and law-enforcement outfits modernize dated systems. Businesses, too, are expected to adopt the technology for pay-by-touch retail systems, for example.

The company, based in South Pasadena, Cal., currently depends heavily on two customers: the U.S. and Venezuelan governments, which provided 25% of revenues last year. In fact, virtually all of its business comes from governments. That means Cogent's profits are not especially sensitive to the ups and downs of the economy.

But government contracts come with their own set of issues. The bidding process can be long and drawn out, funding is often delayed, and contracts can be abruptly canceled. As a result, Cogent's earnings can be erratic.

Profits in the third quarter of 2007 missed analysts' expectations by nearly half, even though sales and profits rose for the full year. These issues have weighed down Cogent's stock, which has lost 46% of its value since last fall.

Investors who take a longer-term view, however, will see a company that could post annual earnings gains of 20% over the next five years as advanced fingerprint ID systems win wider acceptance. And as Cogent adds new customers, recurring-maintenance revenues, now about 20% of the total, will rise, smoothing out its earnings.

At $9, the stock (COGT) trades for 21 times expected 2008 earnings. Cogent has more than $3 a share in cash and has used some of it to buy back more than 1 million shares in last year's fourth quarter and another 1.8 million shares in January. "This company has solid technology and a solid customer base," says Morningstar analyst Rick Hanna, who pegs the shares' value at $16.

Bargain bling dealer

With so many people struggling with mortgage foreclosures, rising unemployment and record-high fuel prices, investors seem to want nothing to do with an online jeweler that collects more than $1,000, on average, in each transaction. Shares of Blue Nile traded in mid April at $50, less than half their $106 peak last fall.

But while economic headwinds will hold profits in check this year, they won't blow the Seattle-based retailer's low-cost business model off course. Through exclusive arrangements with its suppliers, Blue Nile (NILE) offers a selection of more than 50,000 diamonds, although it holds virtually none in inventory. Customers pay for their orders and receive them in the mail long before Blue Nile has to pay its suppliers (45 to 60 days later). It can earn a return on the cash in the interim.

In addition, Blue Nile has no stores, only fulfillment centers in Seattle and Dublin, Ireland, and no commissioned salespeople. Scott Devitt, an analyst for brokerage Stifel Nicolaus, estimates that Blue Nile's operating expenses are 11% of revenues, compared with nearly 50% for traditional jewelers.

Founded in 1999, Blue Nile already has an estimated 4% share of the $5-billion U.S. diamond-engagement-ring market (average price: $6,200). With Web sites in Canada and the United Kingdom, it has begun to penetrate the international market. Last year, foreign sales more than doubled.

[page break]

This year, however, analysts expect flat earnings, ending a three-year period during which profits rose 20% annually. Slowing sales and the recent resignation of Blue Nile's chief financial officer have brought the share price down from the stratosphere. The stock still doesn't look cheap at 47 times expected 2008 earnings.

But because of its low operating costs, Blue Nile should weather a downturn better than its brick-and-mortar competitors and perhaps pick up market share. It generates a lot of cash from operations, has more than $100 million in the bank and has little need to raise outside capital. It's only a matter of time before this young company's robust growth resumes.

Blueprint for success

Major construction projects can involve as many as 200 trades, from carpenters to elevator installers, all of whom rely on blueprints to communicate instructions. Thousands of prints may be generated in the course of erecting a single large building. The reprographics industry, which handles the printing, storing and distribution of these blueprints, is highly fragmented. More than 3,000 businesses serve mostly local and regional markets in the U.S.

One big exception is American Reprographics. With 307 branches in 39 states, it has ten times the reach of its next-largest competitor. It uses its clout to lure big players, such as Boeing and Turner Construction, to demand big discounts from reprographic-equipment suppliers and to license its in-house document-management software to other firms in the industry.

But about 80% of American Reprographics' business is tied to construction, most of it nonresidential. And with residential construction in a funk and other construction on the brink of one (Goldman Sachs forecasts declines in U.S. nonresidential construction spending of 10% in 2009 and 5% in 2010), investors seem skeptical that the company can achieve its 2008 forecast, which calls for a 5% to 10% rise in revenues and profits that will be flat to 6% higher. At $15, the stock (ARP) sells for 56% below what it fetched a year ago.

But chief executive K. "Suri" Suriyakumar insists the Walnut Creek, Cal.-based company will do just fine in a downturn by pressing its size advantage to win more national accounts. "We are the 800-pound gorilla in the industry," he says. "We are in a unique situation in which we can serve large customers who want to reduce their costs in a downturn."

American Reprographics has bought more than 120 rival firms since 1997. Thanks in part to its active acquisition program, operating profits have climbed an annualized 26% over the past ten years, and the company generates plenty of cash, even in downturns. Granted, a nonresidential construction slump could slow things down for a while. But at ten times analysts' expected 2008 earnings, American Reprographics shares look like a bargain.

Cheap appliance maker

When the economic going gets tough, chances are that consumers will purchase fewer hair dryers, curling irons, foot baths and other personal-care appliances. That's why the shares of Helen of Troy (HELE) have fallen deep into bargain territory, down 45% since the summer of 2007. At $16, they trade for ten times analysts' expected profits for the year ahead.

Helen of Troy sells a vast array of appliances, housewares, and grooming and hair products, under a variety of well-known brand names, including Sunbeam, Revlon, Vidal Sassoon, Dr. Scholl's and Brut. In the quarter that ended last November, sales in its personal-care segment, which excludes housewares, fell 6% from the year-earlier period -- a bad omen.

But the company, founded by chief executive Gerald Rubin (who still runs the business), showed during the 2001 recession that it can continue to generate profit growth even in a weak economy. Meanwhile, sales of kitchen gadgets and other housewares (about 25% of revenues) rose 19% in the November quarter and are expected to continue growing. The operating profit margin (profits from operations divided by sales) also rose as the company cut manufacturing and administrative costs and adjusted its product mix to emphasize more-profitable items.

The company, which is incorporated in Bermuda but bases its operations in El Paso, Tex., has more than $100 million in cash. Rubin recently told analysts that he expects that within a year, the company will have nearly enough cash to pay off its $215 million in outstanding debt. Either way, Helen of Troy should surprise the skeptics in the coming year.

Contributing Editor, Kiplinger's Personal Finance