6 Stock Ideas from Value Investing Pros

Occupy Wall Street descended upon New York City's Times Square the other day, and so did some hedge-fund managers with big followings. Kiplinger sat in on the semiannual Value Investing Conference, held the third week of October, in search of these investors' latest and greatest ideas. Here are five we judge most worth your consideration, plus a suggestion to avoid a normally popular class of stocks.

We offer these suggestions with the full awareness that you probably do not, and should not, invest your IRA or brokerage account as if it were a fast-trading, high-turnover hedge fund. Some hedge funds, it is true, are more patient, and that’s in line with our approach.

Kiplinger is also aware that hedge-fund operators are no more infallible than the long list of money managers who built spectacular records at mutual funds but lately have gotten it way wrong, their long-term investment returns regressing to less than those of an index fund.

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One of the suggestions below is a short position, which means you make money if the stock’s price falls but lose a fortune if the price soars. Not everyone is eligible to trade short, and not everyone has the iron guts it requires.

Hedge-fund managers are not unbiased. They usually own more of a company than any regular mutual fund does. For example, William Ackman’s Pershing Capital fund has a 15% stake in Fortune Brands Home & Security, which he strongly recommended -- or, to be candid, promoted -- to this crowd of active investors. Still, the fact that these high-profile managers were willing to explain in deep detail why they chose some of their current favorite investments should be of interest if you have cash awaiting fresh action. Share prices for the stocks described below are as of the October 22 close.

Buy Fortune Brands Home & Security (symbol FBHS, $14.95)

The manager: William Ackman,

founder and CEO of hedge fund Pershing Square Capital Management.

We’re hearing a lot these days about spinoffs. Companies with diversified businesses are breaking up, reasoning that the separate parts will be worth more to shareholders than the unwieldy whole. Fortune Brands Home & Security owns leading brands in plumbing, kitchen and bath accessories, and windows. It also makes the ubiquitous Master padlocks you see at the gym. The former Fortune Brands split into this company and the Jim Beam liquor business in early October. Shares of FB Home & Security are up significantly since they first began trading in September on a “when-issued” basis (Beam Inc. trades under the symbol BEAM).

Ackman’s enthusiasm for the Home & Security shares rests on what he sees as dramatic earnings potential if the housing market even partially recovers before five years. Specifically, he predicted that operating earnings could then double or triple as builders and contractors order more cabinets, windows and doors. Ackman says the company would be worth $18 to $27 per share. And if the housing market continues to languish, Ackman would still have you hold on because the balance sheet is strong enough for investors to be patient.

Buy Dentsply International (XRAY, $34.11)

The manager: Tim Hartch.

Among his duties, Hartch is co-manager of Brown Brothers Harriman’s BBH Core Select Fund (BBTEX (opens in new tab)), a Kiplinger 25 mutual fund selection.

Dentsply manufactures and distributes dentistry supplies to dentists all over the world. Dentsply is so big that dentists don’t have that many other places to stock up. So it has an extremely loyal customer base, which usually spells solid sales growth. Dentsply was a tremendous growth stock from the 1970s until the past few years, but business has slowed with the recession and high unemployment, which has fewer people springing for expensive “restorative,” or cosmetic, procedures. But the recent acquisition of AstraZeneca's dental implants and devices business has analysts and investors figuring that Dentsply will be a high-growth company again. The question is when.

Hartch thinks the stock is worth $44, based on his calculations of its assets and earnings potential, though there’s no specific time frame. He also thinks Dentsply is a takeover target.

Buy CME Group (CME, $264.49)

The manager: Ricky Sandler,

founder and senior portfolio manager of Eminence Capital, a hedge fund.

CME is the biggest owner and operator of derivatives and futures exchanges and stands to benefit from stricter oversight of these instruments. Regulators want to move derivatives onto exchanges to create greater price transparency. That’s where CME comes in, because 83% of its revenue comes from the fees associated with trading and clearing these accounts. The exchange also prospers from volatility in the financial markets because that leads to more hedging of everything from commodity prices to interest rates. CME, which stands for its best-known operation, the Chicago Mercantile Exchange, is also buying stakes in exchanges around the globe, from Brazil to Korea, and owns the Nymex and the Comex. Additionally, CME is launching new options on U.S. Treasuries and emerging-markets currencies.

Buy Transocean (RIG, $54.43)

The manager: Leon Cooperman,

founder of hedge fund Omega Advisors.

At the conference, Cooperman said he wouldn’t be “caught dead” holding U.S. Treasury bonds, that stocks are the most attractive asset category, and that he likes Apple, KKR Financial, E*Trade, Boston Scientific and Qualcomm. But the most intriguing stock, and one that Kiplinger’s also recently highlighted, is Transocean, a provider of oil-and-gas drilling rigs. Here’s the drill: Transocean is still dealing with equipment-maintenance issues following the 2010 BP oil spill in the Gulf of Mexico and faces possible legal liabilities. The cost of this is unknown. What is known is that deep-water drilling rigs are in short supply, contract rates to lease them are rising and Transocean has the largest fleet. The shares are down almost 50% in a year and a half (essentially, since the Gulf disaster) and have a bloated dividend yield of 5.8%. So value investors such as Cooperman have gotten over the Gulf disastaer and are looking at the long-term prospects of Transocean’s core business.

Sell short the shares of Green Mountain Coffee Roasters (GMCR, $67.85)

The manager: David Einhorn,

founder and president of Greenlight Capital, a hedge fund known for betting that companies’ shares are overpriced.

Leave it to David Einhorn to cause a stir on Wall Street by selling short (betting against) one of its favorites. He shorted the defunct Lehman Brothers when Lehman traded at $70 a share. Now he’s negative on Green Mountain Coffee, which makes Keurig single-cup coffee machines. Einhorn’s most logical reason is that after a stock like this one rises more than 1,000% in four years, you need to question whether the underlying growth is slowing. Einhorn argued that the best days are behind Green Mountain because there’s not much left of this market to capture.

Moreover, he contended that the company’s financial statements aren’t transparent, that capital spending is growing faster than the business and that the management is being vague about where this money is going. There’s also brewing competition as its key patents expire in 2012. Even if Green Mountain extends the patents, Einhorn said he thinks competitors will find a way around that and muscle in on the single-cup craze. In sum, Einhorn thinks Green Mountain’s earnings per share are headed sharply downward and will not support the stock’s lofty price and price-earnings ratio.

Avoid integrated oil-and-gas companies, such as ExxonMobil (XOM, $80.13)

The manager: Jim Chanos,

president and founder of Kynikos Associates, the largest hedge fund devoted exclusively to short selling.

It’s not every day you hear that ExxonMobil is a “value trap,” an epithet for a stock that looks cheap but is a dud because it’s “cheap for good reasons.” It’s curiouser still to hear this said about a stock with a modest five-year annualized total return of 4.9% and a history of regular dividend increases. But Chanos is looking forward, not backward. His theme is that production and development costs for all integrated oil-and-gas companies (Exxon, BP, Shell and others that explore, produce and refine) are rising as oil becomes harder to find and recover. He predicts that industry production costs will triple per barrel of oil and slash the industry’s profit margins -- and the stock market is notoriously fickle about industries that settle for less profit, even if it’s still in the billions. Keep this in mind when you’re investing in energy stocks.

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