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Stock Strategist

Five Consistent Value Creators for a Buck or Less!

In times of uncertainty, a solid book value can be a storm anchor.

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Before anyone gets too excited--no, we are not pitching penny stocks on Morningstar. But we will pitch something much more boring, but infinitely more profitable: book values.

For many traditional value investors, a firm's book value is the penultimate indicator of its true worth--as book value can be defined as the share of the company's assets belonging to shareholders. Thus, buying a company for less than book value can literally mean buying dollars for cents. Legions of investors have profited over decades by buying stocks with low price/book ratios--an ample body of research shows that these stocks tend to outperform over the long run.

It sounds simple, but to many, "book value" is a hazy concept--something that you'd find in your local  Barnes & Noble (BKS) rather than in your 401(k). So, we'll do our best to outline it for the average Joe. Conceptually, think of it as the total amount of money invested in a company by its shareholders, plus the profits that have been reinvested over time. Generally, if a company makes money and reinvests all the profits into its business and pays no dividends, the book value should increase by the amount of the profit. So, of course, the more profitable the business, the faster book value increases every year.

However, we think looking at solely price/book values isn't ideal; many companies deserve to trade at low ratios because they are mediocre businesses. So, we think it's helpful to add a second metric: the rate that book value accumulates through time. A solid, defensible business should be able to reinvest in itself at solid rates of return--the definition of having an economic moat. For example,  Google (GOOG) increased its book value by around 33% in 2007. So logically, if an investor can buy Google for its book value, he should realize a 33% return in one year, assuming the stock remains at the same multiple. However, these types of superb businesses usually trade for multiples of their book values.

Fortunately for investors, the operative word is "usually." When the markets are in complete disarray, as they are today, businesses with solid records of value creation can be had for less than their book values. To uncover these businesses, we've created a screen using the following criteria:

  1. Annual equity growth over the last three years greater than 10%
  2. Morningstar Rating of 5 stars
  3. Price/current book value of less than 1
  4. Morningstar moat rating of at least narrow
  5. The company does not belong to the industry groups "Finance" or "Bank"

Some of these criteria are self explanatory. We think it's smart to focus on companies with durable competitive advantages, as their track record of value creation is less likely to be a fluke or a cyclical trend. Furthermore, we've excluded financial companies (and as a result we've also excluded insurers), as these companies often employ copious leverage, which makes book value less relevant, and their earnings are highly dependent on subjective assumptions made by management.

Here, astute readers will note that we are not screening for tangible equity. Wouldn't hard, physical assets be more desirable than ephemeral concepts such as goodwill, especially given the massive write-offs companies have to do when they are in distress? Case in point,  Wachovia (WB) announced a mammoth $19 billion write-off on Oct 22. However, for solid, well-managed businesses, this becomes much less of an issue. Foolish management can just as easily overpay for tangible assets rather than goodwill, and accounting for these things is partly subject to management's discretion. So, the important thing to look for is the durability of the company's business franchise, not whether one can touch its assets.

Below, we'll highlight several interesting prospects our screen produced:

Mohawk Industries
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
From the Analyst Report: " Mohawk Industries (MHK) has steadily become a commanding force in the $25 billion floor covering market. The breadth and depth of the company's distribution system remain unrivaled by its peers and will allow Mohawk to continue to bolster its share in the market, in our opinion."

Eaton
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
From the Analyst Report: " Eaton's (ETN) drive to create a better balance of revenues and a more flexible cost structure paid off in spades during 2007... While the recent macroeconomic trends have started to paint a foreboding outlook for the overall economy, we believe Eaton's diversification and cost-cutting efforts will help it weather yet another storm with a similar degree of success."

Cimarex Energy
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
From the Analyst Report: " Cimarex Energy (XEC) is different from many of the other exploration and production companies we cover. Its focus on returns on invested capital, instead of quickly boosting reserves--like many other firms--is a refreshing change."

Molson Coors
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
From the Analyst Report: " Molson Coors (TAP) operates in markets with minimal growth opportunities, but its significant cost-cutting initiatives have boosted profitability and expanded margins in recent years. With an attractive duopoly position in Canada and a compelling joint venture with SABMiller (SBMRY) in the United States, Molson Coors should extract further value from its operations, in our opinion, while becoming a much stronger player in the United States."

Guangshen Railway
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
From the Analyst Report: "We think  Guangshen Railway (GSH), or GR, can enjoy economic profits and steady revenue growth, given its dominant market position in the Pearl River Delta of south China... Owning the only railway connecting mainland China and Hong Kong, GR's railway network covers the Pearl River Delta, the economic hub in south China, offering a strong environment for steady growth. Further, we think it is highly unlikely that the Chinese government will allow another railroad to be built and compete with GR."

To run this screen and see all the stocks that passed,  click here. Note: The stocks mentioned above passed our screen as of Oct. 22, 2008. The results of the screen may change because of daily price fluctuations or other factors. After clicking, you can save the search to use later by clicking the Save Criteria button in the bottom right-hand corner of the screen. (You will need to be logged in as a Premium Member to view and save the complete screen.)

Michael Tian has a position in the following securities mentioned above: XEC. Find out about Morningstar’s editorial policies.