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Value investing is about spotting bargain stocks before others and riding the share price higher. If all goes to plan, buying in at bargain-basement levels should lead to handsome returns once conditions improve.

Central to the value investing philosophy is that no matter how dire, economic conditions generally improve over time.

The biggest hurdle for most is knowing when a stock is going cheap.

Researching the criteria used by history’s greatest proponents of value investing often leads to a dead end, as few stocks measure up to an exhaustive list of rigid value standards.

An alternative is to begin searching with basic criteria to uncover a list of hopefuls and then digging deeper.

Stock screeners are great for accomplishing this task. For this exercise we chose Return on Equity (EPS) and 5 Year EPS annual average growth.

The beloved P/E ratio can be a historical indicator of potential value based on past earnings, but a Forward P/E that includes forecasted future earnings provides a rough measure of both the past and the future. 

For that reason we used a P/E with forecasted earnings to 2013. 

Forward P/E’s under 10 and ROE’s above 15% with EPS growth at a minimum of 10% annually are benchmark minimums used by many value investors. 

Using those three criteria along with a minimum dividend yield of 2% here’s what we found:

Company

Code

Sector

Mkt Cap

Forward P/E (2013)

ROE

Dividend Yield

5 Yr EPS Growth

Iluka

Res.

ILU

Materials

$4b

6.2

47.7%

3.5% Tx Adjstd

20.3%

JB Hi Fi

JBH

Retailing

$998m

9.62

62.1%

6.2%

47.7%

Decmil Group

DCG

Cap Goods

$426m

6.71

23%

3.9%

43.3%

Grange Res.

GRR

Materials

$294m

8.5

28.5%

7.5% Tx Adjstd

64.8%

BC Iron

BCI

Materials

$290m

5.19

50.8%

5.4%

92%

While the ASX 200 Index XJO is up about 8% year over year, the XMJ materials index has been hit hard, down almost 11%. Iluka Resources (ILU) has suffered even more, declining close to 40%. Here’s the company’s one-year price chart:

Iluka is in the mineral sands exploration and production business with operations in Australia and the United States. The minerals extracted include zircon, titanium dioxide, and rutile. The company is the largest producer of zircon in the world with 33% market share and the second largest producer of titanium products.

Mineral sands go into a wide variety of products with zircon used in ceramics, nuclear fuel rods, jet engine castings and fuel cells. Titanium dioxide goes into industrial coatings and industrial applications needing titanium based metals. 

The company has suffered from dwindling demand for construction materials and falling prices for its commodities. In early October Iluka’s latest production report showed a 58% decline as the company cut production in the face of lower demand. Investors are concerned about the continuing drop in the price of Zircon and in response to the October report investment analysts cut target prices across the board. Macquarie was the only major firm to downgrade the stock, from OUTPERFORM to NEUTRAL. 

Iluka could be a classic “value trap” – a stock that looks cheap and then gets much, much cheaper. 

Company management claims market conditions have bottomed and four of the major firms kept BUY, OVERWEIGHT or OUTPERFORM ratings on Iluka based on its strong balance sheet and attractive assets. 

The company has low debt at $141 million with gearing at 9.7%. However, according to the Australian Mining Review, Iluka receives around 25% of its revenue from China – so much hinges on the outlook for China. One indicator in isolation is not definitive, but China’s Purchasing Managers’ Index (PMI) in October increased to 50.2 from 49.8 in September.

JB Hi Fi (JBH) also appears on our list. Based on fundamentals alone – its ROE, dividend yield, and 5-year average annual EPS growth – it’s difficult to reconcile the 21.1% short interest on the stock. The company has brand identification, a young and loyal customer base, and an expanding national network of stores. Finally, JBH features the latest and greatest “must have” gadgets. So what’s the problem?

The company’s business model is a low price leader and the high Australian dollar and increasing cut-throat global competition (especially from online rivals) is putting margins and future growth under pressure. While operating margins have dropped over the past five years, the Full Year 2012 margin of 6.2% is 0.02% lower than the 2008 value of 6.4%.

Major analysts are mixed but only Citi thinks margins and earnings will continue to decline for another 3 years, meriting a SELL recommendation. Interestingly, earnings per share increased from 2008 of $0.607 to $1.23 in 2011 before dropping to the current $1.059.  On 1 November UBS upgraded JBH to a BUY in the belief market trading conditions will improve and new product launches will help sales.

Finally, if you dig deeper and take a look at a valuation ratio favored by many strict value investors – the Price to Sales Ratio – JBH merits more than a casual look. The company’s trailing P/S is an enticing $0.32. This means for every dollar in sales JBH books, investors are paying a mere 32 cents. 

Some value investors emphasise P/S in their analysis since it’s not easy for a company to manipulate sales figures. Here is JB Hi Fi’s dismal year over year share price chart:

Decmil Group (DCG) serves “blue-chip” clients in the oil and gas, resources and infrastructure services sectors in Australia. Services offered include design, civil engineering and construction. The company is expanding from its traditional roots in Western Australia into Queensland and the Northern Territory. 

RBS Australia and Deutsche Bank have BUY ratings on Decmil. Both houses reckon the company’s expansion plans will increase recurring revenues; RBS reports that 74% of Decmil’s 2013 revenues are already booked.

Despite its current P/E of 9.63 and Forward P/E of 6.71, DCG has outperformed the ASX 200 XJO year over year. Here is the chart:

Decmil’s ROE of 23%, dividend yield of 3.9%, and five year EPS growth rate of 43.3% are not as impressive as other stocks listed in the table, but the P/S of 0.77 puts this company on the value investor’s watchlist.

If one stock in the table ticks all the boxes for contrarian investors, it’s Grange Resources (GRR). The company is a mining explorer and producer of the once glorious and now toxic commodity iron ore. BA Merrill Lynch rates the stock an UNDERPERFORM with High Risk; UBS, JP Morgan, and Macquarie have a NEUTRAL rating with target price reductions on 24 October 2012. The year over year movement in the stock price reflects the troubling environment for the materials sector in general and especially the pure play iron ore producers.  Here is the chart:

How could this company be anything other than a dog with fleas?  How about a Price to Book Ratio of 0.38?  The latest close for GRR was at $0.26 with a book value per share of $0.67. In effect, each share you buy is worth 2.5 times more than the price you are paying. To go along with that, the Price to Sales ratio is $0.75.

Grange is a vertically integrated, mining iron ore and manufacturing producer of magnetite iron ore pellets. The company has existing long life mining and production facilities at Savage River in Tasmania with expansion plans for additional facilities at Southdown in Western Australia. If you believe the price of iron ore will recover, this is one company to watch.

BC Iron (BCI) managed to escape the mining malaise and is up over 20% year over year.  As of 23 October Macquarie has an OUTPERFORM rating on the stock and BA-Merrill Lynch has a High Risk BUY recommendation. UBS maintained a NEUTRAL rating but raised its price target. 

All this is based on a modest recovery in the price or iron ore and potentially increased production from BC’s expansion plans. The company operates a mine in the Pilbara region of Western Australia, in a 50% partnership with Fortescue Metals (FMG). Here is the company’s surprising price chart, compared to the ASX Materials Index XMJ and to FMG:

These days the capital expenditures associated with mining expansion are of great concern but BCI has managed to operate with low debt of $11.02 million compared to $48.8 million cash on hand; gearing is a mere 2%. These numbers make the aforementioned Grange Resources even more attractive, since GRR has total debt of $39.6 million against $197.7 million cash on hand and 5% gearing.

 

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