TechnoMeter

2 Stocks That Have Fallen To Very Attractive Levels

An interview with Mike McGarr, CFA, Portfolio Manager and Equity Research Analyst, Becker Capital Management

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Mike McGarr: Becker Capital Management was founded in 1976. We are a long-only, value-oriented investor. We currently manage about $3.1 billion of total assets, and our Becker Value Equity Fund currently has about $315 million in assets under management.

Our portfolios typically hold between 55 and 65 stocks, and we generally experience relatively low turnover. It’s a very team-oriented process here. We look for companies with basic characteristics like being out of favor as measured by recent underperformance, low valuation, and Wall Street sentiment.

We look for companies that you would consider to be somewhat better than average, and by that I mean we’re not looking for companies with compromised balance sheets. We prefer not to add financial leverage on top of operating leverage. And we like companies that have a reasonably good record of earnings over the years.

We’re not turnaround specialists or deep-value contrarians. Those are specialties that we leave to other people. What we look for are companies where we can develop some conviction that they are out of favor for what you’d call “transitory reasons”, whether it’s related to the economy or a product cycle or some other temporary issue, companies where we believe that a fundamental change for the positive is ahead.

To that end, we like to see fundamentals that are at least stabilizing and preferably starting to improve. And we like a management that can articulate a roadmap to improved fundamentals. That helps us develop our conviction while giving us something to benchmark the company against once we’ve taken a position in the stock.

We’re going to look at all of the traditional sorts of valuation metrics that you’d expect of a value manager: price-to-earnings, price-to-sales, and enterprise value-to-EBITDA. We pay particular attention to return on invested capital and the ability of a company to generate a positive spread to their estimated cost of capital. That tells us that a company is efficient with its capital, and that management is actually generating shareholder value and not destroying value.

Beyond that, we look for companies that are smart with their capital deployment. Whether its dividend increases, share repurchases, smart acquisitions, investing for organic growth or debt pay-down; we just want to make sure that it makes sense for shareholders.

Forbes: And they’re out of favor at the moment, so they’re at prices that you think are attractive?

McGarr: Yes.

Forbes: Can you get into some of the specific names that you like at the moment?

McGarr: Two that are relatively recent purchases. The first one is the general merchandise retailer Bed Bath & Beyond (NASDAQ: BBBY).

The shares are currently trading at about $60. In our view, it’s one of the better general merchandise retailers in the country. They have some 1,500 stores with very good geographic diversification.

They carry a good assortment of what you’d characterize as better-quality merchandise at attractive pricing. And over the years they’ve proven to be pretty popular with shoppers. The stock got ahead of itself in 2013 such that coming into 2014 it looked like expectations were too high. When they, like a number of other retailers, ran into some tough conditions — especially with weather in the first quarter of this year — the shares came down pretty hard.

Even though the numbers weren’t bad the guidance was a little disappointing, and so the shares fell from $80 down to the high $60’s. And that’s where we started to initiate a position. They have since fallen a bit further to about the $60 level, and it looks to us to be a pretty attractive holding.

They have operating margins in the low teens, maybe 13% to 14%; we have a conservative estimate of about 13% return on invested capital. They should do perhaps $5 for calendar ’14 and maybe $5.30 to $5.40 in calendar ’15. So, you’re looking at a 12 multiple on ’14 earnings and maybe 11 times calendar ’15, and that looks pretty attractive to us in a market that’s generally on the expensive side. They should have free cash flow this year approaching a billion dollars, and they have no debt. That gives them a lot of flexibility in terms of further merchandising, store expansion, and share repurchases. So, we like it.

Forbes: Let me ask you a quick question.

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