Deep Value Stocks in Basic Materials (AA, ACI, DOW, DVN, NUE, STLD, BRK-A)

The markets are currently shaky and investors are looking for cover.  While many seek defensive stocks and while many seek high dividends to offer equity exposure with some safety, one area that always attracts certain investors is a targeted value stock from sector to sector.  The basic materials sector is generally very cyclical, so this is when individual picks actually matter in times of uncertainty.  We did run analysis on the sector to look for companies which stand out from their peers when it comes to price-to-book value: Alcoa, Inc. (NYSE: AA); Arch Coal, Inc. (NYSE: ACI); The Dow Chemical Company (NYSE: DOW); Devon Energy Corporation (NYSE: DVN); Nucor Corporation (NYSE: NUE); and, Steel Dynamics Inc (NASDAQ: STLD).

While most “book value” companies are trading at discounts for a reason, we only focused on the basic materials players which may actually grow through these uncertain times.  Each company offers an implied earnings growth scenario.  For next year, analysts expect healthy earnings growth ranging from Alcoa’s 14% to Arch Coal’s 56%.  We also only took companies that have lower price-to-earnings ratios ahead as well to filter out the companies in trouble.  Average trading volume for each of these companies exceeds one million shares daily.

We would also note that each of these shares is currently lower than the prior day’s close due to the global selling that has been seen.  That changes things only marginally, and value investors may get to see yet even more value as a result.  Except where otherwise noted, the source for all performance and financial data is Finviz.com.

Alcoa, Inc. (NYSE: AA) boasts a price to book value of roughly 1.1, clearly best among this list of companies.  Its market cap is $16.4 billion.  Its forward P/E is 9.6.  Analysts look for next year’s earnings to top current year net by 14%. With a Thomson Reuters consensus target price of $19.95 per share, Alcoa has an implied upside of close to 30%.  In trading Wednesday, Alcoa’s shares closed at $15.29, down 0.52%.  The 52-week trading range is $9.73 to $18.44.

Here is what investors need to consider about Alcoa.  Investors always try to use this company as the first read each earnings season to make a determination about companies in general but they also use it to analyze the entire metals sector.  Alcoa has telegraphed growth and recovery ahead, even if it has a spotty record around earnings.  Alcoa has also been called a takeover target by some investment watchers. Alcoa peaked around $45.00 back in 2007 before the recession.

Arch Coal, Inc. (NYSE: ACI) is tricky because it recently closed upon its acquisition of International Coal.  That throws a wrench in the machine, but we still wanted to show what the core company value is.  Arch sports a price to book ratio of roughly 1.9 and its market cap is $5.5 billion.  Its forward PE is less than 7, ranking it the best in this list of companies.  Analysts expect next year’s earnings to exceed current year earnings by more than 55%, the best expected earnings expansion among these six companies. Again, keep in mind that analysts often are extremely late to the party when it comes to interpolating other earnings into a merger mix.

With a Thomson Reuters consensus target price of $39.76, Arch Coal has an implied upside of more than 50%.  In Wednesday trading, Arch Coal’s shares closed at $25.84, down 0.69%. The 52-week price range is $18.81 to $36.86.  The merger will undoubtedly change the values and the outlook ahead and it is possible that the value here may change since the aggregate value of the merger was about $3.4 billion.  We still wanted to show this as the cheap buyer.

The Dow Chemical Company (NYSE: DOW) is probably more of an industrial player than a basic materials player, and it is certainly a cyclical stock that wins with good economies and suffers in bad economies.  The company’s price to book value is less than 1.9 to 1. Dow’s market cap is a massive $42 billion, the largest among these companies. Its forward PE is roughly 10.  With a consensus target price of $46.95 from Thomson Reuters, Dow has an implied upside of more than 25%.  In trading Wednesday, Dow’s shares closed at $35.98, down 0.28%.  The 52-week trading range is $22.11 to $42.23.

Dow was hit hard in the recession and it had to get a costly investment from Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK-A).  This may have actually turned out to be one of Buffett’s best-timed deals ever. Dow was a $45 stock before the recession, but things got so bad that shares fell all the way to under $10 at the selling peak in 2009.  Another black eye there is that Dow has not yet raised its dividend back close to before as its payout per quarter is $0.15 rather than $0.42 from before the recession.

Devon Energy Corporation (NYSE: DVN) was one of the first large oil and gas mergers of the last decade and it can be more volatile than many of the other oil and gas shares.  Its price to book value less than 1.8 to 1 and it has a market cap of just under $33 billion.  Its forward PE is less than 10, which sounds dirt cheap but is not extremely unusual for energy companies.  With a consensus target price of $101.56 from Thomson Reuters, Devon has an implied upside of about 30%.  In Wednesday trading, the shares of Devon Energy closed at $78.09, down 0.17%.  The 52-week price range is $58.56 to $ 93.36.  Why is there only one true oil and gas company in this screen?  It is because that sector is so large that we will be covering that in a different screen.

Nucor Corporation (NYSE: NUE) is on the steel side of the equation, obviously making it cyclical.  As building of structures and capital goods rises, its orders rise.  As those slow, its business slows.  The stock shows a price to book value less than 1.8 to 1. Nucor’s market cap is almost $13 billion and its forward PE is about 10.5.  Analysts expect next year’s earnings to exceed current year earnings by more than 40%, near the best expected earnings growth among these six companies.  Obviously this is a “trust” factor that investors have to assume and those estimates now seem a bit rosy considering the economic downgrades that are coming out.  With a consensus target price of $51.14 per share from Thomson Reuters, Nucor has an implied upside of more than 25%.  Nucor’s shares recently closed at $40.29, down 0.07%.  The 52-week trading range is $34.80 to $48.86.

Steel Dynamics Inc (NASDAQ: STLD) posts a price to book value of roughly 1.6 to 1, making it cheap in the steel sector.  It is also known for being a steel recycler as well.  The company’s market cap is $3.4 billion and that is smaller than many of its peers.  Its forward PE is slightly greater than 7, ranking it second best among this list of companies.  There is a reason and that is because of a volatile share price history.

There is a conundrum here in Steel Dynamics because the growth of earnings this year is expected to be more than 100% and the growth into 2012 is expected to be about 30% in earnings.  Are those attainable?  With a consensus target price of $21.94 from Thomson Reuters, Steel Dynamics has an implied upside exceeding 40%.  Shares recently closed at $15.80, and the 52-week price range is $12.70 to $20.59.  The recession was brutal on this company as it peaked around $40 in 2008 and it crashed to under $6.00 very briefly at the peak of selling in 2008 and again in 2009.  Some have considered this a possible M&A candidate.

Looking for value can be very tricky.  Earnings can be missed, earnings can drop, cash reserves can be chewed up. Analysts often change their targets, earnings estimates, and even their overall bias.  The idea is to pick individual issues that already reflect much of the uncertainty in the markets.  Our take is currently that the markets are actually not able to price in forward events.  George Soros has noted, “Contrary to the tenets of market fundamentalism, financial markets do not tend toward equilibrium; they are crisis prone.”

Warren Buffett was quoted back in the 1990s saying, “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”  We don’t go along with the Buffett model of forever any longer, but you get the idea.

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JON C. OGG & JIM BERDOU