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Finding cheap stocks is all but impossible. Of course, that’s not uncommon when markets continue notching all-time highs. Unfortunately, overpriced markets pose significant risks for investors looking to deploy additional capital.
But that doesn’t mean there aren’t any stocks trading at relatively attractive valuations. And that’s an important concept to keep in mind in this long-in-the-tooth bull market where most stocks are overvalued based on traditional metrics.
That’s why the search for value is the single most important principle to employ right now. Simply put, should the market fall off the cliff, as many pundits expect, stocks bought at a discount to their intrinsic value fare much better than other stocks trading at higher valuations.
These so-called value stocks are often stocks that have fallen out of favor with the market — for any number of reasons. But oftentimes, the reasons a stock is trading below intrinsic value are transitory in nature, such as a bad quarter or two.
But value investors are investors with long time horizons. It’s expected that a company will occasionally have a bad quarter every now and again — even Apple (Nasdaq: AAPL) does from time to time. But no sane long-term investor would ditch Apple because the company performed poorly in the short term, or at least they shouldn’t.
You see, value stocks eventually prove the market wrong. And once that happens, the stock shoots significantly higher as more money runs to the mispriced stock. And it’s this process that has made Warren Buffet billions in profits. Better still, it will work for you, too.
But that begs the question…
Are there any undervalued stocks left? The answer is easy. Of course there are.
For example, Eastman Chemical Company (NYSE: EMN) is currently trading at an attractive valuation.
The Last Real “Value Stock” In The Market?
Eastman Chemical is an international materials and specialty additives company that produces a wide range of products found in everyday items. The company is based in Kingsport, TN, and has a market cap of $13.4 billion. Eastman employs about 14,000 workers globally and divides its business into four revenue segments: additive products, advanced materials, chemical intermediaries, and fibers.
As you can see from the chart above, the stock is up roughly 23% year-to-date, yet trades at a trailing price-to-earnings (P/E) ratio of just 13.5 — a nearly 20% discount to its average P/E ratio of 16.8 since 2009. This implies there’s more room for this stock to run.
But let’s look deeper. The earnings yield of the stock is 7.4 (calculated by dividing 1 by the P/E ratio). Using a method common to value investors, adding the growth rate of the stock to the earnings yield gives credible evidence of whether the stock is trading at, above, or below fair value.
In the case of Eastman Chemical, the sum of the earnings yield, 7.4, plus an expected 2018 growth rate of 15.7%, is 23.1. Comparing this number to the stock’s price to earnings ratio (13.5) indicates Eastman Chemical is significantly undervalued and therefore a strong buy.
But we can go even deeper.
Applying the Benjamin Graham Formula, created by the investing legend of the same name, to Eastman Chemical, the stock’s intrinsic value is $339.28 — a 265% premium to today’s price. But let’s get conservative with the Graham Formula. Instead of using next year’s growth rate, let’s use the previous five-year average growth rate of 4.89% – a 69% discount to next year’s expected growth rate.
Under this very conservative approach, the stock’s fair value is $155.44. That still represents a 67% premium to its current price. And remember, that’s using an unrealistically low growth rate. A more likely growth rate is closer to analysts’ expectations of 8.8%. This gives us a middle price range for the stock of $222. In other words, EMN is currently trading at less than half of its intrinsic value. And that’s about where Buffett’s mentor, Ben Graham, liked to buy stocks.
From a financial point of view, EMN is a solid “buy.” In the third quarter of 2017, EMN grew its operating income by 9.5% to $460 million. The company’s net income from continuing operations grew by 10.6% to $323 million. Best of all, EMN did this while returning $100 million to shareholders through share repurchases. Another $223 million was paid in dividends.
And speaking of dividends, the company announced a $0.56 per share dividend payable to shareholders of record on December 18, 2017. This is a 10% increase from the previous dividend, and the eighth year in a row the company has increased it. Adding the just-announced dividend to the mix, the stock now pays a dividend yield of a little under 3%.
So, by just about any measure, EMN is a strongly performing company. Yet, for reasons only Mr. Market fully understands, the stock is solidly out-of-favor and looks to be a solid buy. Get in before other investors realize their mistake and start bidding the price up.
Risks To Consider: While it may appear EMN is undervalued by most financial metrics, it’s important to remember that companies often deserve their low valuations. It’s also important to remember that undervalued companies sometimes take years to shake off the doldrums and rise to their potential. While nothing indicates EMN is one of these companies, caution is warranted.
Action To Take: Buy shares of EMN up to $98 per share. Mitigate risk by allocating no more than 3% of your portfolio to Eastman Chemical. Use a hard stop of $82.50 to protect your principal. Eastman Chemical is best for investors with a time horizon in excess of 3 years.