Volatile & Cheap: 2 To Buy, 1 To Avoid

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Financial theory argues that the highest beta, or riskiest assets, generate the highest return in the long-run. While this makes sense for a basket of companies, investors should be careful to not get in over their heads and back businesses that have nowhere to go but down. Below, I review 3 companies that were screened for a beta of 2 or greater and a PE multiple of 10x or lower. These companies range from a business with excellent momentum and potential to a business that is on the decline.

Ford Motors (NYSE: F): Still Going Strong

Ford may have a beta of 2.3, but it doesn't merit trading at only a respective 2.6x and 7.7x past and forward earnings--certainly not after weathering the worst of the automobile collapse without a helping hand from the government. Analysts forecast 5.3% annual EPS growth over the next 5 years, and 13 of 19 are calling the stock a "buy" or better. With a 12.7% return on invested capital--37 bps greater than the industry average--and substantial free cash flow generation, risk is more limited than what the market would suggest. $4.4 billion in free cash flow was generated over the TTM, and it is now yielding an impressive 10.4%.

There are several reasons to be optimistic about Ford over the next 12 months. Bank of America recently listed the company amongst its favorite picks in the S&P 500 for the year 2013. And with a new right-to-work law planned for Michigan, Ford will have more leverage over labor and, analysts argue, drive greater productivity from an improved ability to promote employees. Although the law won't come into effect immediately, it is a shift towards greater management support and would make Michigan 24th in a growing number of states to implement the law. In addition to an improving business environment, the company is also innovating. Just this Wednesday, it announced a plan to put $135 million into the development of 5 new electric vehicles. Its new Transit van will also come out with a second turbocharged diesel engine in North America.

Further, the territorial strife between China and Japan is providing a tailwind for Ford, which is seen as a neutral third-party. In November, it sold a record 67.5 thousand vehicles in China, which is a gain of 56% y-o-y. It is just the kind of innovation mentioned above--particularly, Ford Focus--that has driven such fantastic returns. I do not believe multiples can stay this low, and I encourage buying to take advantage of market corrections.

Huntsman (NYSE: HUN): Takeover Target

The chemical product has been cited several times as a takeover target. PE and other chemical producers are rumored to be circling the $3.9 billion company, and this speculation has driven up the stock price by 80%. With a beta of 2.3, the stock looks incredibly risky even despite a 7.7x PE multiple after such a run. EPS is expected to erode nearly 10% next year and is coming off of a 5.1% annual EPS decline rate over the past 5 years. Now that the stock is near its $17.78 price target, upside appears limited.

I also believe the 4.8% positive reaction from third quarter profits was also overdone. Though Huntsman was successful in boosting prices on polyurethane to expand margins, revenue of $2.74 billion still missed expectations by $160 million and represented an 8% y-o-y decline. Europe and Asia have increased demand for composite wood products and adhesives, but takeover suitors don't have the margin of safety that they once did. Particularly, if you are a PE firm that will be holding the company for a few years in the private market, you don't want to buy at an overblown peak when the underlying fundamentals are so volatile. Huntsman also missed top-line expectations by $100 million in the second quarter with revenue of $2.9 billion. But investors are nevertheless focused on the improving momentum coming from rising foam insulation demand. To target this improving environment, Huntsman is looking to expand its Geismar plant, which produces a chemical compound for this market, and will exploit cheap natural gas supplies.

Cliffs Natural Resources (NYSE: CLF): Risky

Cliffs is another very risky stock. It is a producer of iron ore and met coal and trades at 5x past and has a beta of 2.4. Analysts forecast EPS growing by only a rate of 0.6% over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $3.09. At a multiple of 15x, this translates to a future stock value of $46.35. This provides a 16.4% annual average return. It is nevertheless an extremely risky investment to make in light of RBC Capital Markets downgrading the stock from $45 to $32 and UBS downgrading from $58 to $35.

Growth at Bloom Lake has died down with management postponing and even downscaling operations. In Northshore Mining, two of production lines will be idled, and the Empire Mine will be temporarily idled. Cliffs suffers from higher operational costs and greater market volatility than peers. Lower Canadian volume will also come with higher costs. A likely cut in the "unsustainable" dividend has, moreover, not had enough of a reaction on the market price. Recent reports of a delay in the repair of a coal terminal in British Columbia still has the market nevertheless focused on expanding margins. A series of revenue misses and declining emerging market production later, a negative market correction is in order.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Ford. Motley Fool newsletter services recommend Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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