A conservative model for judging the worth of undervalued stocks

As with dusty antiques, gems might be found among the discards


June 25, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.COM

If you're a fan of the PBS television program "Antiques Roadshow," odds are you know a thing or two about investing in undervalued stocks. On the show, viewers bring their family heirlooms and flea market finds to be appraised by an expert, who then reveals the item's value to its owner with the TV camera rolling.

Many trinkets aren't worth as much as their owners hope, but the experts always uncover at least one valuable item per show. As an investor hunting for value stocks, you're attempting to do the same thing as the "Roadshow" experts: Separate the unassuming gems from the fakes.

This is where Morningstar can help you with the valuation model we use to appraise the stocks in our database. Morningstar's valuation measure is very conservative - so conservative that most popular growth stocks are considered overpriced.

One word of warning: Stocks are usually cheap for a reason, so it's wise to find out what's prompting the market's skepticism about a particular company. If a company doesn't have solid financials, good growth prospects and a smart business plan, it's probably not a good long-term investment.

Promising companies that look cheap according to Morningstar's appraisal include Lear; Donaldson, Lufkin & Jenrette; and Washington Mutual.

Lear, the auto parts company, is the biggest bargain in the group according to Morningstar's appraisal. Our model says Lear shares are worth $53.98 per share, but the stock is trading for less than half that price. Investors have been concerned that Lear will lose out as more car companies bid for parts via the Internet, which may shave the part makers' profit margins down to nothing. Lear is also a cyclical company, meaning it might not fare well in an economic downturn. But Lear is the dominant interior car-parts supplier worldwide. And the company manufactures its products very efficiently, so it should be able to sustain some of the margin pressure from Internet bids and still continue to grow.

Lear is also diversifying internationally by establishing more contracts with foreign carmakers. This should help smooth out the company's earnings when the U.S. economy turns south. If a beaten-down securities stock is more your speed, consider Donaldson, Lufkin & Jenrette. Morningstar says this stock is worth $55.99, and it is currently trading around $39. The securities stocks as a group are up slightly year to date, but DLJ shares are down 11 percent over concern that a volatile stock market will lead to fewer profits from the company's stock-underwriting and merger-and-acquisition-advisory businesses.

Income from those areas indeed may decline, but the rest of the company looks healthy. DLJ's financial-transaction processing unit is adding to profit, and the company is expanding its investment-banking operations overseas as a way to geographically diversify its income stream. Investors who buy DLJ shares now should be prepared to hold them for the long term. This stock should prove to be a winner.

Finally, you may want to investigate Washington Mutual, the Seattle-based thrift. This stock has appreciated 16 percent year to date, but Morningstar gives it more room to run. Our model appraises Washington Mutual's shares at $40.74 each - about 42 percent higher than the stock's current price per share.

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