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Good stock ideas exist even in ugly market

Some guidelines for identifying the strongest buying opportunities for equity investors

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By Robert Schwarzkopf

April 5, 2009 6:01 am ET

How does one take advantage of the stock market's weakness in a way that adds value to your clients' portfolios?

One sure way is to identify portfolio managers who have built successful track records as "baby blue-chip" investors, focused on companies with protectable businesses, backed by superior balance sheets, high-profit-margin income statements and exceptional free cash flow. The goal is to identify high-quality companies that are growing faster than their markets.

Amid this recession, we are finding opportunities in quality companies within sectors that have been hardest hit, including energy, transportation and capital goods. These sectors generally are cyclical and capital-intensive.

We have identified companies in these hard-hit sectors whose stocks have declined in sympathy with the performance of their sectors, but whose businesses remain relatively unaffected.

We expect economic recovery from the recession to be longer in coming and to be more shallow than in the past. We are convinced that consumer credit, which quintupled to 100% of gross domestic product, from 20%, over the past two generations as lending standards were loosened will not again quintuple to 500% of GDP.

That means credit will be less available and more expensive on a long-term basis, and that leads us to invest in self-financing businesses that aren't captive to credit markets.

As examples of companies that are likely to prosper during the economic downturn and the expected prolonged recovery, we have identified three exceptional businesses, one in each of the above sectors, with high returns and less balance sheet and earnings risk.

Energy: Carbo Ceramics Inc. (CRR)

Carbo Ceramics is the world's leading producer of ceramic proppants, which are tiny, high-strength pellets that help increase the production rates of natural gas and oil wells.

Generating around $1.60 in sales for every dollar in property, plant and equipment, the company is much less capital-intensive than the oil and gas producers it serves, which average roughly 40 cents in sales for every dollar invested in property, plant and equipment.

This allows Carbo of Houston to generate high operating profit margins of 20% and strong free cash flow. Moreover, it has a debt-free balance sheet in an industry that is dependent on credit for financing.

High oil and gas depletion rates are forcing deeper drilling. Because sand, which is used as a propellant in shallow wells, crushes in deeper wells, the business for Carbo is growing.

Transportation: Landstar System Inc. (LSTR)

Landstar is a leading non-asset-based transportation company that serves shippers in the United States, Canada and Mexico.

These services are delivered through a network of independent sales agents and independent truckers working through Lanstar's communication, scheduling and billing platform.

For owner-operators of trucks, Landstar of Jacksonville, Fla., provides access to Fortune 500 shippers that the trucker couldn't gain access to on his or her own, as well as to revenue-generating freight for the trip home. It provides an outsourced logistics network without a capital infusion from the shipper.

Return on equity is 51%, though it bottomed at 35% in 2003 during the last recession. The stock is trading at 14 times trailing earnings, and the balance sheet is strong, with virtually no net debt.

Capital goods: Donaldson Co. Inc. (DCI)

Donaldson is a leading worldwide manufacturer of filtration systems and replacement filters used to clean and filter air and liquids. 

In an uncertain economic environment, having a business that relies on replacement filters helps to create a consistent cash flow and durable earnings stream in a cyclical sector for the company. 

Over time, Donaldson of Minneapolis has used its technological edge in research and development to create patented products that ensure proprietary replacement for its filters, much like the razor and blade business model. 

The company uses its free cash flow for technology acquisitions and share repurchases, and has a history of increased dividends. 

Since 1990, it has generated a return on investment in excess of its 15% target, while using an underleveraged balance sheet even during the last recession. 

Robert Schwarzkopf is the chief investment officer and portfolio manager at Kayne Anderson Rudnick Investment Management LLC of Los Angeles.

For archived columns, go to investmentnews.com/investmentstrategies.

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