3 Deep Value Stocks With Major Upside
August 25, 2010By: David StermanArticles RSS feedPrintPrint

One of the realities of a tough market is that fully-priced stocks get discounted, and under-priced stocks become really, really cheap. You can forget about the notion that stocks always deserve to trade at whatever price they currently have -- known as the Efficient-Market Hypothesis. Often times, the market is mistaken and stocks can fall well below any appropriate value

Facing another day of red ticker symbols, I went looking for some stocks that appear to be trading well below any sort of logical level. When the market stabilizes and logic returns, it's these oversold names that are often some of the strongest rebounders. It happened in 2002 and again in 2008, when many stocks traded below book value or for not much more than the cash on their balance sheet

. Increasingly, the summer of 2010 is feeling like one of those blue market periods. So let's look at some of these ultra-cheap stocks.

Cogent (Nasdaq: COGT)
This company is a leader in the field of rapid automated fingerprint ID systems, the kind in use at airports and border crossings around the world. If a bad guy is crossing a border somewhere in South America but is wanted in France, these ID systems will flag him right away. That's no mean feat when you consider the number of fingerprints in the massive global databases. Cogent's technology can scan millions of images in a matter of seconds and invariably yield accurate results.

It was a good business for Cogent -- until it wasn't. Sales exploded from $16 million in 2002 to more than $150 million by 2005, thanks to beefed up spending on Homeland Security. Sales stopped growing at that point, though they have been above $100 million ever since. But investors' hopes for a resumption of strong growth have been continually dashed.

If there has been a silver lining, it's that this software-intensive business is remarkably profitable. Cogent routinely generates net profit margins in excess of 25%, and that has boosted cash and investments above $500 million. Cash has risen even as shares have fallen to near all-time lows. The entire company is worth just $775 million, or only $275 million when all that cash is excluded.

Cogent's recent share price weakness is partially the result of missed second quarter earnings estimates. Revenue recognition rules sometimes lead to expenses hitting the income statement before revenue, which is what happened in the most recent quarter. That should reverse in coming quarters. And management insists that new orders have been pouring in with customers such as the Department of Homeland Security, the U.K. Post Office, Los Angeles County, the Pennsylvania Census Bureau and Northrop Grumman (NYSE: NOC). Cogent is also trying to secure potentially big contracts in India, South Africa and Algeria.

Based on recent customer wins, results in the next few quarters should be much stronger, according to the company. Most investors are doubtful of a rebound until they see it. But with roughly two-thirds of the company's market value tied up in cash and the value of the company's technology worth well more than the $275 million it is currently assigned, this looks like a low-risk stock with reasonable upside.

Sterling Construction (Nasdaq: STRL)
This company, which recently slipped just below the $200 million market cap threshold for stocks I'm usually willing to consider, is involved in major transportation and water infrastructure projects, mostly in the U.S. Southwest. The company has had good years and bad years, but has always been profitable. Right now, business is fairly slow: sales fell -5% last year and should only rebound by +5% this year. Yet despite the constrained economic environment, the bidding environment is actually improving for major projects in Sterling's region, and management expects sales to start rebounding more robustly next year.

Whether that rebound happens or not, shares are undeniably cheap, trading for just 75% of book value, around two times cash and around 10 times next year's profits. It's unlikely shares can fall much farther, so investors can view this as an extremely low-risk/moderate reward kind of stock.

CommonWealth REIT (NYSE: CWH)
Formerly known as HRPT Properties, this real estate investment trust (REIT) owns a range of commercial properties throughout the Unite States. These properties are about 86% occupied, and at that level, this REIT is throwing off ample cash for investors. The recent yield was more than 8%.

Most importantly, the company's portfolio of buildings is worth more than $3 billion, even after accounting for the company's debt load. But investors are assigning just $1.53 billion in market value to shares, meaning this stock trades at half of book value. You don't come across that kind of discount very often.

Action to Take --> CommonWealth REIT has the most upside here -- a double -- simply based on the market truly reflecting the value of its assets. Cogent and Sterling Construction's upside is more limited, perhaps upwards of +50%.
Downside for all three of these stocks appears quite limited, but it's important to be patient. As long as the market remains in a funk, so will these stocks -- they simply allow you to sleep better at night compared to other equity investments.

David Sterman
Contributor, SmallStocks.com
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