Dirt Cheap Stocks

With the market down about 40% over the past year, stocks are on sale. And because selling tends to be indiscriminate on days when the market goes into free fall (Standard & Poor's 500-stock index suffered daily losses of 3% or more 23 times in 2008 through December 5), plenty of stocks aren't just inexpensive -- they're dirt cheap.

Zeroing in on cheap stocks worth owning can be tricky. A low price-earnings ratio, for example, can be a trap, especially if earnings have further to fall.

Instead, we look for businesses with leading shares in their markets, and enough financial strength to survive a deep recession and perhaps even improve their competitive advantage (through acquisitions, for example). The seven stocks we've chosen meet those criteria. Plus, even after accounting for all the bad news on the horizon, their shares seem inordinately cheap.

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Cash-Rich Conglomerate

Founded 154 years ago in Chicago to supply engine parts to the booming steam-locomotive industry, Crane(CR) almost immediately branched out into iron pipes, valves, steam-heating equipment and other businesses. Today the firm remains a conglomerate, making everything from aircraft brake systems to food vending machines.

Now based in Stamford, Conn., Crane has a diversified base of corporate customers and little direct exposure to consumers. Some of Crane's businesses, notably one that makes fiberglass panels for trucks and recreational vehicles (13% of sales), have seen a drastic falloff in sales this year. But its larger fluid-handling segment (43% of sales), which makes valves, pipes and fittings, has held up well. In October, the company lowered its 2008 earnings forecast to between $2.75 and $2.90 per share. The lower end of that range is 24% less than the most optimistic 2008 forecast Crane made earlier in the year. Yet its stock has fallen 70% from its 2008 peak (all prices and related ratios are through December 5).

Of course, things could get worse in 2009, particularly in the engineered-materials business, which makes those truck and RV panels. But Crane's aerospace-and-electronics segment (24% of sales), which makes brakes and other systems for the new Boeing 787, should see profitability pick up as the new aircraft goes into production and Crane's engineering costs decline. Even the engineered-materials segment, which Crane dominates with a 70% market share, should turn around eventually as aging baby-boomers warm to RVs. Meanwhile, the company is aggressively cutting costs.

Crane has plenty of cash -- $278 million -- and is on the hunt for companies to acquire (it has absorbed 15 companies since early 2003). Even after lowering its earnings forecast in October, Crane was still expected to generate $130 million in free cash flow (net income plus depreciation and noncash expenses, minus capital outlays) in 2008. In July, the company raised its dividend by 11%, to an annual rate of 80 cents. The shares currently yield 5.7%, a good indication of just how cheap they've become. Over the past decade before 2008, Crane's average dividend yield ranged from 1.2% to 1.8%.

Prosperous Builder

Analysts expect nonresidential construction to turn down sharply in the coming year, and shares of EMCOR Group (EME) are feeling the pinch. The Norwalk, Conn., company is one of the nation's largest builders and operators of electrical and mechanical systems. Emcor shares have fallen 52% in the past year and now trade for seven times estimated 2009 earnings -- well below their average P/E over the past five years of 21.

But despite the bleak construction outlook, Emcor recently raised its fourth-quarter 2008 profit forecast and issued an upbeat outlook for the first half of 2009. Its confidence stems from serving many recession-resistant customers -- such as those in health care, water treatment, government services and electric-power generation -- that should hold up well over the next year. In addition, Emcor says it gets about two-thirds of its revenues from ongoing maintenance contracts and renovation projects (which are less likely than new construction projects to be canceled as a money-saving measure). And Emcor stands to benefit from a massive infrastructure-spending program the new Obama administration is contemplating.

Things aren't entirely rosy. Emcor's $4.4-billion backlog of business at the end of the third quarter was down 5% from the previous quarter, due in large part to the suspension of two big Las Vegas casino projects. Any acceleration in the rate of cancellations would be worrisome. But the company has a good record in previous downturns. Its balance sheet includes $341 million in cash, more than enough to cover $200 million in long-term debt that matures next year.

More Than an Iraq Play

KBR, an engineering-and-construction firm spun out of Halliburton in 2007, specializes in the kind of giant undertakings few competitors can tackle. Under a $3.5-billion contract that ended in 2008, it was the sole supplier of food, utilities and other support services to troops in Iraq. It also has a $16-billion, 35-year contract to construct and operate a variety of facilities for the British army, andit has built more than half the world's liquefied-natural-gas plants.

KBR's specialized skills and expertise don't seem to be reflected in its stock price, though. At $13, its shares trade for seven times expected 2009 earnings. Subtract its $1.1 billion in cash -- equal to about half of KBR's stock-market value -- and the P/E falls to 3.5.

Investors seem wary of a firm that gets about two-thirds of its revenues from Uncle Sam and a big chunk from the oil-and-gas industry. They needn't be. The many governments KBR contracts with, as well as the multinational oil firms it does business with, are for the most part not dependent on the fractured credit markets to finance their projects. KBR's backlog of business stands at $15.3 billion, and chief executive Bill Utt maintains that the likelihood of significant cancellations is Òlimited.Ó

Granted, the expected pullout of U.S. troops from Iraq will, over time, cut into a significant portion of revenue. During the third quarter, KBR's operations in the Middle East accounted for 45% of revenues. But KBR's cash hoard and zero debt put it in good position to replace that business. In 2008, the company bought BE&K, a privately held construction firm, for $550 million, a deal that boosted KBR's backlog by 15%.

Design-Software Star

Autodesk (ADSK), a maker of computer-aided-design software, is the de facto standard bearer for architects, engineers, manufacturers, builders, animators and others. Its software has 9 million users in 160 countries, and universities use it to train new designers.

Other companies have created an entire ecosystem of specialized software products that operate in conjunction with Autodesk programs. Because the cost of switching to rival software is so high, Autodesk's customer base is "sticky," giving the San Rafael, Cal., firm a big edge over competitors. That alone should be reason for its shares to trade at a premium to the market. Yet they're down almost 70% in the past year and now trade for ten times expected earnings for the coming year, well below Autodesk's average P/E of 38 over the past five years.

The problem is that Autodesk's customers are caught in the global credit crunch and either can't get financing to buy its products or don't want to spend the money right now. Analysts expect a 17% decline in profits for the fiscal year that ends January 2010.

But while there's no telling how long or deep the recession will be, there's little doubt that Autodesk will emerge as dominant in its field as ever. With negligible debt, the company can use its $941-million cash stash to extend its reach by buying up small rivals, as it did when it announced in December that it would purchase iLogic, a desktop manufacturing-design system.

In addition, the company has many reasons to expect an eventual return to robust growth. Among them: the possible enactment of an infrastructure-focused government stimulus plan (Autodesk software is widely used by civil engineers), continued growth in developing countries, and an ongoing transition to three-dimensional software, which brings in more than twice the revenue of the current 2-D mode.

Fertile Ground

Over the past two years, fertilizer stocks have behaved much like Internet stocks did during the tech bubble. Shares of CF Industries Holdings (CF), for example, soared 500% from late 2006 until they peaked at $173 last summer. Now, abandoned by momentum investors, they fetch a mere $47. But the Deerfield, Ill., company is anything but a passing fad. It operates the largest nitrogen-fertilizer plants in the U.S. and Canada, and it is a major producer of phosphate fertilizers as well. Farmers of corn, wheat, cotton and other crops consider both types essential to generating high crop yields.

True, the recession and credit crunch could reduce demand temporarily. But the long-term picture -- increasing demand driven by growing prosperity among the middle classes in China and other emerging countries -- still looks good.

One concern is the potential for natural gas -- an essential ingredient for producing nitrogen fertilizer -- to rise in price, cutting deeply into CF's profit margins. But North American gas prices have fallen by half in the past year, and in any event, CF uses derivatives to hedge against big price swings. On the flip side of the coin, prices for phosphate rock have been rising, crimping the profits of many phosphate-fertilizer producers. But CF is not affected because it gets its supply from its own Florida mine, which holds 15 years' worth of reserves.

CF shares trade for just three times expected 2009 profits of $14.16 a share. Back out the company's $20-per-share cash reserve and the P/E is less than 2, a level that seems to indicate distress. But CF has virtually no debt, pays a 40-cent annual dividend (the stock yields 0.9%) and recently completed a $500-million share repurchase -- reducing the number of shares outstanding by about 15%. We should all be so distressed.

From PCs to Services

Hewlett-Packard (HPQ) announced in November that it had halved spending on information technology as part of a larger, $1-billion cost-saving program. That exercise should give the technology giant good insight into the headwinds it faces selling PCs, printers, servers and related support services to its customers. IDC, a research firm, forecasts that corporate technology spending will grow by an anemic 2.6% worldwide in 2009 -- and by just 0.9% in the U.S.

In that light, analysts' expectation of a 7% rise in profits for the fiscal year ending this October may seem optimistic. But the recent $13.9-billion purchase of technology-outsourcing firm EDS will add about $20 billion in revenue in the current year (out of an estimated $128 billion total).

The addition of EDS makes Hewlett-Packard more competitive with IBM, Accenture and others for big corporate technology-outsourcing contracts, which could boost sales of HP hardware. The takeover will also help HP withstand a more-severe-than-expected downturn. HP now gets one-third of its revenues and half of its profits from recurring sources, such as services and supplies.

The Palo Alto, Cal., company is in excellent financial shape. Its balance sheet contains $10 billion in cash and $18 billion in debt, and HP generated $12 billion in free cash flow in its 2008 fiscal year. HP trades for just nine times expected 2009 earnings, a bargain price for a top-quality company.

Battered Boomer Play

Investors have long seen Zimmer Holdings (ZMH), the leading maker of hip- and knee-replacement devices, as a sure way to profit from the wave of aging fifty- and sixtysomethings who will inevitably encounter joint problems. As a result, its shares have always been expensive, with an average P/E over the past five years of more than 30. Lately, though, regulatory problems and product recalls have hit the Warsaw, Ind., firm. Add to that concerns that insurance companies might reduce reimbursements for surgeries and that doctors will prescribe less-invasive procedures, and you get a stock that has lost half its value in the past year. Zimmer shares now look cheap, selling at less than 12 times expected 2009 earnings.

Granted, a deal with the Justice Department has forced Zimmer to change its financial relationship with surgeons who use its implant products, a move that may cost it some market share. The recalls, which involve a hip-implant device and some surgical products, appear to be short-term issues, though, and the hip product is already back on the market.

Zimmer is a reasonably priced bet on joint-replacement markets growing at close to 10% annually. Meanwhile, the company has the financial muscle to plow 5% to 6% of its sales into research and development and to push into related areas through acquisitions. It has $211 million in cash after deducting debt, and it generates $500 million in free cash flow annually.