Cheap stocks? They're an illusion

By Jim Jubak

Stock prices are low, sure enough. But are stocks cheap?

For most growth stocks, I think the answer is "not yet." But I've found three that are close. Two I'm putting on my Jubak's Picks watch list, and I'll buy one of those two if it drops back to its Oct. 15 low. And the third stock I already own in that portfolio and will hold on to even in this tough environment.

Classic growth stocks such as Apple (AAPL, news, msgs), Coach (COH, news, msgs), Google (GOOG, news, msgs) and Whole Food Market (WFMI, news, msgs) certainly look cheap. As of Oct. 21, these four stocks were down 53%, 31%, 46% and 67%, respectively, for the year. You could say they're selling for about half off.

But with the economy headed into what looks like the deepest recession since it contracted by 3% in the fourth quarter of 1990 and 2% in the first quarter of 1991, I don't think these stocks are bargains.

For example, when I bought shares of Apple for Jubak's Picks on June 6, I called the stock a bargain at $185.81 a share because, with projected earnings growth for the fiscal year that ended in September at 33%, the stock's price-earnings ratio of 35 meant you were buying the company's growth on the cheap. It was cheaper on those projected earnings to buy Apple's growth, in fact, than the growth of blue chips such as PepsiCo (PEP, news, msgs) or Johnson & Johnson (JNJ, news, msgs).

A bite out of Apple

A slowing economy has knocked those projections into a cocked hat. On Oct. 21, Apple reported earnings per share of $1.26 for its fiscal fourth quarter. That beat the Wall Street consensus by 10 cents a share. But the company lowered its projection for earnings growth in the current quarter to $1.06 to $1.35 a share. That's way below the consensus projection of $1.65. If Apple's growth for fiscal 2009 falls by the 18% difference between the former projection of $1.65 a share and the recent $1.35 a share, the company won't show any earnings growth at all for fiscal 2009.

Suddenly, the stock isn't especially cheap, even at the Oct. 21 closing price of $91.49 a share or that day's after-hours price of $88. As they say, cheap -- Apple, Coach, Google and Whole Foods Market -- can always get cheaper.

It's not just that these four growth stocks aren't as cheap as they look. Most growth stocks in today's market, despite huge price retreats, aren't exactly bargains. Right now, with earnings growth at most companies set to fall off a cliff, finding a low-priced growth stock that's not about to get radically cheaper is like looking for a needle in a haystack when the haystack is on fire.

That's not to say you can't find a few true bargains among growth stocks. Just that it's hard to do. You can't rely on the usual ratios (for example, the price-earnings ratio to growth rate, or PEG) or expect screens based on last year's earnings or on Wall Street projections for next year's growth to find true bargains for you.

You've got to pull on your asbestos gloves, reach deep into the fire and look at things such as debt loads and cost structures -- things that most growth investors leave to the value-stock crowd -- to find bargains now. I've found three stocks that fit the bill by following these rules for finding bargain growth stocks in today's market.

Rule No. 1

Look for companies with flexible production and low fixed costs.

It certainly won't hurt, either, if variable costs are falling. These are the companies that have the best opportunity to keep earnings growing by cutting costs when demand or prices fall.

Let me start off with a very unlikely candidate for a cheap growth stock: steel maker Nucor (NUE, news, msgs). The common wisdom is that demand for steel drops in a recession as demand from car and appliance makers tanks. And that common wisdom is absolutely correct. Nucor, in its Oct. 16 conference call with investors and Wall Street analysts, reported it had shipped 13% less steel in the third quarter than in the second quarter of 2008. The outlook for the fourth quarter and for 2009 is so murky, the company said, that it won't venture even a guess at production levels or revenue for those periods.

Most steel companies have trouble adjusting to change in demand. At traditional steel companies, turning off the blast furnaces that make steel is a big deal because it takes a long time to get the equipment shut down and just as long to get it running again. Shutting down a furnace also requires either paying wages to the workers at the shut-down plant so they'll be around when the company needs to start production again, or letting the crew go and then scrambling to find experienced employees when the company wants to start the furnace again.

Nucor, however, operates minimills that produce steel from scrap rather than from the raw iron ore that traditional steel makers use. The electric-arc furnaces used by minimills can be turned off and on with the flick of a switch -- well, figuratively, at least. That lets Nucor easily shut down a plant when demand for its product falls and ramp up production at a plant where demand is climbing. The company's work rules give it more flexibility to shift workers as demand changes. Its pay scale, which links pay rates for workers and management to company revenue, enables Nucor to cut labor costs when demand falls, without laying off workers.

So something very wonderful went on with Nucor's earnings in the third quarter, even as the company produced less steel. As production fell, earnings rose to $2.31 a share, a record for the company. Earnings growth soared 93% from the third quarter of 2007 and 26% from the second quarter of 2008 to the third. By shutting down plants when demand for a specific product was falling, Nucor avoided a huge increase in unsold steel inventory in the quarter.

On the other side of the coin, the company was able to increase output where demand was high. In the quarter, Nucor produced more plate and structural steel at some of its mills and less of the sheet steel used in the auto and appliance industries at other mills. The shift contributed to a 21% increase in the average selling price of a ton of its steel in the third quarter from this year's second quarter.

It certainly didn't hurt that steel prices were still on an upward march in the third quarter. The price of the scrap steel and scrap substitute that Nucor uses to make steel soared to $533 a ton in the third quarter of 2008 from $285 a ton in the fourth quarter of 2007. Because scrap steel and scrap substitute make up 50% of Nucor's costs, that price increase would have delivered a huge hit to Nucor -- except that the price of steel moved up faster, so that the difference between scrap and steel prices widened to a huge $193 a ton in the third quarter.

Nucor can't count on the price of steel to keep moving up as demand falls. That would be a huge problem for the company, except that the price of scrap steel looks likely to fall even faster. Since peaking in July, the price of scrap steel on the American Metal Market has dropped by $360 a ton in the past three months. The price of Chicago No. 1 scrap has dropped by $600 a ton in the same three months. It looks like the spread between scrap and steel prices may even increase in coming quarters, therefore, even as the price of steel falls.

That could keep Nucor's earnings growing even as the global economy slows. I'd buy the shares if they fell back to their Oct. 15 price of $27.42. At that price, the shares would yield more than 4% -- good pay while waiting for the economy to turn. (Shares of steel makers, by the way, are among the first to start climbing when an economy begins to improve.)

Continued: Watch the free cash flow

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