Buy the Book and Get the Yield for Free

• ByTim Melvin, RealMoney.com Contributor
• On 1:45 pm EDT, Tuesday August 11, 2009

Thank goodness I do not trade stock index futures. I would be in the poorhouse in rapid and spectacular fashion if I did. My caution has kept me from being as aggressive as some of my peers. I am just stubborn enough that I still think my approach to the market was and is justified by the amount of risk I see in the system.

A friend commented the other night that I tend to be incredibly early on macro themes and I am again this time. I am amazed that in just three short months everyone seems to feel that all the problems in the real estate market are just going away and that only losing a quarter million jobs is good news. I am staying cautious.

Do not, however, take that to mean that I am out of the markets. I am aware that I have a tendency to become disciplined too early and, as my kids never fail to remind me, on occasion even I am wrong. My discipline has grown so strong over the years that when I find a stock that fits my rather rigid "too cheap not to own" criteria, I buy some.

I may temper my buying but I buy and am prepared to average down if the market falls. I have a time horizon of years, not days or weeks. In addition, I am always looking for new ways to spot cheap stocks worth buying no matter what the stock market is doing.

Over the weekend I was cleaning some of my legendary paper stocks and came across some back issues of Outstanding Investor, a quirky publication featuring interviews with top investment managers. Despite editor's ongoing love affair with Warren Buffet, I enjoy this publication and think it is one of the very best sources of investment ideas.

While reading, I found an old interview with Peter Cundill, a value fund manager of some note who hails from Canada and has much success applying his approach around the globe. Cundill mentioned that one of his favorite screening methods was to search for stocks that trade below tangible book value, are profitable and pay a dividend.

His reasoning was that if the assets were sound, then one is getting the earning power and dividend of the company basically for free; this would provide a large margin of safety with upside potential. Sounds reasonable, doesn't it?

I like this approach to screening. The presence of the dividend means that in all likelihood the company is generating more than enough cash to meet its bills and has enough left over to return to the shareholders each year. The profits make it less likely for the company to burn up assets and cash just too keep it afloat.

As always keep in mind that screening is the start of the process not the end and a more investigation must be done. As Chris Browne once remarked, first underwrite and then investigate.

As with just about every other value screen I run these days, the list of stocks produced by the screen is dominated by financial stocks and REITs. Despite of my long-term very bullish view for small banks, I think the next leg of the journey is down for those stocks, so I am avoiding them for now. When it comes to REITs, I am much more interested in other parts of those companies' capital structures these days so I will pass on the equity in that group as well.

There are several electric utilities on the list and that is a group I like. I can't recall a time that I purchased shares of a utility below book value and ended up losing money on the trade. It was an interesting ride on a few occasions, but over a period of years they all went higher. I expect that will be the case this time as well.

Potomac Electric is on the list and I have liked the stock for awhile. My electric bill alone this summer should keep the dividend covered. I also like Portland General, which is also a profitable dividend payer trading below tangible book value.

Some old favorites make the list. Tesoro is on there and I like the stock. I did very well with it earlier this year when refiners spiked and I think it will again. The refining business faces a few touch quarters due to decreasing gasoline demand but at 60% of tangible book I am comfortable owning the stock. I am even more comfortable with backing into ownership by selling puts and will be looking to do so this week.

I wrote about Babcock & Brown Air last week. The next day it reported positive earnings for the quarter. The company continues to buy back debt to strengthen the balance sheet and generate free cash flow. The stock fits the list paying a generous dividend and trading well below tangible book value.

The Cundill method of screening produced some cheap stocks that are worth buying regardless of my market outlook. I will be studying the list more closely this week to see what other gems I can find.

Buzz up!