The Coming Value Party

• ByTim Melvin, RealMoney.com Contributor
• On 9:35 am EDT, Tuesday March 10, 2009

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The merger wave in pharmaceutical stocks is one of the healthiest things I see going on in the market right now. Monday brought the latest bid, when Merck announced a $41 billion deal for Schering-Plough . I have said before that one of the ways to stop a real bear market like we have been experiencing is a merger wave. Stocks reach levels where it is just cheaper to buy assets, earnings, technologies and patents on the stock exchange as opposed to developing them yourself. The pharmas are just the first. I expect the oil and oil service stocks to be the next group to experience a rash of mergers and acquisitions in 2009. Ultimately it will be business acting in the interest of profits that ends the bear market, not government intervention or monetary policy.

I am not making a definitive bottom call; there are still a lot of problems out there. The real estate market still faces pressure from foreclosures and write-offs, and that is probably going to continue for some time. The major banks are a toxic disaster area. The automakers, particularly General Motors , are in deep trouble, with no end in sight. Unemployment has not yet peaked; most think we will approach 10% unemployment before it does. There is a very real risk of the broader market continuing to fall for awhile. But stocks and the assets and earnings they represent are getting cheap.

Let's look at some numbers. According to my stock screeners, 174 of the stocks in the S&P 500 trade for less than stated book value. The Schlossian screen I run to discover companies that trade below book value with very little debt and insider ownership shows more than 600 names, the most since 2003. More than 100 of those have market caps over $100 million, which is also the highest since the Internet went bust.

More than 100 stocks on the NYSE trade for less than a buck, and more than 500 of the names on the Big Board are under $5 a share. My good friend Corban Bates, a recent USMA grad and budding value investor, sent me a list this weekend of net-nets that had 120 names. Almost a third of these were profitable companies. For the first time I can recall, there are enough net-net stocks to build your entire portfolio with these Graham- and Dodd-type bargains. Some of these, like Adaptec and Electro Scientific , I have written about, and fellow RealMoney contributor Jonathan Heller has also done a great job covering stocks that trade below net current asset value.

In addition to my regular weekend reading, I got a chance to go through Marty Whitman's shareholder letters for the first quarter. The Third Avenue Funds, like a lot of others, had a brutal 2008, but Whitman has been among the very best asset based investors over the long run. He noted that about three-quarters of his fund was concentrated in net-net stocks. He also pointed out the futility in trying to pick a bottom and advised concentrating on the underlying value of the companies whose shares you were buying.

Because he has a fantastic track record in distressed bonds, I was very interested to see that both Third Avenue Value and the Third Avenue Small Cap Value run by Curtis Jensen were buying distressed credits in companies he believes are 70% to 80% likely to remain performing credits. In addition to buying more shares in long-term holding Forest City Enterprises , the fund purchased the bonds of the company at levels that provided yields to maturity of better than 30%. Forest City has exchange-traded bonds as well that trade under the symbol FCY on the NYSE. These are senior unsecured notes that trade at less than 25% of par, with yields of better than 30%. Whitman has done very well with this type of investment over the years, and if Forest City can survive the recession, these notes are a home run. In a bankruptcy, a quick glance tells me that these may work out to at least the purchase price as well.

I am not making a broad call for a market bottom. Rushing the trumpets with broad-based buying in stocks and high-yield bonds is still too dangerous right now. In all likelihood, the market will push still lower as politics, banks and real estate remain front and center. I am saying that it is starting to look like a party for value and distressed investors, and it is time to start paying attention to the extreme values being created by the falling market.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider Adaptec, Electro Scientific and Forest City Enterprises to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!