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Stocks With High Profit, Low Debt Keep Me Calm: John Dorfman

With many investors nervous as March hares, this is a good time to look at stocks with high profits and low debt.

I don’t expect a double-dip recession, but if one happens, these companies should withstand it better than most. They should also do fine if the economy improves, as I expect.

Only 8 percent of U.S. companies with a market value of $250 million or more achieved a return of 25 percent or more on stockholders’ equity last year. And only 23 percent of companies have debt less than 10 percent of stockholders’ equity.

The real trick is meeting both criteria at once. A paltry 2 percent of companies managed the feat last year.

The three largest companies that qualify are Apple Inc., Mastercard Inc. and Gap Inc. Of those three, I prefer Gap because it sells for 12 times earnings compared with 23 for Apple and 18 for Mastercard. However, there are smaller stocks I like better.

Let’s begin with Western Digital Corp. Based in Lake Forest, California, Western Digital is the world’s No. 2 manufacturer of hard disk drives for personal computers. Seagate Technology, based in the Cayman Islands and run from Scotts Valley, California, is No. 1. The two rivals hold more than half the market.

Technological obsolescence might threaten the big two some day. Solid state drives or other innovations could someday replace the spinning disks in common use now. For the moment, though, the threat seems distant. Western Digital has been profitable in its past eight fiscal years.

Rising Computer Sales

Disk makers should benefit from the transition to Microsoft Corp.’s Windows 7 as the standard operating system for PCs. Many businesses that normally replace their computers every three years delayed purchases during the recession.

Now that the recession seems to be over and Windows 7 is available, I foresee robust spending on new personal computers by both corporations and individuals in 2010 and 2011. Western Digital sells for six times earnings.

Next let’s look at Wet Seal Inc., an apparel retailer located in Foothill Ranch, California. It sells clothing to teenage girls and young women at its Wet Seal stores, and offers women’s fashions at its Arden B. line.

Wet Seal is debt free, a quality I find alluring. Its current ratio (assets divided by liabilities) is a healthy 3.9.

Unlike Western Digital, which has been consistently profitable in recent years, Wet Seal’s performance has been erratic. It posted losses every year from 2004 through 2007. Under Chief Executive Officer Edmond Thomas, it seems to have turned around and gotten back onto profitable footing.

Financially Sound

Never will I rest easy owning shares in a clothing retailer: Fashion is too fickle. But I like Wet Seal’s financial strength and its low valuations. The stock sells for four times earnings.

Another comeback story is New York-based Loral Space & Communications Inc., which operates a fleet of communications satellites. A predecessor company went bankrupt in 2003, but the current Loral, which emerged from Chapter 11 bankruptcy in 2005, is debt free and earned a $232 million profit last year on sales of $993 million.

Loral lost money in four of the past six years. Disenchanted investors value the stock at less than five times earnings. Disgruntled analysts don’t bother to cover it. The stock is covered by one small brokerage firm, which rates it “hold.”

I think Loral is an interesting speculation for a risk-tolerant investor.

Controversial Pick

Also worth considering, though highly controversial, is gunmaker Sturm Ruger & Co., located in Southport, Connecticut.

Last year the company earned $27 million on sales of $271 million. It has been profitable every year for at least two decades though earnings have bounced up and down. Only three analysts follow the stock, and all suggest buying it.

There is, of course, a moral aspect to this investment. The cities of New York and Washington unsuccessfully sued Sturm Ruger and other gunmakers, alleging that they sell weapons to careless or greedy dealers who allow them to fall into the hands of criminals. The company’s defenders say the weapons are used mainly by law-enforcement officers, the military and hunters.

Sturm Ruger is debt free and earned a 34 percent return on equity last year. The stock sells for 10 times earnings.

Disclosure note: I own Western Digital personally and for clients. I have no long or short positions in the other stocks discussed in this week’s column.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

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