10 Cheap Stocks With Dependable Earnings

Bargain hunters should focus on companies that can deliver on forecasts. The evidence favors these names.

Cheap stocks are suddenly abundant. The S&P Composite 1500 index of large, midsize and small U.S. companies has lost 12% in three months. More than 300 of its members now have price-to-earnings ratios in single digits, suggesting a discount of more than one-quarter to historical levels.

That alone doesn't make these stocks bargains. If earnings in coming quarters prove much lower than expected, today's P/E ratios will have misled. The task for investors is to figure out which companies are both modestly priced relative to forecasts and likely to meet or exceed those forecasts.

One tool professional investors use to predict that is past earnings volatility. Companies with relatively smooth earnings histories — a low standard deviation of quarterly earnings, in statistical parlance — are more likely than others to deliver the same in coming quarters.

But this tool is of limited use now, because the past five years have produced chaotic results for much of the market, and traditionally stable industries now face challenges. Food makers must deal with crop inflation, soap and toothpaste firms are battling a shift in shopper preference to discount brands and even some utilities are seeing a drop in electricity usage. Some companies in these industries will report stable earnings over the next year, but perhaps not all of them.

So here are two ways to tell which firms are reliable. The first is to look for a recent dividend increase. That puts more cash in shareholder pockets, but just as important, it signals that managers are confident about future results. After all, no company wants to raise its dividend only to find the new payments unaffordable in the coming year.

The second is another statistical clue: a tight clustering of the earnings estimates issued by different analysts. Three decades of research, including recent studies by Anna Scherbina, now at U. C. Davis, show two important things about estimate dispersion. First, tightly grouped estimates are more likely than scattered ones to precede an upside earnings surprise. Second, stocks with clustered earnings estimates tend to outperform those without.

One theory on why this is so has to do with the earnings guidance that companies provide to analysts. Firms with good news to report tend to be more forthcoming with details than firms that are struggling, the thinking goes.

The 10 stocks below have modest P-E ratios and healthy dividend yields. They've also raised payments over the past year and have earnings estimates that show relatively close agreement among analysts.

* Based on forecasted EPS for current fiscal year
Data as of Sep. 22, 2011
Source: Thomson Reuters