Three Great Stocks Under $4

By David Sterman
July 28, 2010

According to their by-laws, many mutual funds are forbidden from owning stocks that have a share price of less than $5. Since the heavy hitters won't touch these inexpensive shares, you might find one that's priced for less than it's actually worth, ultimately netting you a greater return.

Of course, once those stocks hit the $5 mark, a whole new world of buyers takes a look at them. Here are some promising companies that you can buy now, before the big fund managers step up to the plate.

Casual Male (Nasdaq: CMRG)

If you know any men who are very tall, or large in general, then chances are they've heard of Casual Male, which carries suits and other menswear in hard-to-find sizes. Yet as you may suspect, the economic slowdown was not kind to this retailer. Sales fell -4% in fiscal (January) 2009, and another -11% in fiscal 2010. If there is a silver lining, the slump forced management to take a close look at expenses, paring fat in order to stay lean in these tough times.

Their handiwork is already in evidence. In the first quarter ended in April, sales fell another -2.6%, but profits soared. For starters, management became much smarter about its merchandising efforts, eliminating the need for wasteful markdowns. And that pushed gross margins to a company record 45.9%. And general overhead was cut about -4% from the prior year. As a result, a $3 million negative free cash flow figure a year ago became a $3 million positive free cash flow figure this time around. That led management to boost earnings per share (EPS) guidance for this year to a range of $0.26 to $0.29, which would mark the best showing in five years.

Now, all Casual Male has to do is wait for the economy to improve and unemployment to fall. Even moderate sales increases could turn this into an earnings powerhouse. Let's assume that gross margins stabilize at 44% in fiscal 2012. And let's also assume that sales also rebound to the $465 million mark seen in fiscal 2007 and 2008. Lastly, let's assume operating expenses rise back up to $175 million from an expected $165 million this year. That would yield about $30 million in operating income, or about $0.70 a share.

Casual Male saw EPS rise to $1.21 at the peak of the last retail cycle in 2007. With lower overhead, a moderately expanded base of stores since then and improved merchandising, profits could conceivably top that figure in the next cycle. Shares, at a recent $3, don't begin to reflect that kind of earnings power.

GSE Systems (AMEX: GVP)

One of the perils of investing in smaller companies is that they tend to get hit especially hard when the stock market is crumbling. Case in point: GSE Systems, which has seen its shares fall from around $5.50 to a recent $3.70. GSE provides training and simulation services to power plant operators, with an emphasis on nuclear power operators. Revenues for the company had been stuck in the $20 million to $30 million range throughout the last decade, but soared to $40 million in 2009, thanks to a string of new contract wins. And analysts expect that momentum to continue, predicting sales will exceed $50 million this year and $60 million in 2011. They derive that confidence form a backlog that has moved north of $50 million.

But this is a fairly lumpy business, as revenue recognition against certain contracts gets lumped into certain quarters. In-the-know investors may have been selling shares on those concerns, which is really the only reason I can divine for why shares have fallen so sharply.

GSE's bulls are focused on the prospects of lots of new nuclear power plants being built. It's already happening in China, where the company is seeing a rising book of business, and it may soon happen in the United States. Considering that many nuclear engineers got their start in the 1970s and are nearing retirement age, we may see a frenzy of new nuclear engineering recruits in coming years. And they'll need GSE's training classes and simulation facilities to get up to speed.

Sealy (NYSE: ZZ)

StreetAuthority resident sage Andy Obermuller highlighted the appeal of this mattress maker back in January. And the assessment is still valid, even if shares have yet to be fully appreciated by Wall Street. Andy reminded us that Sealy routinely earned $0.80 to $0.90 a share when the economy was healthy in the middle of the last decade. Of course, consumers are holding off on replacing mattresses these days, which is why Sealy's EPS is stuck in the $0.10 to $0.20 range these days. But mattresses wear out over time, and the longer people hold on to them, the greater the snapback in demand when purse strings finally loosen.

#-ad_banner_2-#One of the reasons shares are so cheap is because of a seemingly untenable debt load, which stands at $800 million. That's the result of a botched private equity transaction and eventual new IPO that didn't raise enough money to sharply reduce debt. But Sealy is generating more than enough cash flow to support debt service costs, even in these tough times.

Yet this is where leverage can pay off. Any jumps in gross profits can yield even larger jumps in net profits, as the interest costs remain in place. By my math, a +10% jump in sales, leveraged over those fixed debt costs, would yield a +40% boost in income. That may not happen for a few more years, but shares of Sealy now represent deep value. They've fallen from above $4 in late April to a recent $2.65. We don't need to see EPS rise back to $0.80, as Andy referenced above. This would be a dirt cheap stock if EPS rose to just $0.40 or $0.50. This is a potential double, triple, or even quadruple gainer when the economy gets back on its feet.

Action to Take --> All three of these stocks have moved even farther off the radar in recent months. But they're each positioned for an eventual robust rebound in profits, and trade at very low multiples in relation to potential earnings. Yet as with any micro-cap, they could fall even more out of favor before moving back into the spotlight.