There are two ways to think about the battered prices of Washington area stocks. One idea is that if the markets act normally, stock prices eventually will climb back out of the cellar. Call it the Resurrection Scenario. The other idea is that, despite the lessons of history, local stock prices will never return to where they were in recent years. That's the Doomsday Scenario.
Thus far, we can report, investors who believe in the Resurrection Scenario outnumber those who anticipate the arrival of doomsday. As long as that remains true, it follows that investors will be searching for stocks they can buy at bargain basement prices, hoping to reap great profits when the stock market eventually goes back up.
We use the word "eventually" because, as most market experts admit, no one can forecast when the market will hit bottom and turn back up. That means that if you buy a stock that is a raging bargain today, it could easily get cheaper before it rises. And since the market is entangled with a looming recession, a federal budget deficit and a Middle East conflict, there is no telling when that turnaround might come.
That brings us to the question of what makes a stock a bargain. There are many stocks with low prices, of course, but not all are bargains. Some stocks would not be worth owning at any price in this uncertain climate.
Stock analysts agree that a true bargain stock is one that has both high quality and low price. And so, in searching for bargains, the investor needs to know a lot more about a stock than just its price.
We asked several area analysts to choose one area stock they thought was the best bargain in the market today. Here are their choices.
John A. Bailey of Ferris, Baker Watts of Washington. John has our sympathy. He is a bank analyst during one of the worst times in the history of banking.
"It's been so depressing," he said, noting that the news seems to get worse every time the banks report their quarterly financial results.
"It's difficult to believe that bank stock prices will turn up in the short run so long as the real estate market remains this soft," Bailey said.
Nevertheless, Bailey said the best bargain he sees among bank stocks now is Mercantile Bankshares Corp. of Baltimore, a $4.3 billion holding company for 18 community-style banks in Maryland, Virginia and Delaware.
While Mercantile has had some problem loans, it is in far better shape than most other banks. Bailey said that the industry average, when you compare troubled loans to assets, is 1.17 percent. But Mercantile has a rate of only 0.53 percent.
Mercantile scores on another key indicator. Its return on assets is 1.7 percent. In the banking industry, a 1 percent figure is generally considered quite good.
Mercantile, Bailey added, is one of the few banks that has been able to report nearly normal profits despite the decline of real estate.
For the first nine months of this year, Mercantile earned $1.79 a share compared with $1.73 a share for a similar period last year.
Mercantile, whose stock closed at $16.50 Friday, is selling below its book value, which Bailey estimates to be $20 a share. He said nobody could remember the stock ever before selling below its book value.
The stock, which sold for as much as $27 in the last five years, has declined about 35 percent this year.
Since the decline in the share price has not been as dramatic as that of many other banks, Bailey said, investors should not look for more than a $7 to $10 boost when the turnaround finally comes.
Peter C. Keefe, research director of Johnston, Lemon & Co. of Washington. Keefe sees his biggest bargain at Allied Capital Corp., Washington's premier venture capital company. The stock is trading at $14.50 a share, down about 21 percent thus far this year -- probably because Allied is considered a financial company, which is not a ticket to popularity these days.
As banks shy away from commercial loans, Keefe noted, Allied Capital is doing a booming business in supplying money to small companies. And Allied is being rewarded handsomely.
In fact, the financing deals that Allied Capital cut in 1981, during the last recession, helped fuel Allied's prosperity for many years afterward, Keefe said.
"These are the best opportunities Allied Capital has had in 10 years," he added.
Allied shareholders not only get an 8.5 percent yield from their $1.25 annual dividend, but they will soon get a new free spin-off stock from the company's investment advisory division, called Allied Advisory Inc.
Keefe thinks the spin-off stock, to be delivered next month, could be worth $2 to $3 a share. Allied Capital shareholders will get one share of the new Allied Advisory for each share of Allied Capital they now own.
Allied Capital and its divisions now manage about $250 million, but the company thinks the total could rise to $1 billion in the next five years under the new Allied Advisory operation.
Michael L. Mead of Legg Mason and Co., Baltimore. Mead's best bargain is United Dominion Realty Trust Inc. of Richmond.
United Dominion specializes in buying, renovating and renting apartment buildings. The company owns 8,400 rental apartments in 38 complexes, along with 15 shopping centers, primarily in Virginia and North Carolina.
While new apartment units generally cost $50,000 each to build, United Dominion buys older ones for about $20,000 to $25,000 and puts in about $5,000 in renovations. Rents average about $400 a month and occupancy levels are high.
Mead favors the stock for several reasons, including its yield. On the current $13 share price, the company's $1.24 annual dividend translates to a lofty 9.5 percent yield.
Although Mead expects only a modest dividend increase this year of 3.2 percent to $1.28, he believes the company's dividend increases will be in the 6 percent to 8 percent range during the next few years.
Because United Dominion is a real estate investment trust, its financial progress is measured in cash flow per share, rather than the familiar earnings per share used by corporations. On a cash-flow basis, United Dominion reported $1.33 a share in 1989, while Mead estimates the figure will be $1.34 a share this year and $1.46 for 1991.
Although real estate-related companies are in the doghouse these days, Mead expects United Dominion shares to rebound.
Apartment construction was slowed by the 1986 Tax Reform Act, which is creating a short supply. That, in turn, will lead to a tighter market and higher rents. And that should lead to higher dividends in the future, Mead said.
Steve Newby of Newby & Co., Rockville. A specialist in small stocks, Newby said Penril Corp. of Gaithersburg is his best bargain stock. Penril makes data communications products.
A turnaround company that fought its way back from financial troubles, Penril is seeing its stock selling at $4.87 1/2, down 8.2 percent so far this year. The relatively small drop, compared with other stocks, probably reflects the strength of Penril's profits, which were up 29 percent in fiscal 1990.
Newby likes the price of the stock, which is close to the company's $4 book value per share, and the fact that the stock is selling at only about 4.7 times earnings in a market where the average is about 14.
Penril, which was once carried $20 million in debt, has brought it down to $5 million. At that level, the company has twice as much equity as debt, Newby said.
"That's a high comfort level," Newby added.
Newby said that while he sees many relatively cheap stocks in the market, only a few are true bargains. Investors, he warned, should stick to high-quality companies with good balance sheets, companies that can survive tough economic times.
"I don't want to touch anything with a tinge of trouble," Newby said.