Best Stocks to Buy: Another Beaten-Down Industry I'm Buying

By Markets Fool.com


3D printed engine parts at ExOne trade show booth. Source: The Motley Fool

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Sometimes finding the best stocks to buy is just a matter of finding a beaten-down industry that's set for a bounce-back, and finding the best companies within it. There's a solid chance that a former growth-darling industry is exactly what we're looking for.

The 3D printing sector was a terrible place to invest in 2014. The average stock price of the five best-known 3D printer makers --3D Systems Corporation,Stratasys, Ltd.,ExOne Co, Arcam AB ORD, andVoxeljet AG (ADR) -- fell an average of 61.2% last year:

^SPX Chart

^SPX data by YCharts.

As compared to the performance of theS&P 500index, that's an average underperformance of almost75%for what has been touted as the next great growth industry. Factor in an increasingly competitive market, especially with big players likeHewlett-Packardstepping in, and it's easy to understand why investors have fled the industry in a big way.

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However, I'm getting ready to double down and increase my holdings in several of these companies over the next few weeks. Let's take a closer look at which companies -- and why.

Huge gains in prior years set up for a bad 2014?
It's hard to argue that 3D printing stocks didn't enter into 2014 with the potential to fall, considering how much the stocks had all gained over the prior few years. 3D Systems' and Stratasys' stocks both crushed the market from 2010 through 2013:

^SPX Chart

^SPX data by YCharts.

Arcam, Voxeljet, and ExOne all went public in 2013, with two of the three also outperforming from IPO to the end of the year:

^SPX Chart

^SPX data by YCharts

While long-term investors in Stratasys and 3D Systems are still up, the smaller upstarts have just been bad investments so far. Is that really going to change? I think so.

Beware the value traps
Economist John Maynard Keynes once said, "the market can stay irrational longer than you can stay solvent," and I think it's important to remember that as much as these stocks have fallen, there is still the potential for further losses, at least in the short term. Why is that? In short, because of the risk of falling asset value.

The reality is, the winners in the 3D printing space are going to be the ones with the technologies that gain market share. The flip side of this is that the value of the companies' assets doesn't necessarily provide much of a floor to potential losses. Simply looking at the asset value of these companies as compared to their market capitalization -- and the large percentage of asset value that "goodwill" makes up especially for Stratasys -- should reflect how little downside protection the assets of these companies provide:

DDD Total Assets (Quarterly) Chart

DDD Total Assets (Quarterly) data by YCharts.

The smaller players:

XONE Total Assets (Quarterly) Chart

XONE Total Assets (Quarterly) data by YCharts.

As you can see, very little of the value of these companies is based on assets they hold. If their technologies don't gain -- and retain -- market share, there's very little liquidation value.

Why I'm still buying
Limited downside protection doesn't necessarily mean you should stay away. It's just a reminder not to ignore the risks when we choose our investments, and build a portfolio that factors it in.

With this in mind, I'm planning to add to my positions in 3D Systems, Stratasys, and ExOne, all of which make up a relatively small position in my portfolio today.

Why these three? 3D Systems and Stratasys are the two biggest and most diversified companies in the industry. They've both proven capable of acquiring and integrating companies into their businesses, and I think we will see plenty more consolidation over the next several years.

For these two companies, two metrics that are valuable are tied to cash generation. Acquisitions and other investments can make earnings numbers swing, so focusing on the business' ability to generate cash can help us better see the potential, and the current results:

DDD Free Cash Flow (TTM) Chart

DDD Free Cash Flow (TTM) data by YCharts.

In short, both companies have reached a scale where their businesses produce cash flows that can sustain the business while also funding growth. Just to be clear: I'm not saying the companies won't use debt or share offerings to fund futureexpansion -- they both probably will -- I'm saying that the core businesses are viable cash-makers.

I'm also buying more shares of a specialist: ExOne.

ExOne's expertise in metals printing makes it incredibly compelling, and frankly, the business hasn't fallen apart despite the stock's collapse. The stock price has been hammered -- down 80% from its peak -- but that's largely a product of the height of Mr. Market's 3D printing exuberance.

It's also the result of ExOne's size. The company sold less than 50 machines in 2014, and the machines can cost $1 million each. With only $38 million in sales over the past 12 months, it's easy to see how one or two deals taking longer than expected, or a delay in an installation, can have a significant impact on reported earnings.

Frankly, this is likely to be the case for a few years, but the company's know-how and technology in advanced metals printing has significant competitive advantages. These advantages look like they will result in a strong business, and that business should grow even stronger as its installed base grows and aftermarket supply sales become a larger -- and steadier -- source of sales and profits.

Looking ahead
I'm not sure if these stocks will be winners in 2015 or not, to be honest, and I don't think anyone else does, either. However, I'm not investing based on just this year, but instead looking out years down the road. Furthermore, I'm more interested in monitoring the performance of the businesses, versus the stock prices. As long as the companies themselves perform, the stock price will eventually respond.

2014's stock price collapse for the whole industry was less about failing businesses than it was about investor sentiment. Long-term, 3D printing remains an industry with massive potential. I'll be adding to my position in all three of these companies as soon as Motley Fool disclosure rules allow.

The article Best Stocks to Buy: Another Beaten-Down Industry I'm Buying originally appeared on Fool.com.

Jason Hall owns shares of 3D Systems, ExOne, and Stratasys. The Motley Fool recommends and owns shares of 3D Systems, ExOne, and Stratasys. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.