Unpopular But Not Unprofitable

8/2/2010


Anyone can buy the most popular companies. But those who invest in individual stocks are presumably trying to outrace the market, not stay in the pack.

When most of Wall Street zigs, sometimes zagging is the answer.

With that in mind, consider a few measurements of popularity. The nearby tables contain stocks that have run afoul of market opinion. When our Quadrix stock-rating system likes a company more than the crowd likes it, we take notice. In the tables nearby and the paragraphs below, we address three investor-sentiment metrics — and identify stocks that aren’t getting the love.

Broker rating

If a stock has strong fundamentals, good growth potential, and a reasonable valuation, don’t let its rejection by Wall Street analysts scare you off. A broker rating of 1.0 equates to a strong buy, while a 5.0 reflects a strong sell. Most stocks earn buy ratings, in part because brokers tend not to cover stocks they don’t like. However, all of the stocks in the table below earn broker ratings of 2.3 or higher, suggesting they are not Wall Street darlings.

MEDIOCRE BROKERAGE RATING
Quadrix
—— Scores ——
Brokerage
—— Rating ——
Company (Price; Ticker)
Value
Overall
Stock
Industry
Industry
BMC Software
($38; BMC)
68
91
2.3
2.2
Systems Software
Freeport-McMoRan
($70; FCX)
94
89
2.3
2.0
Metals & Mining
Laboratory Corp.
($75; LH)
64
83
2.4
2.0
Health-Care Svcs.
Newmont Mining
($56; NEM)
67
99
2.4
2.4
Gold
Research In Motion
($53; RIMM)
92
100
2.3
2.2
Telecom Equipment
Ross Stores
($54; ROST)
74
99
2.7
2.2
Apparel Retail
Sigma-Aldrich
($57; SIAL)
40
72
2.3
2.1
Specialty Chemicals
Note: Quadrix scores are percentile ranks, with 100 the best.

Historically, Sigma-Aldrich ($57; SIAL) has not behaved like a traditional chemical firm. The company delivered higher per-share profits and cash flow in each of the last seven years, managing annualized growth of 19% for profits and 15% for cash flow during that period.

The company’s 170,000-item product line includes a range of research chemicals and reagents as well as specialty chemicals for manufacturing. That business mix is far less cyclical than those of most chemical firms.

In the June quarter, Sigma earned $0.81 per share excluding restructuring costs, up 19% and $0.04 above the consensus, on 6% sales growth. Operating profit margins rose sharply on higher volumes, a favorable product mix, and cost cuts. The company reiterated expectations for per-share profits of $3.05 to $3.20 this year, versus the $3.11 consensus at the time of the announcement. Sigma-Aldrich is not cheap at 18 times trailing earnings. But it trades at a 5% discount to its three-year average P/E ratio, and its consistent growth warrants a premium to the market. The stock is a Long-Term Buy.

Short interest

Listed in the table below are five monitored stocks with substantial short interest. Short sellers sell borrowed shares that they hope to buy back at a lower price. Short interest reflects the number of shares sold short.

SHORT INTEREST
Short Interest
—— (Millions) ——
Short
Interest
as % of
Float
–—Short Ratio –—
Company (Price; Ticker)
Current
Shares
3-Mo.
Avg.
(Days
to Cover)
3-Mo.
Avg.
GameStop ($20; GME)
27.2
24.4
18.8
4.8
4.3
L-3 Communications
($73; LLL)
3.6
2.7
3.1
3.2
3.0
McKesson ($65; MCK)
9.3
7.9
3.6
3.4
3.3
TJX ($42; TJX)
10.9
13.5
2.7
1.8
2.8
Varian Medical Systems
($56; VAR)
8.4
6.8
6.8
6.1
6.0

The short-interest ratio equals the number of shares sold short divided by the average daily trading volume. This ratio represents the number of typical trading days required to cover outstanding short positions. The higher the ratio, the greater potential for a short squeeze.

A short squeeze occurs when a heavily shorted stock begins to rally, causing short sellers to rush to cover their positions and driving the price even higher.

Plenty of doomsayers are betting that GameStop ($20; GME) will continue to underperform the market. Shares sold short equaled 27.2 million, or nearly 19% of shares outstanding, exceeding the three-month average by nearly 3 million shares. The short ratio, or the number of days needed to cover a short position, is 4.8. True, sales of video games remain under pressure, and every few months a new threat seems to emerge from rivals envious of GameStop’s profitable niche in used games. But amidst all that gloom, even a small piece of good news could spark a genuine rally.

Investors game for a high-risk, high-reward play should consider GameStop. The stock earns a Value score of 99 and trades at just nine times trailing earnings, 52% off the three-year average. Despite persistent headwinds, GameStop posted higher sales in each of the last three quarters and generated free-cash-flow growth of at least 30% in each period. GameStop is a Buy.

Share turnover

One measure of a stock’s liquidity is turnover, or 12-month trading volume divided by average shares outstanding. Conventional wisdom holds that if a stock has low liquidity, investors can run into trouble getting out of the stock in a hurry if something bad happens. Liquidity tends to be more of an issue with small stocks, but all of the Forecasts stocks in the table have turnover ratios of 1.3 or lower.

SHARE TURNOVER
Quadrix
Overall
Score
12-Mo.
Trading
Volume
(Mil.)
Shares
Outstanding
(Mil.)
— Share Turnover —
Company (Price; Ticker)
Rate
Percentile
Rank
Abbott Laboratories
($49; ABT)
82
2,015
1,556
1.3
58
Coca-Cola ($55; KO)
76
2,684
2,331
1.2
62
Colgate-Palmolive
($85; CL)
75
682
523
1.3
58
IBM ($129; IBM)
90
1,751
1,324
1.3
57
Johnson & Johnson
($58; JNJ)
58
3,058
2,796
1.1
64
PepsiCo ($66; PEP)
71
1,925
1,602
1.2
60
Wal-Mart Stores
($51; WMT)
60
3,944
3,841
1.0
66
Note: Quadrix scores are percentile ranks, with 100 the best.

Illiquidity does add risk to stocks, particularly for institutional investors with thousands of shares to sell. But stocks with low liquidity tend to trade at discount valuations in reflection of that risk. In a study published by Morningstar, stocks with low turnover ratios outperformed from 1972 through 2008.

Johnson & Johnson ($58; JNJ) has taken a beating because of the clumsy way it handled multiple recalls of its consumer medications. Since the end of June, the shares are down 2%, while the S&P 500 Index gained 8%. With 12-month trading volume of slightly more than 3 million shares and a share count of nearly 2.8 million, J&J has a turnover ratio of 1.1.

Not helping matters, a new report shows that federal inspectors uncovered a pattern of noncompliance at yet another J&J plant. Regulators found 12 different types of violations varying from poor recordkeeping to ignoring quality-control procedures. In other news, trials showed that rilpivirine, an experimental HIV drug to be used in combination therapy, caused fewer side effects, though fewer patients responded to the treatment.

While J&J won’t offer investors explosive growth, it does seem capable of reliable, steady operating momentum. Wall Street expects per-share earnings to grow 2% this year and 7% in 2011, targets that sound conservative. J&J, with a generous dividend yield of 3.7%, is a Long-Term Buy.

The new Volume Metrics

The investor-sentiment indicators featured above — brokerage rating, short interest versus the three-month average, short ratio, and share turnover — are variables used for the Quadrix Volume Metrics score.

Volume Metrics has been substantially revamped, de-emphasizing trading volume in favor of sentiment measurements. The category score now represents a contrarian indication, rewarding stocks for high levels of short interest and a low proportion of buy recommendations from Wall Street analysts.

Insider buying and selling are now considered, with stocks rewarded for a high level of insider buying. As always, the Volume Metrics score is not considered in the calculation of the Overall score.


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