When Stocks Don't Feel The Love

11/28/2011


When we hear bad reviews of a movie, we are less likely to buy a ticket. If our friends pan a new restaurant, we probably won't schedule an anniversary dinner there.

If we aren't careful, we might treat stocks the same way. And that's often a mistake. Have you ever enjoyed a movie despite negative reports? You probably have, because our tastes don't always match those of the reviewer. People dislike movies — and stocks — for different reasons.

Most investors like to be in "winners," the popular stocks with the best growth prospects. But most research suggests that buying the market's darlings won't help you earn superior returns. You should not be afraid to buck the trend and buy unpopular stocks.

Market participants show their distaste for stocks in several ways. Here are three:

Analysts can give stocks poor ratings. In general, analysts tend to be optimistic. On a scale of 1 (Strong Buy) to 5, the average stock in our Quadrix® research universe with an analyst rating earns a 2.2, which equates to a Buy. Fewer than 31% average a rating of Hold (3), Sell (4), or Strong Sell (5).

In many cases, analysts show their disdain for a company by not covering it. If only analysts who like a stock choose to rate it, consensus ratings may overstate the investment community's true optimism.

Investors can sell shares short, betting on a decline. To sell short, investors sell borrowed shares at the current price, hoping to purchase the shares back later at a lower price and pocket the difference. We looked at 1,399 members of the S&P 1500 Index with five years of short-sale data. As of mid-November, investors had sold short more than $339 billion in shares of those companies. On average, the short interest equaled 6% of the companies' stock-market value, up from 5.3% in January but below the average of 6.6% over the last five years.

Stockholders can sell the shares outright. If enough people sell a stock, it tends to lag the market. Are we suggesting that investors go out and buy losers? Not at all. In general, we prefer stocks with relative strength, that have outperformed the market. But if a quality company underperforms because of a change in public perception disproportionate to bad news about the company, that weakness may provide a buying opportunity.

All three of the above actions represent the equivalent of someone else's review of a stock. We don't advise you to ignore reviews — after all, if most diners hate the food at a new restaurant, it probably isn't very good. But if you can find a stock that deserves more love than it gets, you may have a winner. After all, a company does not need to do well for its shares to do well; it only needs to do better than investors expect.

Quadrix can help identify stocks with broad-based fundamental strength — regardless of how the rest of the world views them. The table below lists stocks that earn poor reviews from analysts or investors but solid Quadrix scores. Four such stocks are discussed below.

Nearly 12 million Alliance Data Systems ($95; ADS) shares have been sold short, equating to roughly 20% of the company's share base. But strong share-price momentum puts short sellers in a bind. The stock has risen 34% so far this year and bounced 19% from its August low. Alliance also finds plenty of love in Quadrix, earning Overall, Performance, and Quality scores of more than 90.

Some investors worry about Alliance's balance sheet, with net debt of $6.02 billion. But the company has grown cash from operations in seven of the last eight quarters, with revenue rising at least 7% in every period. The dividend is fairly well covered, and operating earnings over the last year were enough to cover interest expense nearly three times over. Wall Street sees more growth ahead, with Alliance Data projected to earn $8.24 per share in 2012, up 13% on 9% higher sales. Yet the shares trade at 13 times trailing earnings, a 41% discount to their five-year average P/E ratio. Alliance Data Systems is a Focus List Buy.


BMC Software ($35; BMC) sells computer software that improves clients' productivity. Unfortunately, BMC has not been particularly efficient regarding its own sales force. A depleted sales staff hurt September-quarter orders, and it might take BMC a couple more quarters to get on track. The stock has fallen 9% since the September-quarter earnings report, extending a slide that began over the summer.

But investors are dismissing the company's strong track record, cheap valuation, and still-solid growth outlook. The stock trades at 11 times trailing earnings, near its lowest P/E in more than eight years. At less than 11 times estimated earnings for the current fiscal year, BMC shares trade 13% below the median system-software stock in the S&P 1500. And despite its troubles, BMC enjoys strong operating momentum, with per-share cash from operations up 34% over the last year. The company still appears positioned to grow per-share earnings at least 8% in both fiscal 2012 and fiscal 2013 ending March. BMC Software is a Buy and a Long-Term Buy.


Few stocks carry more baggage than Hewlett-Packard ($27; HPQ). A serial offender for questionable acquisitions and disappointing quarterly reports, H-P has struggled to chart a clear operational course. During the 11-month tenure of CEO Leo Apotheker, H-P lost nearly half of its market value; in September, investors greeted new CEO Meg Whitman by pushing the shares to a six-year low.

H-P shares dipped after the company said it earned $1.17 per share excluding special items in the October quarter, down 12% but above the consensus. Revenue slipped 3% to $32.12 billion, also exceeding the consensus. Among H-P's four largest segments, only services grew revenue, up 2%. Personal computers dipped 2%, enterprise declined 4%, and printers fell 10%. Looking ahead to fiscal 2012 ending October, H-P anticipates earning at least $4.00 per share, implying a decline of up to 18%. Hewlett-Packard, trading at less than seven times the company's revised guidance, is a Long-Term Buy.


Intensifying competition among Canadian carriers is restraining Rogers Communications' ($35; RCI) growth. Its cable business grew revenue 4% in the nine months ended September, and wireless gained just 2%. Wall Street expects total revenue to increase less than 3% in both 2011 and 2012, a far cry from Rogers' 10-year annualized growth rate of 17%. Making matters worse, attrition for wireless subscribers has risen this year, while average revenue per wireless user dipped 4% as cheaper prepaid services accounted for a greater percentage of phone plans.

But Rogers is out in front of Canada's migration to the next-generation service, and over time, that technological leadership should pay off. Rogers also returned $634 million to shareholders through dividends and buybacks in the September quarter, up 21% from the same quarter last year. The quarterly dividend rose 11% this year, and management expects fairly steady growth in the payout. After taking care of dividends and capital expenditures, the company tends to deploy its excess cash tends for share repurchases. Rogers, yielding 4.0%, is a Long-Term Buy.

SCREEN OF THE MONTH: UNLOVED STOCKS

All 18 of the monitored stocks below appear fundamentally strong, as evidenced by their high Quadrix Overall scores. Despite those solid fundamentals, the market does not love these stocks.

Some earn subpar consensus rankings. On average, stocks ranked by analysts earn a 2.1 on a scale of 1 (Strong Buy) through 5 (Strong Sell), which equates to a Buy rating. Stocks in the top section earn scores of 2.5 or higher. Some of the stocks have unusually high short interest, suggesting that many investors are betting they will decline in price. Stocks in the middle section have short interest (borrowed shares sold in hopes of repurchasing later at a lower price) equal to more than 6% of their shares outstanding. Stocks in the bottom section have poor relative strength, as measured by their total returns, minus the total return of the S&P 1500 Index.

Some stocks qualify as unloved for more than one reason. An A rating means above average, while a B means average. Stocks recommended for purchase are presented in bold.

% of
Shares
Sold
Short
Days to
Cover
Short
Positions
Relative Strength
Ests. EPS
Growth
Company (Price; Ticker)
Consensus
Rank
3
Months
(%)
6
Months
(%)
12
Months
(%)
Curr.
Year
(%)
Next
Year
(%)
Quadrix
Overall
Score
Advice
Sector
Unloved by analysts
Advance Auto Parts
($68; AAP)
2.5
4.3
2.9
11.0
15.6
1.7
26
13
93
A
Cons. Discret.
AGCO ($43; AGCO)
2.7
2.0
1.0
15.6
(4.7)
(5.5)
85
7
99
A
Industrials
Applied Materials
($11; AMAT)
2.5
1.6
1.2
(6.5)
(13.8)
(13.4)
(44)
62
97
A
Technology
ConocoPhillips
($69; COP)
2.7
1.8
2.4
1.9
3.7
11.8
45
(1)
90
A
Energy
Eli Lilly ($36; LLY)
3.0
2.0
2.3
(4.2)
3.4
4.3
(8)
(17)
90
B
Health Care
Hewlett Packard
($27; HPQ)
2.7
1.2
0.9
3.1
(16.5)
(35.8)
6
(3)
75
A
Technology
Rogers Commun.
($35; RCI)
2.9
3.9
NM
(12.3)
(0.2)
(3.5)
6
5
86
A
Telecom Svcs
Unloved by short sellers
Alliance Data Sys.
($95; ADS)
2.1
20.1
11.9
6.8
13.1
55.0
25
13
90
A
Technology
Best Buy ($26; BBY)
2.5
8.9
4.9
3.5
(6.8)
(39.8)
(1)
10
92
B
Cons. Discret.
Capital One Financial
($41; COF)
2.0
6.7
4.6
(7.2)
(16.7)
5.7
27
(20)
84
A
Financials
Unloved by investors
Apache ($95; APA)
1.6
1.4
1.6
(7.6)
(13.5)
(11.2)
30
8
85
A
Energy
BlackRock ($157; BLK)
1.8
0.6
1.1
(3.9)
(11.8)
(8.7)
9
8
82
A
Financials
BMC Software
($35; BMC)
2.1
1.8
1.0
(13.5)
(27.0)
(21.5)
8
8
75
A
Technology
Freeport-McMoRan
($36; FCX)
1.7
1.9
0.8
(19.9)
(16.4)
(26.7)
5
0
88
A
Materials
J.P. Morgan Chase
($30; JPM)
1.5
1.2
1.0
(17.3)
(21.8)
(25.0)
17
8
64
A
Financials
St. Jude Medical
($36; STJ)
2.1
1.9
1.6
(20.4)
(21.2)
(9.1)
9
10
75
A
Health Care
Walgreen ($31; WAG)
2.3
2.1
2.2
(17.1)
(20.6)
(9.4)
8
10
77
A
Cons. Staples
Walter Energy
($69; WLT)
2.5
3.0
0.6
(12.4)
(33.1)
(29.0)
0
27
76
A
Materials
Note: Quadrix scores are percentile ranks, with 100 the best.     NM Not Meaningful.

 


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