Five flat stocks ready to rebound
These companies lagged as the market steamed ahead, but they are intriguing plays for patient investors.
(Fortune Magazine) -- The stock market has returned to territory not seen in six years. In late September the Dow Jones industrial average came within a few points of the record-high 11,723 set on Jan. 14, 2000. That was reason to celebrate for many investors, especially those fortunate enough to own such Dow (Charts) standouts as Merck and AT&T, both of which have returned more than 30 percent this year. And with interest rates and oil prices easing, there are reasons to believe the good times will continue.
But rather than hopping on a hot stock and hoping for the best, it may be smarter to seek out unappreciated value; Merck and AT&T, after all, were in the doldrums a year ago. "Investing is like hunting," says Bob Costomiris, portfolio manager of the Wells Fargo Advantage Mid Cap Disciplined fund. "The best time to hunt is when and where others aren't."
That's why we set out to find companies with healthy prospects that most investors have shunned lately. We talked to fund managers about companies in unpopular industries that have been beaten down and scorned by analysts. We found five promising choices ranging in size from megacap to small cap. They all match low expectations (and low price/earnings ratios) with strong balance sheets and meaningful growth on the horizon. With a little patience, investors could reap strong returns from our five out-of-favor picks. Here they are, starting with the largest.
Shareholders of the home-improvement giant haven't had much to celebrate this year: The stock price has fallen 10 percent since January. Same-store sales fell slightly in the second quarter as real estate cooled, and some investors have worried that a housing bust could make things worse. Others wonder whether the world's third-largest retailer, which has opened more than 2,000 stores in the U.S., Mexico and Canada, may be suffering from the Wal-Mart syndrome - running out of room to grow. And the flap over CEO Bob Nardelli's lavish pay package hasn't helped.
Nardelli admits that the housing slowdown is hurting sales, but he thinks the damage will be offset by steps the company is taking to strengthen itself - he calls it "internal remodeling." Home Depot generates a ton of cash, which it has used to revamp stores, improve technology, make strategic acquisitions, repurchase stock (17 percent of outstanding shares since 2002) and boost its dividend. Earnings are expected to grow 9 percent next year, helped out by buybacks, an increase in money spent per customer, and innovations like self-checkout. Home Depot is also counting on HD Supply, a wholesale operation targeting the professional construction and maintenance market, projected to have $12 billion in sales this year and $25 billion by 2010. Trading at 11 times 2007 earnings - a historical low - Home Depot has rarely looked so cheap or attractive.
Last year's merger of Sprint and Nextel created the nation's third-largest wireless provider. Shares have plunged 20 percent this year as investors fret over possible problems integrating the companies, which operate two totally separate networks. But fans such as Bill Miller at Legg Mason and Mason Hawkins at Longleaf Partners believe the short-term fears are overblown, and that the firm will soon be a cash machine.
As the only pure-play wireless provider among major U.S. telecom firms, Sprint Nextel isn't weighed down by a shrinking landline business. And as management pursues various merger-related cost cuts, the bulls bet free cash flow will soar, allowing the firm to pay down debt, buy back stock, and reinvest in the business. Trading at 12 times projected 2007 earnings and slightly less than book value, the stock is certainly cheap. Assuming sales can grow at a modest 5 percent clip over the next five years, Morningstar analyst Michael Hodel figures shares are worth $28.
In September this auto components and systems engineering company announced that it would lay off 850 people and reduce its 2006 earnings projections by 10 percent in response to a decrease in business from big U.S. automakers and a 60 percent increase in its estimated raw material costs. The stock is down 6 percent this year.
You might think that with the U.S. auto industry in crisis, BorgWarner has nowhere to go but down. But the company has moved decisively to protect itself from Detroit's woes by expanding overseas. Today it gets 60 percent of its sales outside North America, up from 8 percent in 1997. Arthur Moretti, who runs Neuberger Berman's Guardian fund, also lauds BorgWarner's ability to introduce sought-after components, including turbochargers, engine-cooling technology and transmission systems, to improve fuel efficiency and lower emissions. BorgWarner is trading at 12 times its estimated 2007 earnings, in the middle of its historical range. Moretti believes that as long as the economy stays on track, the company could enjoy stronger earnings and a higher P/E, which would be doubly rewarding for investors.
The food and pet-products company has been punished by rising energy and commodity prices, which have driven up its costs to make and to move products. The stock has been stalled for two years, but Eric Heyman, director of research at Olstein Funds, says that Del Monte has performed well under pressure, cutting $50 million in costs and building free cash flow. "When a company has free cash flow, it has a lot of avenues it can take to increase shareholder value," he says. In fiscal 2006, Del Monte bought back $125 million of stock, announced its first dividend and paid down debt.
Del Monte also went on the offensive, selling off noncore soup and infant-food businesses in 2005 and investing in its faster-growing pet business, acquiring Meow Mix and Milk-Bone. "A stagnant management doesn't do anything - they sit back," says Heyman. "This management is taking charge." Sales are already starting to perk up, growing 9 percent in the most recent quarter, compared with 3 percent in the prior quarter, and earnings are projected to grow 7 to 9 percent this year. Heyman thinks that the market has underestimated Del Monte and that it should be a $15 stock.
In terms of market expectations, Reader's Digest is just about bottom of the barrel. Publishing is out of favor; its audience isn't exactly Gen Y. Says Wells Fargo's Costomiris: "Most of my peers say, 'Aren't all their readers dead?' "
The business might be slowing down, but reports of its death are greatly exaggerated. Sales rose slightly in the most recent quarter; operating profits, minus a restructuring and inventory charge, were up 15 percent, and Reader's boasts a 3.1 percent dividend yield. Almost half of Reader's business is overseas, protecting investors from a softening in the U.S. economy. New projects like online property Allrecipes.com and the successful launch of Food Network celeb Rachael Ray's magazine, expected to reach a million subscribers in early 2007, are showing signs of life.
Thyra Zerhusen, who owns the stock in her ABM Amro Mid Cap fund, notes that the market is sour on publishing companies in general because of the migration of readers and advertisers to the Internet. But Zerhusen contends that many traditional publishers are actually well positioned to take advantage of putting content online at a marginal cost, resulting in high returns. As for Reader's, she adds, "I wouldn't be surprised to see the stock closer to $20 in the next 12 months."