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Analysis: Unpopular stocks can become valuable friends

Analysis
FOR about seven decades, academic studies have shown that unpopular stocks – those whose price is low relative to the company’s earnings – outperform stocks with higher price-to-earnings (P-E) ratios.

I was curious about what would happen if one were to take low P-E investing to an extreme. So, beginning in 1999, I have tracked the one-year performance of the 10 stocks that begin the year with the lowest P-E ratios.

These P-E outliers have performed very well. Here is the record, which should not be confused with that of any actual investment portfolio that I manage.

The compound annual return on the outlier stocks for the years 1999 through 2010 was 16 percent, compared with 1.5 percent for the Standard & Poor’s 500 stock index. In those 12 years, these out-of-favor stocks have outperformed the S&P nine times. The exceptions were 2006, 2007 and 2008.

These performance figures are hypothetical, in the sense that no fund actually carries out this trading strategy. The figures include dividends but disregard taxes, commissions and other trading costs. Bear in mind that the sample size is small, and that past performance doesn’t guarantee future results.

In 2010, the low P-E outliers notched a 25 percent return, compared with a 15 percent return for the S&P 500. The best performer was BreitBurn Energy Partners LP, up 104 percent. The worst was Mirant Corp - which now, after a merger, is known as GenOn Energy Inc - down 33 percent. Eight of the 10 stocks rose.

Exceeding expectations
The rationale behind low P-E investing is that stocks advance by exceeding investors’ prevailing expectations. Low expectations are easier to exceed. Thus, paradoxically, unglamorous stocks with well-known problems often outperform glamorous issues that are popular with investors.

Buying extremely out-of-favor stocks comes with a large dose of risk. The low P-E outliers declined 61 percent in 2008, when the bottom fell out of the market and the economy. The S&P 500 was down 37 percent that year, even taking dividends into account.

The out-of-favour stocks roared back in 2009, notching a 97 percent return, against 26 percent for the index.

To be included in the study, a stock had to have a market value exceeding $500 million, and debt less than stockholders’ equity. Those two requirements may mitigate the risk to some degree.

The outliers were identified as each year began, except for 2008 and 2009, when they were identified on January 29 and February 27, respectively. In every case, performance was measured for the calendar year.

Out of favour
Most of the stocks emerging from this screen are out of favour for some obvious reason, and are high risk. Also, the screen frequently produces a cluster of stocks in a single industry, defying the tenet of diversification.

And now, let’s look at the 10 stocks with the lowest P-E multiples as we enter 2011.

The lowest of the low, selling for three times earnings, is Earthlink Inc, an internet service provider that focuses largely on dial-up connections. Earthlink, based in Atlanta, has been losing customers to carriers that concentrate on broadband. The company’s revenue peaked at $1.4 billion in 2003 and was about half that in 2009.

Kulicke & Soffa Industries Inc, of Fort Washington, Pennsylvania, designs and makes semiconductor assembly equipment. Analysts expect earnings to fall about 60 percent in the fiscal year that ends in September 2011. That’s why the stock sells for four times earnings.

Cutting Debt
Oshkosh Corp, based in Oshkosh, Wisconsin, makes military transport vehicles, cement mixers, fire engines and ambulances. I owned it a few years ago but its debt load scared me away in the past few years. Now the company has pulled debt down to less than stockholders’ equity, so I will take another look. The P-E is four.

Back in 1995, Novell Corp of Waltham, Massachusetts, had $2 billion in revenue and was considered a rival to Cisco Systems Inc in computer networking. Cisco then was only 10 percent larger than Novell by revenue. Today, with revenue below $1 billion, Novell is less than 3 percent of Cisco’s size. In November it agreed to be purchased by Attachmate Corp for $2.2 billion.

Micron Technology Inc, a semiconductor manufacturer with headquarters in Boise, Idaho, has seen an upturn in revenue lately, to more than $2 billion in each of the past three quarters from less than $1 billion in the depths of the recession. It has been profitable five quarters in a row and sells for six times earnings.

Earnings drop
Impax Laboratories Inc of Haywood, California, makes generic and proprietary drugs, specialising in neurological conditions such as Parkinson’s disease, attention deficit disorder and depression. Analysts expect it to earn a record $2.95 a share for 2010, then suffer a sharp earnings drop in 2011. The stock fetches six times earnings.

Also sporting a multiple of six is Western Digital Corp of Lake Forest, California, the world’s second-largest disc-drive maker by revenue. It is one of my 10 favorite stocks for 2011.

Skechers USA Inc, the number-two US sneaker maker after Nike Inc, seems due for a comeback in 2011 after a rough 2010. The California-based company declined 32 percent. The stock carries a P-E of six.

Apollo Investment Corp, based in New York City, is a business-development company that lends money to medium-sized companies. It has an erratic profit history but turned one last fiscal year and is expected to stay profitable this year and next. The P-E is six.

Cancer drugs
The final spot on the outliers list goes to Ariad Pharmaceuticals Inc, a Massachusetts company working on small-molecule drugs to treat aggressive cancers. In May, Merck & Co signed a licensing agreement to sell one of its drugs. Ariad sells for six times earnings.

John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own.

Disclosure: John Dorfman, personally and for clients, owns shares in GenOn and Western Digital. He also owns Impax Laboratories for many clients. He has no long or short positions in the other stocks discussed in this column.

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