5 Fallen Angel 'Lite' Stocks

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 |  Includes: CWCO, LCAV, MDR, STRT, VIEW
by: Marc Gerstein

The fallen angels investment theme is a long-standing classic. It focuses on once-strong companies whose shares have plummeted as the companies fell on hard times with the idea that good stock price gains could be achieved if and when the firms regain even a portion of their former luster. This can be a difficult theme to implement since some such outfits never recover. But in today's harsh financial and market environment, where shares of even the best companies have been battered, we have an opportunity to reach for upside potential normally associated with fallen angels without exposing ourselves to much trouble beyond ordinary cyclicality.

Selection criteria

After establishing a basic universe that eliminates OTC stocks and companies in the Finance sector, this screen uses the following rules:

  • Over the past 52 weeks, the stock underperformed the S&P 500 and its industry average.

    When articulating a fallen-angel theme, it's tempting to require a certain amount of share-price decline; 35 percent, 50 percent, and so forth, or for the stock to be at least a certain percent below its 52-week high, or something like that. But lately, so many shares have plunged for reasons that seem disproportionate to changes in fundamentals, I don't believe it would be constructive to get too picky about the details of the fall (often, it has seemed as if the major influence on share price performance has been who holds the shares and how badly they needed to raise cash). It seems quite sufficient to simply require that performance over the past 52 weeks be worse than average (defined in terms of the S&P 500 and industry norms).

    This is as far as I'm going to go in terms of the negatives. The rest of the rules will be designed to look for positive indicators.
  • The stock's performance relative to its industry average over the past four weeks was better than over the past 52 weeks.

    As positive indications go, this one is pretty mild. The best case scenario would be to get stocks whose relative (to industry) performance turned positive in the past four weeks. But given the lite nature of this screen, I'll also accept stocks whose four-week relative performance was merely less bad. The key, one way or the other, is to jump on some indication, however subtle it may be, that something in the past four weeks represents an improvement over the 52-week state of affairs.
  • The company's five-year return on investment is better than the industry average.

    If I were asked to identify company quality using only a single rule, this would be the one. It tells us how effective management has been in squeezing a profit out of the capital base with which it works, it does so for a prolonged time period, and it factors out the impact of external factors that impact everyone in the industry. And it's a great way to balance margin and turnover (often, investors focus too much on one to the detriment of the other). I choose not to use the more classic return on equity formulation because this metric could be boosted by aggressive use of debt, smoothening I'd like to avoid right now. In fact, the next rule addresses that very topic ...
  • The latest total debt to equity ratio was below the industry average.

    With interest rates being so low and lenders being so jittery, a case can be made for the CFO who borrows heavily, even if only to hoard capital. And that may be an interesting topic for another day. But right now, consistent with the lite approach, I prefer simplicity; companies with balance sheets that could be considered strong without resort to theoretical discussion.

Backtesting

Don't expect a screen like this to backtest spectacularly. The first rule, which calls for 52-week poor relative performance compared with the market and the industry average, is not usually something we seek out in our often-trend-driven market culture. So Figure 1, which presents the results of a Portfolio123.com backtest from 3/31/01 through 1/13/09 (assuming four-week rebalancing and 0.5 percent price slippage on each transaction) shows more than I had expected to see at this time.

click to enlarge images

Click to enlarge

But the story cannot end here. On most runs, the screen produced more than 100 names. So we need to narrow the list.

Normally, fallen-angels investors are patient. They usually need to be since it's hard to say exactly how long it can take a troubled company to turn itself around. But given the special, albeit painful, nature of our current situation, not to mention the lite flavor of this screen, I decided I'd like to find stocks that stand a plausible chance of delivering in three-to five-weeks, rather than three-to five-years (assuming, of course, the market doesn't fall off another cliff). So I'm going to sort based upon a short-term market-oriented criterion.

I'll narrow the list to the five stocks that score best in an Estimates Revision rank I created on Portfolio123:

  • Consensus EPS estimate for the current year, 4 week revision (40% weight)
  • Consensus EPS estimate for next year, 4 week revision (40% weight)
  • The preponderance of upward revisions among analysts publishing estimates (20% weight)

To backtest this approach, I switched to Porfolio123's advanced backtester. There, I logged a set of successive four-week portfolios consisting of the top five. Each of these four-week portfolios was launched one week apart (and included an assumption of 0.5 percent price slippage). The first portfolio was established on 3/31/01 and the last got started on 12/20/08. (All in all, there were 402 of these four-week portfolios.)

Table 1 summarizes the overall results.

That's better than the other backtest, but not dramatically so.

But Figure 2, which shows the performance of the most recent four-week portfolios, is noteworthy.

Click to enlarge

The four-week returns we see in periods 398-401 are downright powerful. Similar four-week gains were also seen at times in the 2002-03 period (although the extreme we saw in period 400 was not replicated).

That gives appeal to this strategy. I can't count on such numbers persisting, and as an all-seasons strategy, this one is pedestrian. But I'm intrigued by the potential it holds to produce some upside "outliers" in an environment such as this (again, crossing my fingers and hoping we don't experience another plunge in the near future).

The current stock list

Here are the five stocks at the top of the list as of this writing.

  • Strattec Security (NASDAQ:STRT)

This company makes auto locks (doors, trunks, ignition). It makes the traditional mechanical kind and the newer electronic varieties. STRT started selling recently to Honda, but for the most part, it sells to the U.S. Big Three. During normal times, the company's fundamentals have been pretty good. But when it comes to current challenges, where might one even begin.

For what it's worth, STRT fits several subcategories in the chapter entitled "The Perfect Stock, What a Deal!" in Peter Lynch's One Up On Wall Street: it does something dull; it does something disagreeable (Lynch had things like toxic waste in mind, but right now, one might suggest that reliance on the Big Three qualifies); it's a spinoff (it was spun off by Briggs & Stratton; it happened a while ago, in 1995, but when you sell to the Big Three, you take whatever brownie points you can get wherever you can find them); it's a no-growth industry (the company might debate this and argue that high tech locks will come on strong and that may be correct, but first, you need the vehicles and the growth situation there is not good); and, it's got a niche (I'll put on exclamation point on that one). Lynch also spoke of no institutional ownership or analyst coverage. STRT isn't quite at that level of obscurity, but for what it's worth, only one analyst covers the stock and institutional holdings are small.

Lynch factors aside, the main play here is cyclical. Assuming the market gets some visibility of recovery (even if a year or so in the future) and assuming the Big Three survive in one form or another, there could be a powerful recovery angle here. Of course this may not happen. That's why they invented diversification.

  • LCA-Vision (NASDAQ:LCAV)

LCAV is a leader in the field of laser surgery that corrects vision problems (its Lasik brand is well known). The good news is that this procedure eliminates the need for eyeglasses or contact lenses which many regard as burdensome or in the case of glasses, un-aesthetic. The bad news is that such expenditures are about as discretionary as you can get. So in the third quarter, revenues had dropped by about 50 percent year-to-year. That's quite a come-down after some years with growth rates north of 20 percent, and often above 30 percent. Management also acknowledged some issues regarding pricing strategy and customer service procedures. But the big picture is the economy. When the money gets tight, this is probably number one, or close to it, in lists of expenses people can defer. Completing the picture is a stock that's now almost 75 percent below its 52-week high.

There's a shareholder group making lots of noise and demanding board seats. As usually happens, management is politely resisting. It's impossible to say whether anything will come from this. Many such episodes fade, but some gain momentum. Even if the stock doesn't get a boost from anything along those lines, at least we do have the cyclical angle. It's hard to say when better times will arrive, but LCAV's balance sheet is strong enough to allow it to wait. (Ongoing expense control initiatives help too.)

  • McDermott International (NYSE:MDR)

Not much needs to be said here. When it comes to oilfield servicing, this company is one of the majors. And at this specific point in time, the investment case is easy to articulate: If you are inclined to be in a stock like this, the probabilities of success are a heck of a lot better if the purchase is made when oil is closer to $40 per barrel than is the case when oil is around $140.

  • Consolidated Water (NASDAQ:CWCO)

This could be one of the more interesting companies you never heard of. It provides potable water in places where this is hard to come by. Right now, and for the most part, this means the Cayman Islands and other parts of the Caribbean. Like STRT, it fulfills several items on Lynch's perfect-stock checklist: it's certainly dull enough; it's got a niche; and best of all (something we didn't see with STRT), people have to keep buying what it sells.

Water is a generally interesting theme. In the U.S., we take it for granted. But in much of the world, potable water is not so easy to come by. I've seen water described as the new oil, and there have been some recently launched ETFs based solely on this theme.

  • Cogo Group (COGO)

I'm not sure I like this company's new name (it used to be called Comtech) but I do like its business. This China-based firm serves contract manufacturers by designing modules they can use in their products, which thus far have primarily been in wireless communications. Interestingly, though, it gets recurring revenue. Part of the arrangement requires its customers to make the modules using components they buy from COGO.

Yes, yes, yes, I know handset demand is iffy and prices are under pressure. But looking at the big picture, is anyone arguing with a straight face that product evolution in this area is even close to winding down? As is usually the case, the major growth opportunities of the next decade are likely to be things we don't yet know about. But to the extent we can mine existing fields for forward growth ideas, wireless probably remains a pretty good choice.

The company is talking about expanding into other areas. (That may be why they changed the name; to get rid of the Com, as in communications.) If this pans out, so much the better. But frankly, I'm satisfied with the communications exposure.

Given the usual hazards of prediction even under the best of conditions, aggravated by the exceptional challenges the financial system and economy now face, I cannot suggest that this list will provide upside-outlier type performance. But given the cyclical exposure (I could see STRT and LCAV representing strong plays here), MDR as a play on potential energy recovery, and COGO with its cyclical growth angle, I can suggest that this list is a plausible expression of the fallen-angel lite theme. If CWCO acquires its way into a region that is more headline grabbing, or if something else happens to draw headlines to the area of water availability, so much the better.


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