Are Today's Low Quality Stocks Tomorrow's Treasures?

 |  Includes: ANF, BFR, CPT, JOY, LAZ, MAT, MCK, NTY, SBUX
by: Stephen Castellano

Part of our work at Ascendere Associates LLC entails generating a model long/short portfolio strategy that keys in on factors like operating momentum, earnings growth and relative value. These ideas taken together and updated monthly generally and over time seem to work well. In another context, we use the model portfolio to generate ideas for more in-depth research coverage.

Our strategy is based in part on a 1997 Harvard Business Review case study on Numeric Investors L.P., McKinsey & Company's approach to valuation, other sources and our own insights. Numeric's approach was probably cutting edge at the time but is now considered quaint by today's standards, though we find such a general approach very useful.

Our recently published reports on McKesson Inc. (NYSE:MCK), Joy Global Inc. (JOYG) and Starbucks Corp. (NASDAQ:SBUX) highlight one of the equity research services we offer to institutional investors. They demonstrate how a data-intensive approach can be used to shed deep insight into the detailed long-term assumptions that the sell side consensus is embedding in various stocks, and the ways that long-term valuation can be affected by changes in the various assumptions. Adding some industry knowledge, general experience and intuition from our perspective or that of another research team makes for a powerful combination.

However proud we are of our work, the problem with any model is that they sometimes fail - or at least they do not provide expected results. The performance of the model portfolio's performance through 2008 was exceptional. But take a look at the model portfolio performance for most of 2009 and for the month to date, for example. While high quality stocks in the long portfolio are up, low quality stocks in the short portfolio have outperformed even more, thereby greatly detracting from the overall model portfolio performance for the month to date.

It seems after a brief respite, that once again market is anticipating that poor operating results and analyst revisions of many "low quality" stocks have reached their nadir. One more thing to point out - we have noticed that a number of insiders are selling the "high quality" stocks on our list, while insiders are simply inactive with "low quality" stocks.

Models are never perfect, and sometimes they fail. But they always offer context and act as a valuable tool for further analysis. From that perspective we offer the following "new" stock ideas that may deserve a closer look for the week starting Monday, February 22, 2010. Coincidentally, all the stocks below are all small- to mid-cap names.

Possible long ideas

Mattel Inc. (MAT $21.78) -- The designer and manufacturer of various toy products worldwide, including Barbie. The company is showing good operating momentum and relative value, with more cash than debt on its balance sheet. An attractive dividend yield of 3.4%. Consensus estimates may imply continued improvements in ROIC but a slowing rate. A caveat is that their seems to be a lot of insider selling at the company.

NBTY, Inc. (NTY $45.48) -- Manufactures, markets, and retails nutritional supplements. Consensus estimates show that good operating momentum will probably continue, and relative value is very good. A caveat is that insiders recently sold a significant amount of shares and this stock has been recently highlighted by a high number of technical trading systems -- if everyone knows about an idea there is a chance it has already played out.

BBVA Banco Frances S.A. (BFR $6.14) -- An Argentinean diversified bank that has a depository receipt trading on the New York Stock Exchange. The bank is showing drastically improving ROE against a price-to-book ratio of 1.6x versus an average of 3.1x for all diversified banks that trade on major U.S. exchanges. Very often, international companies that trade on American exchanges trade at a discount due to their American peers due to various country risk factors.

Possible short, or contrarian long, ideas

Abercrombie & Fitch Co. (ANF $35.55) -- A specialty retailer of casual sportswear apparel. Non-compelling though not drastically poor relative valuation against a backdrop of declining ROIC and relatively low ranking for estimate revisions. This may not be the best short idea given its very strong balance sheet and a consensus high estimate which could indicate an ability to reverse its recent misfortunes. In fact, this could be a good "contrarian" long idea to work on. No insider sales or buys since August 2009.

Camden Property Trust (CPT $39.30) -- A real estate investment trust that operates and develops multifamily properties. Its 5.2% yield attractive, but consensus estimates indicate that negative ROE levels could persist in the near term. Debt level almost equal to its market cap. May be appropriate to revisit this as a possible short idea at $46, which is the sell side consensus high price target.

Lazard Ltd. (LAZ $36.09) -- A worldwide financial advisory and asset management firm with headquarters in Bermuda. Recent results have been relatively poor, but consensus estimates imply that ROE could turn positive again by the June 2010 quarter.

Disclosure: No positions