It's no secret that buying beaten-down stocks is the key to maximum gains. But here's what most investors fail to understand: If you want to hit the investment home run, you have to go after the stocks that everybody else hates. Like Goldman, Transocean and Monsanto.
It Pays to Buy Shunned Shares
A tour of recent history underscores that buying what investors hate has been a highly rewarding strategy. Take the Asian contagion. If you had stepped up to the plate shortly after the 1997 debt crisis, when several Asian countries defaulted on their bonds, you'd be sitting on a gain of 203% - perhaps even more if your timing was exceptional.
Then there's the case of Amazon.com Inc. (NASDAQ:AMZN). If you'd snapped up shares of the e-tailing heavyweight right after the "dot-bomb" collapse, you'd have reaped a gain of 2,104% through Sept. 1. Most recently, investors who shrugged off the whole collapse of the American car-making industry and demise of Detroit to buy Ford Motor Co. (NYSE:F) have enjoyed some gear-jamming gains: From its Nov. 19, 2008 low point at $1.26 each, Ford shares have raced to a gain of better than 821%.
In each of these three cases, one fact was true: Investors who reaped the biggest gains bought into these situations when they were at their most unloved. This is not unusual, says John Dorfman, chairman of Boston's Thunderstorm Capital LLC and a Bloomberg News columnist who's known for his often-contrarian viewpoints. In fact, Dorfman's personal research shows that the stocks that Wall Street analysts hate often beat the ones they love.
From 1998 through 2009 - a period in which most "loved" stocks were flat and essentially went nowhere - the four most "hated" stocks as measured by analysts' ratings turned in gains of about 6% a year, Dorfman's research shows. Last year (2009) was a particularly solid year for "despised stocks," which gained 47% - compared with only 23% for analyst favorites. Sears Holdings Corp. (NASDAQ:SHLD) was the leader of the pariah-stocks pack, gaining 115%.
Given all the evidence that says not to do so, why is it that investors continue to hang on analysts' every word? It beats the heck out of me, but author and noted scientist John L. Casti says that emotions will continue to overrule sound investment judgment. In fact, in his new book, "Mood Matters: From Rising Skirt Lengths to the Collapse of World Powers," Casti argues that this is precisely why investors regularly fail to make accurate predictions about anything - which includes failing to predict which stocks are mostly likely to go up in price.
Investors whip themselves into a bullish frenzy at market peaks and become cynical at major market bottoms - just the opposite of what should be happening. Not surprisingly, most investors sell when they should be buying and buy when they should be selling.
Sound familiar? It should: Investors have an amazing ability to make exactly the right decision at precisely the wrong time - which is why breaking this habit may be the single most profitable decision we can make today.
Three Hated Stocks You'll Love
When making investment decisions in difficult - or uncertain - markets, you need to be able to detach yourself so that you understand the emotional state of the broad investment masses, without letting those emotions cloud your judgment. Once you've done that, the next step is to identify "unloved" companies whose shares have been beaten way down from their highs. From that group, pick out the players with the core business strength and rebound potential to transcend the emotional tempest that's at hand.
This analysis can involve such seemingly simple - but productive - techniques as assessing newspaper headlines and magazine covers. Other types of analysis can include various quantitative screening techniques. Both approaches will help you understand the current state of investor emotions, while also demonstrating which stocks Wall Street is pushing - and which ones it's urging investors to avoid. After all, those are the stocks that may eventually attract fresh analyst upgrades.
This approach is one of the few ways left for individual investors to beat Wall Street at its own game. In that spirit, here are three unloved "villains" that are not going away anytime soon.
Goldman Sachs Group Inc. (GS): With its shares down 34% from their October 2007 peak, this beleaguered investment-banking giant is arguably the most vilified firm on earth right now. At the same time, it's quite likely one of the most powerful financial institutions to ever grace this planet - occupying the same rarified air as the Warburgs, the Rothschilds and the Oppenheimers.
Last year, Goldman Sachs essentially stared down U.S. regulators, shook off record-breaking fines like a dog shakes off fleas and took home a staggering $13.385 billion. Its armor is a little dented, and there are perhaps some more dings to come - judging from such fines as the $27 million penalty levied against it last week by England's Financial Services Authority (NYSEARCA:FSA).
Profits will probably decline in the face of new regulation but chances are better than average that Goldman is still going to do better than its peers. Good, bad or ugly, the firm is the undisputed heavyweight when it comes to trading profits and investment-banking fees. Plus it is probably high on the list of winners, should Republicans gain the upper hand in November's midterm elections.
Goldman's projected five-year growth rate is 11%, and its shares are trading at an attractive Price/Earnings (P/E) ratio of 7.8. P/E ratios below 10 are generally very favorable because they suggest the price may be abnormally low, especially given the projected double-digit earnings growth.
Transocean Ltd. (RIG): You may recall that Transocean operated the BP Deepwater Horizon Gulf of Mexico rig that created one of the world's worst oil spills this summer. Thanks to nonstop media coverage of the accident, Transocean shares have been hammered and are down 33% from where they started the year and a full 64% below the $161.40 per share peak RIG shares achieved on May 20, 2008.
However, the Swiss driller is known as one of the best operators in the industry - and its cutting-edge deepwater technology figures to keep its services in demand for years to come. As of Feb. 10, Transocean had a $30.4-billion backlog. The company generated revenue of $11.5 billion last year. Its earnings are projected to advance at an average annual rate of 8.2% during the next five years. The shares are trading at a bargain-basement P/E of 6.7.
Monsanto Co. (MON): Monsanto is villain Numero Uno for folks across the planet who view themselves as part of the global healthy foods movement - and who view "engineered" foods as an unwelcome and potentially dangerous development. Partly as a result, the company is under fire for its genetic crop modifications, as well as for alleged predatory pricing increases around the world.
That bullseye on its back is not the only problem Monsanto faces: It's also the target of several lawsuits alleging improper sales-and-marketing practices.
The upshot: Monsanto shares are down 59% from their June 2008 peak of $142.69. And yet, Monsanto's got billions in ongoing research, an extensive patent library and the closest thing to exclusive government approvals to market its products in food-and-water-starved regions of the world where crop efficiency is paramount - modified or not.
Monsanto produced $11.7 billion in revenue last year, and its earnings are projected to advance at an average annual rate of 14.25% over the next five years. Its shares are trading at nearly 32 times trailing earnings, which gives me pause. However, its P/E on projected earnings is 19.6, which is slightly more palatable and a lot closer to the company's five-year projection for annual profit growth.