By David Sterman
For many investors, May 4, 2011 marked a key turning point for stocks. On that day, the Dow Jones Industrial Average plunged more than 100 points. This also happened on four different occasions in that same month. Most stocks have been unable to withstand such blows and have been trending lower ever since. In fact, less than 20% of all stocks are up since early May. Of these, only a select group of stocks has been able to post outright rallies, rising more than 10% in the last month alone.
Moving up when the market is moving down is often a harbinger of continued strength to come. So it's advantageous to look into these "whistling past the graveyard" stocks closely. If and when the market stabilizes, these stocks have great potential to break out.
I ran a screen to see what kinds of stocks are rallying right now, excluding any companies that have recently received buyout offers and any stocks that are worth less than $500 million. A few sectors are showing real strength. For example, the for-profit education sector, which had been pummeled in 2010 in the face of increasing Congressional scrutiny, has been showing new life recently. Stocks like Bridgepoint Education (NYSE: BPI), Education Management (Nasdaq: EDMC) and ITT Educational Services (NYSE: ESI) have all rallied higher in recent weeks as quarterly results have not been as bad as many had feared. Despite the rally, Bridgepoint and ITT trade for less than 10 times projected 2011 profits, which could be the catalyst to attract value investors.
The electronic retail sector has also shown resilience in this bear market. After falling from $30 last June to $17 in February 2011, I thought shares of electronics retailer hhgregg (NYSE: HGG) were too cheap. In fact, they got a lot cheaper, falling all the way down to $12. Yet a turn appears to be at hand. Shares rallied more than 10% on May 26 on the heels of a solid quarterly report, and are now back up above $14.
The electronics retailer has been opening new stores at a fast clip (the store count now stands at 175, up from 130 a year ago), and these stores are yielding good leverage off of the company's overhead. Shares trade for about 11 times projected fiscal (March) 2012 profits. I expect this stock to finally move back into the $20s when investors see a few more quarters with strong results. This should underscore the view that a company capable of 15% annual profit growth is worthy of a profit multiple of at least 15.
PAETEC Holdings (Nasdaq: PAET)
This provider of fiber-based Internet-traffic management has put investors on a rollercoaster ride. Shares fell more than 25% from mid-February to late March (as the broader market was rising), and then rebounded more than 40% since then (as the broader market began to slump). The recent rebound comes as investors finally glimpsed profitable results following a recent acquisition spree.
Handling web traffic for large enterprises can be quite a challenge. Companies serving the industry need facilities located along major access points of the Internet backbone so they can offer clients an end-to-end data transmission network. Thanks to a series of deals during the past few years, PAETEC now controls a fiber-optic network more than 10,000 miles long. It's the fourth-largest network in the country behind only Level Three Communications (Nasdaq: LVLT), Time Warner Cable (NYSE: TWC), and Cogent Communications (Nasdaq: CCOI). PAETEC's data centers now control 320,000 square feet of space, putting the company among the industry's top five in this metric as well.
To take market share from those bigger players (as well as incumbent phone companies such as Verizon (NYSE: VZ)), PAETEC has sought to differentiate itself by offering a range of value-added services. Business intelligence software, hosting services and industry-specific software used in industries like energy and utilities are among the new services offered.
With the acquisition spree largely complete, PAETEC appears committed to proving its capabilities in terms of cash-flow generation. The company generated $91 billion in earnings before interest, taxes, depreciation and amortization (EBITDA) in the first quarter of 2011 (up from $65 million a year earlier), and is on track to generate roughly $400 million in EBITDA this year, according to analysts. This would represent a 50% jump compared with 2010 levels. Dougherty & Co. recently initiated coverage on PAETEC with a $6.50 target price, which is roughly 40% above current levels.
These recent breakout stocks had struggled earlier in the year but appear to be finding their footing now, even with the broader market still in a funk. Keep a close eye on these stocks. A stable market should help these shares to power even higher.