Valuation-Based Contrarian Picks

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 |  Includes: ALKS, CMG, CMI, DE, HPQ, LSI-OLD, SBUX
by: Value Research

Challenging the consensus is quite difficult and requires guts of steel. Contrarians have to shut out the allure of stories, interviews in the financial media, and other distractions in order to focus on valuation.

Today, independent thinkers are also confronted with the challenge of identifying the consensus. Who isn't a contrarian or a value investor today? How can a consensus be identified when everyone claims to be different?

Even though Jim Cramer's trades are not long-term recommendations, his picks can be a very useful barometer of investor and media attitudes. Contrarians can use his picks as an indicator of current market sentiment to selectively counter.

Of Cramer's 65 buy and sell stock opinions recently issued on CNBC's Mad Money (5.07.2012 to 5.10.2012), three sell calls and four buy calls can be challenged on a valuation basis. Alkermes (NASDAQ:ALKS), Chipotle Mexican Grill (NYSE:CMG), Starbucks Corporation (NASDAQ:SBUX), and LSI Corporation (NASDAQ:LSI-OLD) are too richly valued to be buy picks. On the other hand, Hewlett-Packard Company (NYSE:HPQ), Deere & Company (NYSE:DE), and Cummins Inc. (NYSE:CMI) are too cheaply valued to be sell picks.

These picks are summarized below:


Ticker

Cramer's Call

Airdate

P/E

P/B

P/S

Insider Transactions

HPQ

Sell

5.10.2012

8.18

1.17

0.37

36.9%

DE

Sell

5.10.2012

11.75

4.7

0.97

5.0%

ALKS

Buy

5.10.2012

0

2.6

7.58

-4.1%

CMG

Buy

5.10.2012

56.16

11.06

5.39

-3.8%

SBUX

Buy

5.09.2012

31.8

8.13

3.31

-6.6%

CMI

Sell

5.07.2012

10.45

3.4

1.1

1.7%

LSI

Buy

5.07.2012

30.96

3.67

2.01

-1.7%

Click to enlarge

After reviewing the price multiples of ALKS, CMG, SBUX, and LSI it is clear that these stocks are richly valued according to static valuation metrics. Net insider selling of these picks over the past six months is also discouraging.

Sadly, even pleasant future growth scenarios are not much consolation for such richly valued stocks. What could an investor expect from these picks?

Total returns were calculated over a three year holding period for three of these stocks which have positive earnings. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) Giving these buy recommendations the benefit of the doubt, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock:

3 Years Growth

Ticker

Cramer

g (past)

g (future)

Terminal P/E

Annualized Return

ALKS

Buy

198.8%

N/A

N/A

N/A

CMG

Buy

39.6%

22.4%

20.6

-6.3%

SBUX

Buy

17.1%

18.9%

18.9

-3.1%

LSI

Buy

-18.6%

16.4%

19.6

-4.7%

Click to enlarge

Even after incorporating optimistic earnings growth, these stocks are just too expensive.

Alternatively, HPQ, DE, and CMI were discovered as contrarian buy picks with attractive valuations by sifting through the week's sell recommendations. These contrarian buy candidates were evaluated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratio, that is, price paid today divided by earnings at the end of the holding period for each stock:

3 Years Growth

Ticker

Cramer

g (past)

g (future)

Terminal P/E

Annualized Return

HPQ

Sell

8.9%

4.8%

7.1

12.8%

DE

Sell

16.6%

10.9%

8.6

5.9%

CMI

Sell

21.9%

15.2%

6.8

14.0%

Click to enlarge

The attractive valuations of these stocks protect investors from tough scenarios, providing them with better odds for positive returns.

These projected returns ignore stories and current sentiment while using valuation and math to demonstrate how buying expensive stocks can cost investors dearly. They flip the script on these seven stock calls.

Read the article disclaimer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.