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Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.

This little-known quote is credited to John Templeton. Sir John Templeton was a legendary investor who used a contrarian approach to investing. Templeton took contrarian investing to the extreme. Templeton stated contrarian investing wasn't simply investing against the grain but buying into companies hitting rock bottom or what he called "points of maximum pessimism."

A contrarian believes that certain crowd behavior among investors can lead to exploitable opportunities. Pervasive cynicism about a stock or sector can drive the price so low that it exaggerates the investment's perils and belittles its future prospects. Identifying and seizing on these opportunities is a well-known investing tactic utilized by many legendary investing experts.

We are in the midst of a sell off based on macroeconomic and geopolitical issues. Often, this is precisely the time to pick up shares in out of favor stocks. Some of these stocks have very positive fundamentals and just recently beat analysts' earnings estimates and soared higher while others have missed and been severely punished.

In the following sections, we will take a closer look at these stocks to determine if the moves are justified. We will perform a brief review of the fundamental and technical state of each company. Additionally, we will attempt to discern if any upside potential exists based on sector, industry or company specific catalyst. The following table depicts summary statistics and Thursday's performance for the stocks.

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Brocade Communications Systems, Inc. (BRCD)

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Brocade is trading below its 52 week high and consensus estimates. The company is trading 22% below its 52 week high and has 25% potential upside based on the analysts' consensus mean target price of $6.01 for the company. Brocade was trading Thursday at $4.83, up almost 2% for the day.

Brocade has some fundamental positives. The company is trading for book value and has a forward P/E of $7.92. Brocade is trading for 5.34 times free cash flow. EPS is up 58% quarter over quarter.

One near term catalyst for the stock may be Brocade's plans to monetize part of its oversized San Jose campus which will strengthen its balance sheet. The stock has performed well since the start of June and recently broke above the 50 sma. I would buy the stock once it confirms the uptrend by breaching the 200 day sma.

One metric that is very telling is the fact that Brocade is trading for approximately five times free cash flow. This is a sign the stock is significantly undervalued. Most analysts consider a stock trading for 15 times free cash flow undervalued. The risk/reward equation appears favorable at present. The stock is a buy.

Frontier Communications Corporation (FTR)

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Frontier is trading well below its consensus estimates and its 52 week high. The company is trading 48% below its 52 week high and has 35% potential upside based on the analysts' consensus mean target price of $4.91 for the company. Frontier was trading Thursday at $3.63, up over 1% for the day.

Frontier has some fundamental positives. The company is trading at 82% of book value, 69% of sales and has a forward P/E of $16.32. Frontier pays a dividend with an 11.14% yield, although the payout ratio may mean the dividends are unsustainable.

I decided to put my money where my mouth is on this one and opened a position in FTR at $3.50 and recently took profits near the $4 mark. The sustainability of the dividend worries me. I would avoid FTR into earnings.

FTR reports earnings on July 31st. Analysts' average estimates predict Frontier Communications' revenues will shrink -5.8% and EPS will remain flat year over year. The average estimates for revenues and EPS are $1.25 and $0.06, respectively.

Sprint Nextel Corp. (S)

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Sprint blew away earnings Thursday morning and is up significantly. The company is still trading 23% below its 52 week high and has surpassed the analysts' consensus mean target price of $3.90 for the company. Earnings were just recently announced so analysts may be coming out with new estimates in the near future. Sprint was trading Thursday for $4.04, up almost 20% for the day.

Fundamentally, Sprint has some positives. Sprint is trading for slightly under book value and only 30% of sales. EPS next year is expected to rise by 28%. Insider ownership is up 45% over the past six months.

Though Sprint's Q2 report had its share of bad news, the carrier also raised its 2012 EBITDA guidance to $4.5B-$4.6B from a prior $3.7B-$3.9B. This information is being well-received by investors on edge about Sprint's cash flow. Sprint's iPhone sales were flat Q/Q while Verizon (NYSE:VZ) and AT&T (NYSE:T) posted sizable drops. Sprint platform postpaid net adds were up 68% Q/Q to 442K, and postpaid churn fell to 1.69% from a prior 2%. Sprint's efforts to promote unlimited data might finally be bearing fruit. Sprint is definitely a buy; nonetheless, you may want to wait for the stock to cool off a bit.

SUPERVALU Inc. (SVU)

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SVU is trading well below its consensus estimates and its 52 week high. The company is trading 77% below its 52 week high and has 149% potential upside based on the analysts' consensus mean target price of $5.00 for the company. SVU was trading Thursday for $1.92, up over 10% for the day.

Fundamentally, SVU has few positives. SVU is trading for only 10% of sales. The forward P/E is 2.37 and the stocks is trading for 1.57 times free cash flow. Insider ownership is up 39% over the past six months.

UBS recently upgraded the stock from Sell to Neutral on July 12th with a $4 price target. SVU, which had 47% of its float shorted as of July 13, remains extremely volatile. Shares took off Thursday after diving, as bulls hoping buyout talks pan out do battle with bears focusing on a heavy debt load and deteriorating fundamentals.

This is definitely a stock that fits into Templeton's definition of maximum pessimism. This would be a highly speculative buy. Nonetheless, I am intrigued by the stock at this level.

Zynga, Inc. (ZNGA)

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Zynga is trading well below its consensus estimates and its 52 week high. The company is trading 81% below its 52 week high and has 260% potential upside based on the analysts' consensus mean target price of $11.15 for the company. Zynga was trading Thursday for $3.18, down 38% for the day.

Fundamentally, Zynga has few positives. Year over year revenue is down. The company is losing money hand over fist. Zynga's net profit margin is -41.57. That means almost 1 out of every 2 dollars are lost.

As a stated in an earlier article, I would avoid Zynga like the plague. The company completely whiffed in regards to the latest earnings announcement and was crushed. This is a highly speculative company and stock. Some may see this as a buying opportunity, I do not. I would not short Zynga, but would avoid this stock at all costs.

Conclusion

Stocks trading for $5 or less tend to be more volatile with frequent, larger percentage moves in the stock price. This provides the opportunity for greater returns (or losses) relative to the market. When stocks are at the point of maximum pessimism it is extremely hard to pull the trigger and start a position. Study the fundamentals. Do your own due diligence and take your time. Sometimes stocks are down for good reason.

Use this information as a starting point for your own due diligence and research methods before determining whether or not to buy or sell a security. If you choose to start a position in any stock, I suggest layering in a quarter at a time on a weekly basis at a minimum to reduce risk and setting a 5% trailing stop loss order to minimize losses even further.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in S, SVU, BRCD over the next 72 hours.

Source: 5 Turnaround Plays Under $5 - Are They Zeros Or Heroes?