Focus List Update: 'Low-Quality' Stocks Continue to Surge

by: Stephen Castellano

"Low-Quality" Stocks Continue Their Run as Hard Data Lags Real-Time Improvements
For some time now, we have been explaining how low-quality stocks have been surging to double-digit percentage gains over the last few months. The surge in Allscripts-Misys Healthcare Solutions Inc. (NASDAQ:MDRX) is a recent case in point. MGM Mirage (NYSE:MGM) and Harley Davidson (NYSE:HOG) are some others we have pointed to recently. Plenty of other stocks on our "low-quality" lists have been surging as well, and we think more could be on the way.

It seems that many investors are continuing to ignore improving company fundamentals and increasingly large cash positions, while instead choosing to focus on grander thematic issues such as the 16% "underemployed" rate, a pending withdrawal of economic stimulus, our country's huge debt levels, the possibility of sovereign debt defaults and more generally the inevitable declining dominance of the U.S. in the global economic system. To these investors, the market is "wild", "random" and "stupid." There is no let-up in their fear-mongering as many stocks continue to make double-digit gains.

The latest negative article we have seen from the mainstream media is from Kevin Drum of Mother Jones. Another recent negative slant is provided by Mark Hulbert on Market Watch while quoting Jeremy Grantham of GMO. Reading them, there sure seems to be a lot of dumb but richer investors out there.

"Luckily" for us, we have no vested position in the market moving up or down. We have developed model portfolio strategies that in theory and on average should generate a return whichever way the market is moving. Perhaps because of our more "objective" view, we have developed a grand unified economic theory of our own: "The market doesn't care." That is, the market does not care about negative economic themes. The only thing that matters is cash flow generating and return on invested capital, and this is a theme that keeps gaining momentum. If the market ever does choose to "care" about grander economic themes, we will rely upon our proprietary long/short weighting indicator to guide us in the right direction.

A case in point as to what is working right now is our aggressive model portfolio, now up about 16% for the YTD and 600%+ since its back tested "inception" 5+ years ago - because it has no short positions against "low-quality" stocks when the market is appreciating and is instead fully levered on returns in high-quality stocks. Once this theme plays out this portfolio is practically guaranteed to experience a short-term double-digit loss as the long/short indicator takes time to adjust. Though once adjusted, significant returns could resume through the next extended period. We are discussing this strategy with thrill-seeking friends, royal families and institutions and hope to have it actually deployed soon. For the more prudent, we have other strategies available that are working well enough, but simply do not make for good headline copy right now.

Maybe AMR, POM, GRP, TRMB and ILMN could be the Next Double-Digit "Better-Quality" Gainers
From an individual stock picking level, investors may want to focus on "low-quality" stocks that may be facing easy comparisons. That is, we want to find more stocks like MDRX. We still have not found the time to look at these stocks in detail, but we list them here for others that do.

For example, we have mentioned TOL as one possibility. But perhaps some better candidates could be companies like AMR Corporation (AMR), Pepco Holdings (NYSE:POM), Gen-Probe (NASDAQ:GPRO) and Trimble Navigation Limited (NASDAQ:TRMB) could show better potential. All four have experienced positive analyst revisions significant enough to move it off of our "low-quality" lists. Perhaps improved hard-data fundamentals and stock prices could follow.

In addition, we also would like to compare the specific rankings of MDRX to other companies and see if we can come up with any matching quant ranking profiles. We have already done so in the Healthcare Sector, and one company did show similar fundamental traits: Illumina (NASDAQ:ILMN). For investors seeking less risk versus reward, we point them to our "high-quality" ideas for the week that we mention below.

New "High-Quality" Stocks Return 3.56% for the Week Ended April 9, 2010
New "high-quality" stocks on our weekly list returned 3.56% on average for the week ending April 9. Additional factors placed UGP and PAAS on our "focus list", and together these two returned 2.66%. The S&P 500 (ex dividends) returned 1.38% for the week.

New "Low-Quality" Stocks Return 3.20% for the Week Ended April 9, 2010
New "low-quality" stocks on our weekly list returned 3.20% for the week. The three focus list stocks on the low quality list - TOL, CHU and EQT returned 3.89%.

About the lists
These ideas are generated in a similar way to the Ascendere Long/Short Model Portfolio, which rebalances roughly 80-100 stocks on a monthly basis. Unlike our monthly model portfolio, we have not backtested the factors in our weekly focus list, but we would not be sharing these ideas unless we thought they could show some promise. At the same time, the higher frequency may simply be introducing noise to the process.

Perhaps one way to cut through the noise is to compare these weekly lists with lists from other sources. For example, a number of the stocks on these weekly updates have appeared on Goldman Sachs' Conviction Lists a few days or weeks later. We note that some of the best names on this list have preempted a number of sell side upgrades, as described in our "Nostradamus" report, and such stocks seem to show the most promise.

New Stocks for the week ending April 16, 2010
As of the close of April 9, 2010, there are nine new "high-quality" stock ideas, five of which make our focus list. There are also 13 new "low-quality" stocks, including two focus list ideas.

New "high-quality" ideas for the week include Gap Inc. (NYSE:GPS), CarMax Inc (NYSE:KMX), Bed Bath & Beyond, Inc (NASDAQ:BBBY), Regal Entertainment Group (NYSE:RGC), Panera Bread Co. (NASDAQ:PNRA), Del Monte Foods Co. (DLM), Ares Capital Corporation (NASDAQ:ARCC), Berkshire Hathaway Inc. (NYSE:BRK.B) and Micron Technology Inc. (NASDAQ:MU). Of these, KMX, RGC, ARCC, BRK.B and MU make our focus list.

New "low-quality" ideas for the week include Sony Corp. (NYSE:SNE), Magna International (NYSE:MGA), Central European Distribution Co. (NASDAQ:CEDC), Enerplus Resource Fund (NYSE:ERF), Brookfield Asset Management (NYSE:BAM), Host Hotels & Resorts, Inc. (NYSE:HST), Camden Property Trust (NYSE:CPT), InterMune Inc. (NASDAQ:ITMN), Huntsman Corporation (NYSE:HUN), Mosaic Co. (NYSE:MOS), AK Steel (NYSE:AKS), Alcoa (NYSE:AA) and AngloGold Ashanti Ltd. (NYSE:AU). Of these, only BAM and CPT make our focus list.

We are loathe to share highlight Material stocks like AKS, AA, MOS and AU as "low-quality" short ideas; in fact, during an economic recovery these stocks will show the best gains, and many of them have been doing so in recent months. For the sake of consistency as it relates to our model portfolios, we are sharing this list. To avoid "obvious" contrarian long positions such as these, we created the Aggressive Long/Short Model Portfolio, which we mentioned above.

A PDF of this report is available here.

Risks and Disclaimers
Investing in stocks include a high degree of risk, including the risk of total loss. We are not soliciting the sale of any security. We do our best to provide relatively and accurate data and analysis, but make no guarantee.





"High-Quality" Stocks Off the "Buy List"

"Low-Quality Stocks Off the" Sell List"

Disclosure: None

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