Time To Dumpster Dive? Not Yet!

by: Alan Brochstein, CFA

If you are like me, you like to buy low. If you are like me, you often resist that urge. Buying low often means you have to be right and the crowd has to be wrong, which can happen, but that's typically the exception. You don't want to bet on the candle maker beating the light bulb manufacturer.

I contribute enough to Seeking Alpha to know that if I title my article something about "dumpsters", "bottom-fishing", "half-off" or "extremely oversold", I get a lot more attention than if I highlight "quiet break-outs". Similarly, high-momentum stocks (let's call them "rockets") attract a whole different class of readers. What's popular, in this case bottom-fishing, doesn't mean it's right.

I tend to focus on finding stocks that are not so extreme for an entry, perhaps showing early momentum. That's not to say that I don't sometimes make an exception. While I typically will not add a high-flier to any model I manage unless it corrects, I will sometimes bottom-feed. I shared my views on one such stock this summer: Mako Surgical (NASDAQ:MAKO). I ended up adding a small position to my Top 20 Model Portfolio almost a month later near 13 (and selling in September above 18 - we are long again now).

While it's typically the exception for me to grab what many call a "falling knife", there is one time of the year where I think bottom-fishing makes a lot of sense: Near year-end. Why? The crowd is selling for reasons other than information: Window-dressing and tax-loss harvesting. The latter is obvious, as it's smart to sell losers to reduce the tax impact of gains previously realized. This year, maybe carrying those losses into the regime of likely higher future tax-rates could actually minimize that impact. Still, stocks are up, suggesting that there are gains to offset. Window-dressing refers to the idea that pros typically don't want their mistakes sitting on year-end statements, so they sell their losers.

Defining year-end is tricky. We are all familiar with 12/31, but it escapes many that a lot of mutual funds have a 10/31 fiscal year-end. Well, 10/31 happens to be right in the middle of earnings season. Not only is it earnings season, which adds volatility every three months, but the Q3 reports often include a first look at the outlook for the following year. I'll get back to this point, but this is why it's important not to be early in going against the crowd. This year's elections could also have a role to play in the timing of the sales of "losers".

What used to be a "January Effect", which is the notion of smaller stocks doing well in January after they recover from tax-loss selling and perhaps an increase in risk-tolerance, sometimes happens in December, so this really begs the question: When is the best time to bottom-fish for the year-end effect? If you wait until Christmas, you might find out that the Thanksgiving Day sales were the best bargains.

So, my recommendation is to hold off, for now, on buying underperformers. There is a certain popular talk show host who anointed ten stocks to buy now (or on a dip, whichever proves to have ultimately offered the best possible entry in hindsight) because of the positive window-dressing spin. I actually think that from a trading perspective, this guy (let's call him "Jim") may be right. I shared a slightly different angle than buying stocks that are up 50-100%, suggesting buying what I called "healthy laggards". I followed up with "11 More Healthy Laggards to Consider". For you contrarians out there, almost no one bothered to read the article (illustrating my previous point about people focusing on the extremely oversold or the best performers).

Now is the time to start the research process and not to pull the trigger unless the stock moves so extremely in response to bad news that it is a compelling entry. Even then, keep in mind that selling can persist, but these earnings season disasters might move to the front of the line.

The time to pull the trigger more broadly on this theme? There is no precise date. In my view, it could be as early as 11/12 and as late as mid-December. Last year, with limited losses to harvest due to the overall market being flat for the year, we had a more traditional "January Effect" in January. This year, it could be earlier, like 2010. 11/12 marks the first Monday after earnings season is over, when the pros are able to come up for air. The election will be over too. This is four weeks away, so it gives plenty of time to research some of the "losers".

When I am trying to find candidates for the year-end/next-year bounce (or, better, for long-term entry), I like to focus on companies with good balance sheets and that are profitable. Another thing I like to do is find at least some short-term momentum, especially relative to the market but also absolute. If a stock is going to go up a lot, it first has to go up a little. Let someone else take the chance on buying the low print!

While there isn't a definitive way to go about bottom-fishing at year-end, this screen (using Baseline) should help illustrate the point:

  • Russell 3000 member
  • Net Debt to Capital < 20% (Note: This is overly restrictive for some sectors, like Utilities)
  • Projected to be profitable in 2012 and 2013
  • YTD price return < -20%
  • 3-month price return < -10% (15% worse than market)

This resulted in 72 names (about 2.4% of the R3000). To reduce the list to a more manageable number of stocks to potentially evaluate, I put in a requirement that the stock have a price above 5 and a $300mm market-cap. Here are the stocks that made the cut:

Please keep in mind that these are not recommendations. I have sorted the list from low forward PE to high. To the far right, I have highlighted those stocks with short-interest greater than 15% of the float. There are two schools of thought here. On the one hand, if they are heavily shorted, it may be a red flag. On the other hand, it could be a signal that the market has moved to excessively towards pessimism. In any event, I include it, because it's to understand the dynamics behind a very high short-interest.

I shaded four stocks showing near-term price momentum (beating the S&P 500 over the past month). As we get closer to the time-frame I shared (and beyond it), this becomes more important to monitor in my view. For now, stocks that are very negative could be the opportunity, but over time, those moving to modestly positive near-term price momentum will attract my focus.

I shaded five stocks in orange that are on my watchlist, including three in one or more of my model portfolios, and I am happy to share my quick thoughts on those. Hitting them in order, I would be careful with EZCorp (NASDAQ:EZPW) for now. Their recent 8-K filing appeared ominous to me, suggesting a one-time item potentially hurting them in their fiscal Q4 but also a likely challenged outlook for FY13. The stock is very inexpensive and sitting near support of 18, so I think that it deserves attention when they report in November (no date scheduled yet).

Super Micro (NASDAQ:SMCI) pre-announced negatively, doing alright on the top-line but continuing to struggle on margins due to challenging HDD pricing (they locked in at a bad price). This is one that I think is very oversold, but the news is now out (unlike EZPW). It is looking like a year-end steal potentially, one I am actually willing to buy now (added this week). Of course, I added at higher prices too, so caveat emptor.

AVX (NYSE:AVX) is very inexpensive, trading slightly below tangible book value. I don't have any reason to think that this one will perform in the very near-term, but it certainly falls into the category of worthy of further consideration. I have owned it most of the year in one of my models - ouch. Fellow contributor Vince Martin just shared an excellent summary of the removal of an overhang.

Carbo Ceramics (NYSE:CRR) is one that has really disappointed all year. I got involved and uninvolved during the year and have a negative fundamental outlook for the company (high-end proppants face diminishing demand except for a few situations) . With that said, it is very heavily shorted, so it could turn out to be a good trade, especially if one can buy it on bad news (if it plays out that way).

Clean Harbors (NYSE:CLH) has performed poorly since the analysts disagreed with the company. After a tough Q2, the company maintained full year guidance, but the estimates fell nonetheless. I added this one to one of my model portfolios very recently. I think it is a very high-quality company experiencing temporary challenges that encouraged profit-taking. While it's down a lot in 2012, it's up sharply over the past two years, beating the S&P by 15%. It's valuation of 8X EV/EBITDA doesn't reflect the uniqueness of the company's capabilities with hazardous waste or its specialty industrial services.

As far as the rest of the list, a few that jump out at me are Gentex (NASDAQ:GNTX), which has been hammered after legislation to require rear camera displays was delayed, and Staples (NASDAQ:SPLS). I guess as long as we are on the Consumer Discretionary sector, Express (NYSE:EXPR) caught my attention when it was slammed earlier this month.

I think that we will see an early end to tax-loss selling and window-dressing this year, most likely between 11/12 and Thanksgiving (similar to 2010). Now is the time to begin assembling a list of potential buys, but it's too early to pull the trigger in most cases. Earnings season disappointments could induce further selling of losing stocks. When the losers start to show some near-term positive relative price performance, perhaps one-month, as I suggested, but also perhaps over a shorter period, it could be a sign that the worst is over. This is the time of year when I am more comfortable suggesting that one man's garbage is another man's treasure.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long AVX, CLH, MAKO and SMCI in one or more model portofolios at InvestByModel.com