Chasing headlines — buying and selling shares based on company, industry, or market news — is a strategy that many investors successfully employed when stocks were flying high. But in today’s uncertain climate, going under the radar can also reap rewards. Often referred to as sleeper stocks, these downtrodden or overlooked shares can lead to solid returns.
Any stock that is not in the limelight or has fallen out of favor with the investment community and yet has solid fundamentals is a good sleeper candidate. “After the bubble burst for large-cap companies in 2000, smaller companies started to shine,” says John W. Rogers Jr., founder, chairman, and CEO of Ariel Capital Management L.L.C. in Chicago (No. 2 on the BE ASSET MANAGERS list with $19.36 billion in assets under management). “They had been neglected for so long and were so cheap that there was nowhere to go but up.”
One investor who has awakened to sleeper stocks is Andrea Hardy, an IT team leader with a healthcare company in Indianapolis. In 1999, she bought shares of her former employer, ITT Educational Services (NYSE: ESI), a provider of technology-oriented, postsecondary degree programs, since she felt there was a market for the company’s services. Since then, the stock price has gone from around $10 a share to $67. “I’m holding on,” says Hardy. “If the economy slows down next year, which is a possibility, people will go back and retool [their career strategy] by getting more education, so the company should do well.”
Why look at sleepers? For starters, some of these unsung stocks have had impressive returns. Take medical robotics manufacturer Intuitive Surgical (Nasdaq: ISRG). If you purchased this stock in January 2005, you would have nearly tripled your investment before the end of that year. The shares soared as hospitals continued to adopt technology needed to perform minimally invasive surgeries. Then there’s aQuantive (Nasdaq: AQNT), a digital marketing company that gained more than 180% as the stock rode the wave of online advertising.
Some of this year’s sleeper hits include Ambassadors International (NASDAQ: AMIE), which is up some 122% so far in 2006. Shares of the travel event management company did not take off until the announcement of two acquisitions within its industry. Systemax (NYSE: SYX) is up 175% so far. A direct marketer of brand-name and private-label computer and industrial products, its share price has been steadily rising throughout the year as Systemax fixed accounting problems that had plagued the company.
DOWN, BUT NOT OUT
Though many sleeper candidates tend to be of the small- and mid-cap variety, large-cap stocks that have fallen out of favor can also fit the bill. Rogers favors CBS Corp. (NYSE: CBS), a recent spin-off of Viacom, and Black & Decker (NYSE: BDK), which has been devalued by 15% between May and September. “CBS is one of a number of media companies trading at very low prices, considering their fundamental value,” says Rogers. “Black & Decker seems very cheap because the market has overreacted to the possible impact of a weaker housing market on sales of power tools.”
There’s no shortage of sleeping giants ready to awaken. McCormick & Schmick’s (NASDAQ: MSSR) is a seafood chain whose stock, as of this writing, is down from $28 to $22. However, the company has excellent management, according to Jennifer Milan, vice president of equity research at Ryan Beck & Co., an investment banking firm in Florham Park, New Jersey. Milan’s target price for the stock is $31, which would be a gain of around 40%.
Another is eDiets.com (NASDAQ: DIET), which will introduce a prepaid meal service, shipping a week’s worth of portion-controlled meals to customers. Scott Van Winkle, a managing director at Canaccord Adams, a financial services firm in Boston, says the stock, now languishing around $3, could get back above $8 — a 266% gain. (For disclosure purposes, Van Winkle notes that eDiets.com is an investment banking client of Canaccord Adams.)
So what other sleepers are ready to be roused in 2007? John Buckingham, manager of the Al Frank Fund (VALUX), suggests that investors look at Lenox Group (NYSE: LNX), formerly known as Department 56, which sells tableware, giftware, and collectibles. “The company is still integrating last year’s acquisition of glassware maker Lenox, and the share price has suffered,” he says. Currently trading at under $6 (it was over $14 in May), Buckingham’s target price is $10 by the end of 2007 — which would be an increase of more than 75% — if management’s profit expectations are met.
Buckingham says American Science & Engineering (NASDAQ: ASEI) may be a good fit for those interested in inspection systems. The X-ray inspection systems company just landed a potentially lucrative contract from the U.S. Department of Homeland Security for cargo inspection systems focusing on nuclear detection; another new federal contract covers its mobile X-ray detection and inspection vans for port security. Prior to those deals, the stock suffered a drop from $93 to $47. “Our one-year price target would be $65, with $75 not out of the question by the end of 2007,” says Buckingham. Thus, the one-year gain could be as much as 60%.
Buckingham is also bullish on PortalPlayer (NASDAQ: PLAY), a semiconductor maker for portable electronics. He says its new Preface technology, which enhances applications for notebook computers, has great promise, even though the share price is down considerably this year. “I wouldn’t be surprised to see the company trade at $18 in 2007, a 50% advance from current levels,” Buckingham says.
Ryan Crane, chief investment officer and senior portfolio manager of Stephens Investment Management Group in Houston, is bullish on video game retailer GameStop (NYSE: GME), which merged with Electronics Boutique in 2005 to bring the corporate total to more than 4,000 locations. Crane says GameStop could trade at $60 or higher sometime in the next year. It currently has a price of $47. Among Crane’s other picks is Hologic (NASDAQ: HOLX), the leader in digital mammography systems. “Only 10% of the market has converted to digital,” he says, “so there is plenty of growth ahead.” Hologic also provides software to analyze the images and tools to perform minimally invasive biopsies. Crane says the stock, which had fallen from $56 to $47 at the time of this writing, has as much as a 40% upside, which could send the price over $60 in 2007.
Crane expects Tetra Technologies (NYSE: TTI), another stock that has fallen out of favor, to turn around. The stock slid from $32 to $22 with the drop in oil prices. Two of its three divisions are tied to oil and gas exploration and production while the third provides well abandonment and decommissioning services, which are in great demand after last year’s hurricane season. Crane says the company’s earnings could grow 30% and the stock could gain 33%. Intermec (NYSE: IN) is another one of Crane’s picks. The company focuses on radio frequency identification, which is similar to bar codes but allows tagged items to be scanned at a much faster rate while generating more information. Wal-Mart is an early adopter. “As the market materializes,” says Crane, “Intermec’s profitability will increase, and I expect the stock price to exceed its former highs sometime in the next 12 months.” If Intermec, now selling around $26, gets back to $39, that would be a 50% gain.
After a long spurt, oil prices backed off a bit in late 2006, driving down stocks in the energy sector. At some companies, the sell-off might have gone too far. Ensco International (NYSE: ESV), for example, which provides offshore drilling services, is down more than 25% from its April 2006 highs because of weakness in oil and gas prices, according to Jerry Jordan, manager of Jordan Oppor
tunity Fund (JORDX). “In 1997, ESV was a $40 sto
ck with peak earnings of $2.25 per share and crude oil at $22 a barrel,” he says. “Now it’s still a $40 stock, with peak earnings of $8 to $10 and crude oil at $60.” Jordan puts a target price of $60 on the stock, about 50% higher than the current level.
HIDDEN GEMS
If you’re reluctant to select
S. Lamont Turner, 59, a retired postal worker in Baltimore, is one investor who prefers the mutual fund approach to buying these low-flying stocks. He and his wife, Diane, have a balanced portfolio of funds with an allocation of about 20% to mid-cap funds. “Medium-sized companies want to be like the big ones, so they’ll take more risks and they can generate more revenues quicker than large companies can.” His holdings in that category are Hartford Midcap A (HFMCX), which has returned 15% a year for the last three years, and Hotchkis and Wiley Mid-Cap Value I (HWMIX), which has returned 20% per year.
“Lamont has a managed account, meaning that professionals choose the funds that suit his risk tolerance and time horizon,” says Turner’s financial adviser, James Johnson, in the Baltimore office of Raymond James Financial. “He was in large caps before but our model has him in mid caps, too, so he has more balance. Unless you want to do a lot of research yourself, you’re probably better off investing in mid caps and small caps through mutual funds.”
The bottom line is, the right mix of sleeper stocks early in the year could rouse even the sleepiest of portfolios.
John Rogers’ Sleeper Picks
When John W. Rogers Jr., Ariel Capital’s founder, chairman, and CEO, and John Miller, a senior vice president of Ariel’s portfolio management team, look at stocks, one critical number is the discount to private market value. That number refers to the difference between the current per-share price and what a sophisticated buyer would pay for the entire company. A steep discount could signal an even steeper profit potential. For example, if a $40 stock would bring $80 per share from an acquirer, it’s selling at a 50% discount: $40 less than the $80 per-share target price. Such a stock has the potential for a 100% gain, from $40 to $80.
For 2007, Rogers and Miller believe there are some real opportunities in the media and real estate space. According to Rogers, recent interest in the Internet has hurt publishing and advertising-related stocks. “The market fears
media-related stocks will lose ground to new competition. We think these companies will do better than expected in this new environment.” Rogers and Miller realize that the housing market has peaked but feel that fears of a bust are overblown, so some stocks connected to real estate are selling at bargain prices:McClatchy Co. (NYSE: MNI), publisher of daily newspapers including the Minneapolis Star Tribune, The Miami Herald, The Sacramento Bee, Fort Worth Star-Telegram, and The Wichita Eagle, borrowed money to acquire Knight-Ridder and some of its under-managed properties, Miller says. Better management will likely produce more free cash flow and allow the company to pay down debt. Recently selling around $42, down from $66 in late 2005, the company trades at a 40% discount to private market value.
Lee Enterprises (NYSE: LEE) publishes 51 daily newspapers and more than 300 weekly newspapers, mainly in midsized markets such as Napa, California; Bloomington, Illinois; and Madison, Wisconsin. Like McClatchy, it has taken on debt to make acquisitions, pressuring the stock price from $41 to $25, but Lee’s new strategy should pay off in 2007. The estimated discount is also 40%.
Journal Register Co. (NYSE: JRC) focuses its publishing in the Northeast and Midwest. The company is attracting private equity interest, indicating that sophisticated investors think the stock is cheap at under $6, down from almost $17 a year ago. The discount here is put at 50%.
Valassis Communications (NYSE: VCI), a marketing services company, is a pioneer of the Sunday newspaper coupon booklet. A proposed acquisition of ADVO drew the market’s disfavor and the stock dropped from $24 to $18 since early July. If Valassis can get out of the deal (the dispute is in court), the stock price could go back up. It’s trading at an approximate 40% discount to Rogers’ private market value estimate.
Mohawk Industries Inc. (NYSE: MHK) manufactures carpets, rugs, and floor tiles. “The market thinks slower home sales will hurt this company,” says Rogers, “but you don’t need to buy a new home to buy new carpeting.” Falling oil prices will help profits because raw materials include petroleum. Current discount to private market value: 40%.
Realogy Corp. (NYSE: H) was spun off by parent company Cendant in July and now holds real estate franchises like Century 21, Coldwell Banker, and ERA. Spin-offs often sell down initially because investors unload the new shares they’re issued. The stock now looks oversold, at a 25% discount to estimated value.
Steelcase Inc. (NYSE: SCS) makes office furniture, which is likely to continue to be in demand even if housing sales continue to fall. The stock sells at an estimated 30% discount, signaling the chance for real profits.