Choosing Which Knives to Catch

 | Mar 07, 2013 | 3:00 PM EST  | Comments
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Stock quotes in this article:

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pwe

On Wednesday, I started the search for stocks that have lagged the market badly over the past year and may offer an opportunity in spite of the new highs in the DJIA. I came up with a list of 360 falling knives stocks that are down more than 50% in the past year, and then I started the process of winnowing the list to some investable candidates. The 33 stocks based in China went right out the window. Two were in Hong Kong and quickly joined their cousins in the garbage can. (I will not buy Chinese stocks under any circumstances.)

When I started applying various criteria to my list, candidates started flying out the window because the bulk of them are simply not investable at this time. When I applied the criteria for a perfect stock I found just a handful that are below book value, are profitable and pay a dividend. In this group, Penn West Petroleum (PWE) stands out as an interesting buying opportunity right now. The Canadian oil-and-gas companies have suffered from the price differential caused by lack of pipeline access. At some point, this is going to change and companies such as Penn West will get more favorable pricing.  The stock is down 50% over the last year, trades at 70% of tangible book and is currently yielding more than 10%.

When I remove the dividend requirement, I found some interesting stocks that are worth buying. On a price-to-book value basis, Electrobras (EBR), the Brazilian utility, is the cheapest stock in the world right now. In its effort to combat inflation and spur growth, the Brazilian government has restricted rates for utilities and the stocks have been battered. EBR trades at less than 20% of book value and has moved down 65% over the past year. The shares should recover -- along with the local economy -- with an assist from the 2014 World Cup and 2016 Olympics. It may be a bumpy ride, but I think patient buyers could see enormous returns form this stock.

One of my favorite oil-and-gas, exploration-and-production (E&P) companies makes the grade under this set of requirements. Swift Energy (SFY) is transitioning from traditional Gulf of Mexico oil-and-gas company to a player in the unconventional oil field business. The company has three rigs running in the Eagle Ford shale field in Texas and it has amassed about 78,000 acres in the region. The company missed estimates in the final quarter of the year and the shares have been punished. The stock is down 52% in the last year and fetches just 60% of tangible book value. The enterprise value (EV)/earnings before interest, taxes, depreciation and amortization (EBITDA) ratio is just 4.3 and I believe the stock belongs on the "too cheap not to own" list.

When I look at the falling knives with heavy insider buying, some interesting names pop up. After missing the positive expectations of Wall Street, Molycorp (MCP) has seen its shares pummeled. Trading at 1.8x tangible book value, the shares may not be cheap enough for me, but officers and beneficial owners have been aggressively buying the stock in recent weeks.

Insiders at coal miner Arch Coal (ACI) have been picking up shares, which are trading at around half of tangible book value. Arch is one of my favorite picks in the coal sector at the moment and although the near term appears bleak, coal demand will eventually level off domestically and begin to climb outside the U.S., particularly in emerging markets.

The current list of falling knives does not have too many "fallen angel" stocks among them. A lot of them are highly leveraged and have terrible long-term prospects. For example, Cliff Natural Resources (CLF) is very cheap on a price-to-book basis but it will probably experience more near-term weakness. Investors can start accumulating some of these beaten-down stocks, but need to follow the standard advice to stay small and move slow. The odds of being able to add more shares at lower prices look pretty high to me.

The list also has some longshot candidates. Although they may not fit traditional valuation parameters, they may offer eye-popping return potential -- if they do not fail entirely first. On Friday, I will look at some of the falling knives with the potential to be home runs for aggressive patient investors.

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