Inversion Appreciation

 | Apr 24, 2013 | 12:30 PM EDT
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For the past couple of days I have been considering stocks that are expected to have low or even negative total returns over the next few years. After reading financial writer Mark Hulbert's comments on the Value Line Appreciation Index being near five-year lows, I wanted to know which stocks were expected to underperform the stock market. It was a useful exercise and provided some idea of stocks to avoid until pricing becomes more reasonable. However, in keeping with Carl Jacobi's advice to "Invert, always invert," I decided to see which stocks the research service indicates might have the highest total return over the next three to five years.

I have used the list of highest potential total return for years to cherry pick cheap stocks and long shots. It is one of the first pages I check each week when the issue hits my desk. I have found some tremendous winners on the list over the years with a few huge turkeys in the mix. Stocks on this list tend to be fallen angels, turnaround and hopelessly out of favor. This time, rather than pick the low-hanging fruit on the list, I am just going to reveal the stocks with the highest projection of annualized returns with no underwriting or investigation applied.

The highest projected return selection is LSI Corp. (LSI) the chip and computer storage company. The company is in two of the most competitive segments of the technology sector and their competitors are a scary bunch as they go head to head with leaders like EMC (EMC) and IBM (IBM). The company has been hurt by macro factors such as the global economy and personal computer slowdown, but the turnaround potential when the economy improves is enormous. The company's new products give it a strong presence in important sectors like cloud computing and data centers, which could be a significant source of growth over the next five years. The company has no long-term debt and plenty of cash, so they should be able to survive through the slowdown and eventually thrive in a recovery. In a stronger economic recovery, the stock could easily triple over a three- to five-year horizon.

The second-highest total return potential belongs to Extreme Networks (EXTR), a provider of networking products and services. The company sells its switching solutions to Internet service providers, content providers and data centers and, like LSI, it is experiencing a slowdown due to global macro factors. The company has restructured and cut costs and the balance sheet is strong enough to withstand the downturn. There are also signs that business is recovering and its flagship BlackDiamond switch is gaining across most market segments. The company is using its cash and cash flow to buy back stock during the downturn, which provides price support for the shares. It will be a bumpy ride while waiting for a sustained global recovery, but this stock could triple or more over the next few years.

The stock with the third-highest price recovery potential as ranked by the research service appears to be the riskiest to me. I am bullish on the steel business and when it does recover, shares of AK Steel (AKS) could easily triple or more. The trick for this company may be lasting until the recovery takes hold. This company increased its debt load in the past year and issued more shares to shore up its cash position. It has more than a billion dollars of debt and earnings are not even covering the annual interest payments. There are signs of improvement in automotive, and lower material and energy costs are helping in the short run. The company outperformed analyst estimates in the most recent quarter but it was still a loss as sales and shipments continued to decline. Interestingly, the bond market seems confident the company will make it as its debt issued yield just around 10%, far less than a truly distressed credit might fetch. This is a classic "hero or zero" stock. If it survives until the steel market improves, you could see a return of four or five times your initial investment. There is a significant chance they don't make it, however, and in that case, you will almost certainly lose your capital.

I really have no clue what the markets or the economy will do in the short run, but over the next five years they should improve and these three stocks could give aggressive investors huge returns when business conditions improve.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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