How to Catch a Falling Knife

 | Aug 27, 2012 | 10:00 AM EDT
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As I write this, my place in Miami is being buffeted by 30 mph winds and steady rains -- courtesy of Hurricane Isaac, which is passing to the west. The weather has been dreadful this weekend and my golden retriever has cabin fever at this point, but tomorrow should bring a beautiful sunny day. As a contrarian investor, I find this a useful analogy about a lucrative strategy I use to pick up out-of-favor equities whose stock prices have fell drastically, but which also have sunnier days ahead.

The trick to this sort of investing is avoid firms that have a broken business model, such as Dell (DELL), or have had their market share permanently lost to nimbler competitors, for example, Research In Motion (RIMM). When I want to make these sorts of cyclical bets, I look for three things besides cheap valuations. (A) I want the company's revenues to be still growing as it is easier to address poor margins than a contracting market space. (B) I find it helpful if the beaten down shares have some sort of technical support at the current price level. (C) Most importantly, I want to see recent insider buying in the shares. When I am researching stocks, I am always amazed by how many stocks I find that have had big moves after long declines, which have insider buying near the nadir of their descent.

Here are two stocks that currently meet all of these criteria.

Olympic Steel (ZEUS) is a manufacturer and distributor of metal products (excluding metal tubing and pipes) in the U.S.

Four reasons ZEUS is a solid value pick at just under $16 a share:

  1. Insiders have been active buyers since November of last year. They have bought approximately $1.5 million worth of new shares in myriad transactions over this time period. All purchases have been made at higher levels than the current stock price.
  2. Despite the steep decline in its stock price starting in the second quarter, the company is still growing. Analysts expect 15% revenue growth this year and a sales increase in the high single digits in fiscal 2013.
  3. The stock is cheap at just 58% of book value and less than 7x forward earnings, a deep discount to its five-year average (17.3). The median price target of the five analysts who cover the stock is $32 a share, which is double its current price.
  4. The stock looks like it has solid long-term technical support at these levels (see the chart below).
Olympic Steel (ZEUS)
Source: Yahoo! Finance

ACCO Brands (ACCO) manufactures and distributes office products primarily in the United States, Australia, the U.K. and Canada.

Four reasons ACCO is significantly undervalued at under $7 a share:

  1. Insiders started to step in and buy the shares in second week of August. Numerous insiders have added new shares over the past week totaling over $400k in purchases.
  2. The five analysts that cover the stock have a $12 median price target on ACCO. Targets range from $11 to $14 a share. Revenues should increase almost 50% this year as a result of a merger with a competitor.
  3. The company has beat earnings estimates five of the last six quarters and is trading at just over 6x forward earnings, a discount to its five year average (9.9).
  4. The stock looks like it is trying to put in a short term bottom here (see the chart below).
ACCO Brands (ACCO)
Source: Yahoo! Finance



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