Ugly Stocks That Could Produce Pretty Returns

 | Aug 30, 2011 | 2:30 PM EDT
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Yesterday on the heels of a 2%-plus market advance, it appeared as if a certain market truism was proven correct, yet again. The truism goes something like this: "If you can invest in battered down stocks trading at 'left-to-die' prices amid market turmoil, then you stand a good chance of significantly outperforming the market."

Amid the market advance yesterday, Central European Distribution Corp (CEDC) exemplified this truism. CEDC -- a business I recommended recently because its price had fallen off a cliff due to apparently temporary issues -- surged by nearly 50%. CEDC is not a small, hidden stock: Prior to the 50% climb, the company boasted a market cap of over $300 million and traded more than 2 million shares daily.

However, I have caveats to this market truism, and they are that the business have quality characteristics since I am after value, not value traps. CEDC was highly levered and dealing with a tough market in Poland and Russia, but the company boasted top market shares, an intriguing optionality.

More so, the stock was trading at $6 with earnings-per-share (EPS) expectations for the current year of $0.80. In 2007, EPS was $1.91, and the stock trade for as high as $61. So, what happened? Mark Kaufman, an investor in the beverage industry, announced that he had amassed a 9.6% stake in CEDC. Thanks to the news and a stock price that was trading at less than one-third book value, the shares shot up like an uncoiled spring.

In playing on this theme, I looked for businesses that are being left for dead, but have attractive business qualities in the hope that the combination of these two factors could lead to a significant share surge. It helps of course to have a favorable push from the markets. With valuations decent again, the onset of an election year and investors like Buffett who think that a recovery may occur sooner than the Federal Reserve anticipates, markets could be friendly from current levels.

Frontline (FRO) is the world's biggest oil tanker operator and is currently in the midst of one of the worst shipping environments, due to a glut of new ships that arrived before the 2008 financial crisis. The company recently announced a $33 million loss in the second quarter, and guidance pointed to poor conditions continuing. Yet, this forecast came at the same time that Wilbur Ross, noted for his success in investing in distressed assets, announced a plan to buy 30 oil tankers. Until shipping rates improve, operations will struggle. Shipping rates are affected by oil consumption and the price of oil. FRO shares trade for $7, down from above $70 in 2008.

Discount retailer Stein Mart (SMRT) trades for $7, has no debt and more than $2 per share in cash. With traditional retailers offering discounts of their own, the competition is heightening. But, SMRT looks cheap trading at 7x earnings, and it generates solid cash flow. These characteristics could lead to upside levers, such as a special dividend, activist initiatives or acquisition.

Cooper Tire and Rubber (CTB) is the ninth-largest tire maker in the world. High raw material costs have pressured the bottom line. Shares now trade for $12, down from $27. Still the company's revised expectations are for 2011 EPS of above $2. It's likely that cost pressures will still remain an issue for the rest of 2011, and cash-strapped consumers can delay replacing tires -- but only for so long. As such, Cooper holds a degree of pricing power. It trades for 6x times earnings.

When you buy an asset that no one likes or because the consensus is that the business is no longer viable, you are likely going to be a very "cheap" price. If it turns out that the business is viable after all, however, chances are your upside will be anything but ordinary.


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