The Hunt for Ugly Ducklings

 | Oct 24, 2012 | 2:00 PM EDT
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When it comes to companies that were once ugly toads in the eyes of Mr. Market, only to transform into beautiful creatures, the stories are endless. For instance, it's to hard to imagine now, but 10 years ago Apple (AAPL) was widely viewed as a struggling, out-of-date computer company with products that were deemed obsolete.

I'm fairly certain I don't have any Apple-like toads to offer, but some companies today are very unattractive to Mr. Market, and they may soon find their way back into his good graces. As Warren Buffett likes to put it, pessimism is the friend of the value-seeking investor. Find me a great investment, and I'll bet the strongest returns came to those who bought when everyone else was selling.

One such name could be discount retailer Big Lots (BIG), which is wildly unattractive to the market today. This company's business -- selling overstock merchandise at ultra low prices -- is not a sexy or glamorous one. Today shares are trading around $27, which values the business at 9x forward earnings and less than 5x enterprise value by earnings before interest, taxes, depreciation and amortization (EV/EBITDA). In its peer group of ultra-discount retailers, Big Lots is cheapest of the bunch.

To be sure, Big Lots doesn't sell the fashion that TJX (TJX) TJ Maxx stores do, or daily necessities like Family Dollar (FDO). But Big Lots does generate cash, and lots of it. Over the past three years free cash flow has averaged at close to $300 million a year against market capitalization of $1.7 billion and EV of $1.9 billion. Take a clean balance sheet of a business that's generating healthy consistent cash flow, and put that business in a low-lending-rate environment, and you have a business ripe for a buyout -- in other words, share-price appreciation.

Turning to the fast-food space, in under 10 years McDonald's (MCD) shares have appreciated from $15 to nearly $90 due a strong re-imaging campaign that has included restaurant renovations, free Wi-Fi at its locations and, most important, a more diverse menu with lots of healthy options.

The laggard in the industry has been Wendy's (WEN) -- but, under new CEO Emil Brolick, Wendy's is undertaking a similar marketing campaign to that of McDonald's. The company is currently experimenting with a new store look, and has even come out with a new logo. Most important, the company is focused on positioning itself as the higher-quality fast food burger chain. Also note that activist investor and large shareholder Nelson Pelz sits on Wendy's board as nonexecutive chairman.

At $4.15, Wendy's shares are hovering near a 52-week low. Even more significant is that, for many years now, the stock has lagged not only the general stock market but also its fast-food peers amid lost focus as the company has shuffled between several CEOs. It appears Brolick is here to stay, and his strategy seems intelligent, considering that it has worked wonders for McDonald's.

A year ago, housing stocks were widely disregarded and shares were abandoned en masse. Now that sprouts of a housing recovery are taking root, virtually all housing-related stocks have climbed by 50% or more. Investors must tread carefully when dealing with ugly, hated securities. At the same time, these kinds of names can be coiled springs that will ultimately soar higher when the pessimism fades away.

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