Whacked-Out Stocks, Great Opportunities

We find ourselves in the midst of a ferocious bear market, a frightening recession, and a huge financial crisis. Amid all these fears, many stocks aren't trading on fundamentals; their prices instead reflect nothing but pessimism.

As illogical and daunting as it may sound, this can actually be a blessing -- and a guarantee of outsized long-term returns -- for smart, calm, diligent investors.

You're kidding, right?
I have been an Urban Outfitters (Nasdaq: URBN  ) shareholder for quite a few years now. I even held on to the stock through the turbulence that followed its serious fashion misstep in 2006. Urban Outfitters needed to coax droves of customers back through its doors, and it pulled off that feat with flying colors. Its stock recovered, surging to $38 a share at one point in the last year.

At my last check, Urban Outfitters shares now trade at about $15 per share, the level the stock hit in 2006, when the retailer was having real problems with its actual business. The stock's beaten down again now, but the problems with its business are nowhere in sight.

Urban Outfitters has done remarkably well this year despite the gloomy consumer spending environment, growing earnings 31% last quarter. Yet its shares have gotten whacked again. This time, however, they're simply getting spanked along with the broader market. (Admittedly, a line of legalese in its recently filed 10-Q apparently spooked investors a bit, too.)

With a price-to-earnings ratio of 12 -- insanely low, when you consider analysts expect 20% growth over the next five years -- Urban Outfitters is a good example of a stock whose fundamentals have gone out the window. Its share price more reflects pessimistic psychology than any realistic assessment of operational strength or growth. It's a quality stock that's been beaten down simply because it's part of a suffering industry, even though Urban Outfitters' actual performance has been an outlier in these terrible times.

For savvy investors, this type of situation spells opportunity.

Taken to the woodshed
Concerns about the financial crisis, the recession, and their effects on consumer spending are whacking stocks across the board. Check out just a few of the stocks that have hit new 52-week lows as of this writing:

Company

Stock price

52-week price change

P/E ratio

Dow Chemical (NYSE: DOW  )

$14.85

(66%)

5

Steelcase (NYSE: SCS  )

$4.43

(72%)

7

Take-Two Interactive (Nasdaq: TTWO  )

$7.30

(74%)

6

Activision Blizzard (Nasdaq: ATVI  )

$9.28

(52%)

7*

* Based on current-year earnings estimates. Data from Yahoo! Finance.

Severely beaten-down stocks are probably not unfamiliar to you; precipitous drops in stock prices and single-digit price-to-earnings ratios are common these days. Buy-and-hold investors know that such across-the-board drubbings create great opportunities to snap up bargains.

Of course, investors shouldn't be arbitrarily snapping up stocks just because they recently hit 52-week lows, although such lists are a good place to start coming up with ideas.

After all, we are in a dangerous economic climate, and some companies do face real risks to their businesses. Investors must tread carefully. For example, there are good reasons why Dow Chemical's stock got taken to the woodshed. Its joint venture with a state-owned Kuwaiti oil company fell through, leaving Dow holding the bag for financing its $15 billion acquisition of Rohm & Haas. For every month the company delays, it's fined another $100 million. Adding insult to injury, Moody's and Standard & Poor's also cut their credit ratings on Dow.

Opportunities abound when so much pessimism is at hand, but investors must choose their stocks with great discrimination.

A whacked-out but wise stock shopping list
My dream stocks these days, like Urban Outfitters, are great businesses with smart management teams, plenty of cash on their balance sheets, and little or no debt.

Two such names that come to mind are Apple (Nasdaq: AAPL  ) and Netflix (Nasdaq: NFLX  ) . Both have high-margin, growing businesses, superb balance sheets, and are led by dedicated and talented founders. (Well, assuming Apple CEO Steve Jobs returns from his recently announced six-month hiatus.) Not coincidentally, they're both recommendations of Fool co-founders David and Tom Gardner's Stock Advisor service, which is currently beating the market by 29 points.

To see what other stocks David and Tom are recommending today, simply click here for a free 30-day guest pass to Stock Advisor. (Through Tuesday, Stock Advisor is offering a special inauguration sale -- you can get a 12-month membership for $99, a more than 30% discount. Click here for full details.)

Nothing wacky about great opportunities
These are unquestionably scary times, but with the proverbial blood running in the streets, investors have a great opportunity to seek out high-quality stocks that will survive and thrive over the long haul. Making careful choices of stock prices that are fundamentally out of whack is a great way to build an excellent long-term portfolio.  

Alyce Lomax owns shares of Urban Outfitters. Activision Blizzard, Netflix, and Apple are Motley Fool Stock Advisor recommendations. Steelcase and Dow Chemical are former Motley Fool Income Investor picks. Take-Two Interactive is a Motley Fool Rule Breakers recommendation. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (80)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 25, 2009, at 7:49 AM, FRINEDOFFOXY wrote:

    Right on the money! I too have hung on to shares of URBAN, and added more at this level. This industry is all about fashion. You have you prosper and if you don't you struggle. Miss the fashion mark and you better recover quickly. Your ability to do that says

    more about your management than any other signal.

    URBAN recovered quickly from a fashion misstep, Buy em now and gloat about your eye for good stocks later.

  • Report this Comment On January 25, 2009, at 3:47 PM, VictorFL wrote:

    Urban Outfitters is spending almost all their cashflow from operations on capital expenditures. They mostly eat what they produce. Almost nothing left to the owners. Part of that "almost nothing" is eaten by equity dilution - about 1-3% a year.

    At $15.94 per share, the cap is $2.67B while book value is $1.02B. Due to recession the revenue may easily fall and push cashflow below capex. Lets not forget that the URBN future depends on swings in customer taste. Also, that their products belong to the category of "wants" (as opposed to "needs") - the consumer may live without buying brand apparel for years, while the company can't live without the consumer. Especially during recession. The company will probably survive such scenario, but it will take them years to justify the current market cap. If that happens, the cap will probably fall below book value, that's about 75% drop in share price.

    Several good things: no goodwill, no intangibles, good margins, sales rising at CAGR 25%+, no long-term debt, current assets almost twice as total liabilities - but an investor should not care about all that, if all the surplus cash will go to someone else's pocket or be eaten by the co for the sake of growth.

    The company is heavily investing in the middle of recession. It may be a good sign, but not necessarily. On the other hand, the product prices are quite low comparing to some other apparel retailers. So, maybe the recession will not have much effect on sales after all.

    BTW, comparing wildly swinging cashflow from operations to steadily rising earnings proves only that the company is playing the game of winks and nods with Wall Street analysts. With 88% institutional holdings, it's very likely that when something bad happens, the last to learn about that will be individual investors. In such case they will see a huge price drops (like the last one) happening for no apparent reason, and followed by (probably sponsored) articles about how "discounted" this stock is, and luring unaware investors while the big guys sell. Just like this article.

    In my opinion it's better to wait for at least several months to see how the company situation unfolds. There's too much risk right now, both market risk (general pessimism) and business risk (recession, slowing consumer spending, investing in the middle of recession, etc).

    Anyway, there are many more stocks currently trading under book value with almost same business qualities and huge potential. Why not focus our money there?

    Vic

    practical-investor.com

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