Get Ready for the Bounce

"Don't catch a falling knife," as the old saw commands. (Pardon my mixing a cutlery metaphor.) The idea of buying a former superstar stock at a discount price certainly has its attractions, but you've got to make sure you catch the haft -- not the blade. That's where Motley Fool CAPS comes in.

Today, we once again stand beneath Mr. Market's silverware drawer, measuring which knives have fallen the farthest. Then we'll call on CAPS to ask which of these stocks -- if any -- Foolish investors believe are ready for a rebound. Let's meet today's list of contenders, drawn from the latest "52-Week Lows" list at WSJ.com:

Companies are selected from the "New Highs & Lows" lists published on WSJ.com on Friday last week. 52-week high, recent price, and CAPS ratings from Motley Fool CAPS.

Pick your poison
Mr. Market has handed us a toxic trio of industries to choose from this week. Do you prefer to dabble in a finicky financial sector with Kearny, brave the perils of ObamaCare with athenahealth, or wade into the Gulf of Mexico muck that now stains the oil sector with Diamond Offshore?

Each stock has its fans. For example, alkamist81 picked Kearny to outperform way back in 2008, anticipating "the eventual rebound of the financial sector. A little early for bottom feeding, but I am just indiscriminately putting all stocks that are tagged S&L." It seemed a risky strategy at the time, but hasn't actually worked out too badly. While Kearny hasn't fared as well as bigger banks with more political backing, such as JPMorgan Chase (NYSE: JPM), it has managed to keep pace with the market rebound since alkamist81 picked it.

More recently, chowda1229 made the case in favor of athenahealth, arguing that "The deployment of EMR in physician practices comes down to a simple truth: Primary care physicians ... are cash poor. They simply do not have the time nor the resources ... to deploy and maintain a EMR 'network' in their offices.... the winning solution WILL BE web based...and the most cost effective, scalable and reliable solution on the market is Athena." (See in-office electronic medical records provider Quality Systems' (Nasdaq: QSII) Q4 report from Friday, which showed a pretty significant earnings miss.)

Elsewhere in CAPS, our 165,000 (and growing) members have weighed in. On average, they like chowda1229's pick better than alkamist81's idea. But the company that really gets them excited this week is ...

The bull case for Diamond Offshore
Will BP's bane be the end of offshore oil drilling, and Diamond Offshore in particular? Not according to All-Star investor ttboydxb, who predicts that "gulf of mexico will be just a small blip," and calls the company a "long term pick."

CAPS member Spiceman53 agrees, arguing: "The world is addicted to OIL. Nothing soon is going to replace it. Mid and deep water is where new discoveries will happen. That is what will make Diamond shine!"

And now, for your daily dose of irony, our third and final pitch in Diamond Offshore's favor -- dating from one week before the Deepwater Horizon disaster: On April 14, MarcD10 wrote: "Offshore drilling is cleaner, safer, and more efficient than ever before. Laws are changing and offshore drilling will be a predominant way in which we will supply our continued dependence on oil. Diamond Offshore is one of the biggest in that industry, with some deepest drill rigs, who will absolutely benefit from changes in legislation on offshore drilling."

Ahem
But even if the cleaner-safer-better hypothesis has been disproven, could it be that investors are overreacting to the crisis in the Gulf? Could there be value in capitalizing on that overreaction?

Perhaps. After all, at just 6.7 times trailing earnings, and 7.4 times next year's predicted results, Diamond Offshore does look awfully cheap. The company carries a quite reasonable debt load, pays a modest dividend to its shareholders, and Deepwater or no, analysts still expect to see the company grow its profits at better than 10% per annum over the next five years. Problem is, stocks like Diamond Offshore are often "cheap for a reason" -- and in fact, I see two very good reasons.

Drill deeper
First and foremost, there's the fact that the company's reported income greatly overstates its actual production of free cash flow. Over the past year, for example, Diamond Offshore reported earning $1.3 billion. But its free cash flow amounted to only $235 million -- 82% lower than the headline figure! That's significantly worse than the 58% gap between free cash flow and net income at rival Noble (NYSE: NE), for instance, and way, way worse than the mere 10% discrepancy we find at Transocean (NYSE: RIG).

Second, and of more pressing concern, is the ban on offshore drilling that President Obama announced Thursday. The primary reason Diamond Offshore's reported income exceeds its actual generation of cash is that the company regularly makes large investments in capital infrastructure -- investments that for the time being are going to have trouble generating revenues while hobbled by the drilling ban.

Time to chime in
Now, in an oil-thirsty world, it's anybody's guess how long the ban will remain in place -- and how costly the new safety regulations will be once the ban is lifted. What is certain, though, is that this ban is bad news for Diamond Offshore. That it's likely to crimp profits growth, and impair the value of investments the company has already made. To me, therefore, it seems unwise to expect a "bounce" out of Diamond Offshore while these factors remain in flux.

That's just my opinion. What's yours? Tell us about it on Motley Fool CAPS.