Start Small, Win Big With Zillow?

Wall Street pros have nothing on retail investors who stake small sums of money monthly on undervalued small-cap stocks. Because they're mostly ignored by the big guns, these types of stocks offer the best, outsized opportunities for growth.

I screened for stocks under $3 billion in market cap, offering earnings surprises of 15% or more in the previous quarter, with long-term earnings growth forecast to be at least 15%. We'll then filter our findings through the collective investing wisdom of the Motley Fool CAPS community and those they think have the best chance for winning.

One stock that floated to the top was real estate information provider Zillow (NYSE: Z  ) , which saw earnings soar 500% over analyst expectations. Wall Street still expects its earnings to grow 40% annually for the next five years, and with a $1.3 billion market cap it falls squarely into our range for potential investment candidates.

Of course, don't jump on a stock just for those reasons. It should just be a starting point for more research as we need to look more closely to see whether analysts' faith in them is well-founded.

A foundation built on sand
The latest housing numbers offer a hopeful indication that the worst of the housing market has passed: According to the National Association of Realtors, existing homes sales hit an annual run rate of 4.47 million in July, while the median price jumped 9.4% from a year ago to $187,300, marking the largest one-year gain since January 2006.

Just last week, Ben Bernanke aimed to keep the housing market moving in that direction by agreeing to buy $40 billion worth of mortgages each and every month as part of his QE3 program. Hovnanian (NYSE: HOV  ) recently reported strong numbers, and if it keeps up like this, KB Homes (NYSE: KBH  ) and Toll Brothers (NYSE: TOL  ) will soon be able to start building McMansions again, too.

Last month, Zillow reported earnings of $0.04 a share that completely blew analysts' expectations of a penny in profit out of the water. Revenue surged 75% on the strength of its marketplace division -- a service similar to Tree.com's Lending Tree that pairs up homebuyers with mortgage providers -- where revenues doubled, while display say a 33% increase. Zillow's stock is up 90% in 2012.

Information service providers like Zillow and CoreLogic (Nasdaq: CLGX  ) certainly benefit from housing's recovery, but they don't have the sunk costs and risks a homebuilder does, making them a safer play if you think housing's on the rebound.

Closing in on you
Unfortunately, I'm not one of them. Despite foreclosures falling 1% in August from the month before and being down 15% from the year-ago period, it's a mirage of improvement. The settlement in the so-called robo-signing scandal is the main cause of the big drop in foreclosures year over year, but the shadow inventory of homes -- those houses facing repossession or distressed sale, but on which proceedings have yet to begin -- remains huge, with one analyst estimating it could be as high as 8 to 10 million homes. That's a weight hanging over the market, and Bernanke's low interest rate policies could even exacerbate that situation by lowering the carrying cost for banks.

Moreover, over 15 million homeowners -- nearly a third of those with a mortgage -- are underwater. That number may be down slightly from the month before, but even Zillows says negative equity still totaled $1.15 trillion at the end of the second quarter.

As good as Zillow's growth has been, it's coming at a cost as it expands its operations, which it needs to do to meet competitive pressures as well as market demand. Trulia is looking to go public in a $96 million IPO to tap into the demand for housing data. Total costs and expenses jumped 85% as sales and marketing more than doubled and technology and development costs rose 76%. Zillow actually had more homes viewed on a mobile device than on a desktop and unique users across all of its platforms jumped 61%.

Price is what you pay
At 58 times earnings estimates, though, it doesn't appear cheap... nor by almost every other metric you'd look at as almost every one is just as bloated. In contrast, Corelogic trades at just 18 times estimates, and its enterprise value goes for a very attractive 12 times the free cash flow it produces. Zillow is trying to capitalize on its valuation by offering dilutive secondary offering of 3.5 million shares.

"I just don't understand how people look at a stock like this, at the price it's at," says CAPS member steeeeve, "and decide 'yeah, I'll buy that.' Zillow is a perfectly nice website. But seriously?"

I have to agree, and I've rated it to underperform the broad market averages on CAPS. But you can tell me in the comments section below whether you agree Zillow is as overvalued as the recovery of the housing market.

A small price to pay
Owning home a used to be the path to financial security and a well-earned retirement. No more. But the road is still open and the Motley Fool has put together the free report, "3 Stocks That Will Help You Retire Rich" that describes the savings habits you need to build long-term wealth and talks about three stocks to help build a smarter retirement portfolio. Access this free report by clicking here.

Fool contributor Rich Duprey holds no position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Zillow. Motley Fool newsletter services have recommended buying shares of Zillow. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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