Surprising Low-Rated Stocks the Leaders Love

Piggybacking on the picks of great investors and money managers can often lead to big rewards -- especially when the stocks in question are beaten down. If Buffett's buying railroads, perhaps you should look there, too. Does Bill Miller think financial stocks are beaten down? Maybe investigating more closely will help improve your own results.

Over on Motley Fool CAPS, our top-rated All-Star players represent the best 20% of our more than 86,000 professional and novice investors. I'm looking among them for players who've chosen one- and two-star stocks to outperform the market. The majority of CAPS investors may consider these stocks losers, but if our ace contrarians think otherwise, these picks might be worth a look.

Here are a few stocks that have gotten the nod from the cream of our CAPS investors:

Typically, there's a low-rated stock that has also enjoyed a large one-year run-up in its stock price, leaving me leery. Sure, stocks can continue to run, but these picks' high valuations -- and low ratings -- leave me cold. Not so this week, as all have had dismal annual performances.

Not surprising, perhaps. Industries represented here are airlines, financial services, and retail, some of the hardest hit areas of a softening economy.

Peeking over the shoulder
None of this group has been hit harder than Downey, the holding company of Downey Savings & Loan. Like a typical banking institution, it accepts deposits and makes loans, but it also engages in real estate development, construction, and property management in California and Arizona. Not two of the sweetest spots to be invested in real estate these days.

In a recently released report, Downey said its total nonperforming assets (NPAs) had grown from less than 1% a year ago to more than 9%, which would signal a seriously troubled institution. While it could be said to have a diversified asset base because it is also a savings and loan, should the housing crisis worsen as many expect it will, any signs of trouble at the bank could make its position even more precarious.

Yet is the situation as dire as it appears? Downey also reported that 94% of its loans were current in their payments, which would suggest a seeming discrepancy with the numbers. Not so fast. Back in January, the bank reported on its earlier efforts to assist borrowers who held option ARM mortgages. The program was only offered to borrowers whose loans were current at the time, so the bank initially didn't include them as troubled debt restructurings (TDRs). However, upon further consideration, its accountants counseled that unless the new loan terms were accompanied by an updated property valuation, credit report, and income analysis, they had to be considered TDRs. As Downey hadn't performed those additional tasks, it had to reclassify them all as nonperforming assets, even though 94% of them are still current in their payments.

In summary, as bad as the housing situation is, Downey doesn't appear to be as far down the sinkhole as a first glance would suggest.

Over on CAPS, investors don't think the S&L has much of a chance to outperform the market. More than 80% of those who weighed in give it the thumbs-down. Top-rated CAPS All-Star olenoides pointed in October to the growing number of NPAs, but also thinks that the bank has been lowering its loan loss reserves to make its numbers look better.

In August their non performing assets on their portfolio was 1.96% up from .32% only a year ago. The current trend over the last several months puts their NPA's at almost 3% at years end. In August their interest rate spread was 2.95% ... NPA's are only going to get worse and interest rate spread is not going to get better either. They've also booked a huge amount of neg. am income and have lowered loan loss reserves to make their earnings look better than they are in the last two quarters.

The few bulls for Downey have suggested that the bank's stock sell-off has been overdone, but that its lower valuation makes it a potential takeover candidate. Of course, such pitches were made when Downey was many points higher.

Finding value under rocks
So there you have it -- five low-rated laggards that have gotten big endorsements from some of the best and brightest investors in the CAPS community, although there are always some who are not so sure. If you want to add your two cents on these or any other businesses, sign up to join Motley Fool CAPS, absolutely free.