Meet Some 2-Star Sleepers

Have you met CAPS? It's The Fool's new investing community, where players choose stocks that they think will either outperform or underperform the broader market. If enough players weigh in on any particular stock, a star rating gets assigned, with the ratings of the more successful players carrying the most weight.

We tend to write plenty about the top five-star and lowly one-star stocks in CAPS around here. Both ratings tend to signal that it's time to sit up and pay attention -- whether it's because investors think a company's about to set the world on fire, or because they think a company's going land them in the burn unit. Some of my best outperform calls have come from top-rated stocks, from sizzling seismic data processor Dawson Geophysical to flashy chipmaker SMART Modular Technologies. Likewise, some of my best underperform calls have been on one-star dogs like subprime flameout New Century Financial and all-talk, no-drill Particle Drilling Technologies.

All that aside, there's just something endearing about two-star stocks. They're obviously unloved, but often enough, I'd like to think they're more than a little misunderstood. In my CAPS stable, I've got five two-star dark horses:

As always, these stocks are not formal recommendations, but rather starting points for further research.

A dark horse in midstream
Crosstex is a midstream natural-gas player that I learned about from athenamike, a value investor who's a fund manager by day. Here's his CAPS pitch:

Crosstex owns an impressive array of midstream assets that both transport and process natural gas. I believe the company can provide 25% free cash flow to equity and grow that at around 12.5% per year over the next 3 years.

Another CAPS fan is weiwentg:

Crosstex energy has an attractive yield as is, so it's a good income-producing stock. However, it also has significant growth prospects, because of its acquisitions in the Barnett Shale. Its gas treatment operation is icing on the cake; if they are correct, natural gas prices will stay high, producers will drill deeper to get more out of their wells, the resulting gas will contain high CO2 levels, and Crosstex will profit from that.

These players are not alone in their enthusiasm for this business model. The superinvestors at Chieftain Capital own a huge chunk of this company, whose assets entirely consist of a large stake in a publicly traded master limited partnership, Crosstex Energy LP (NASDAQ:XTEX). The limited-partnership units offer a higher yield and tax advantages, but the general partner offers leverage to the growth of the LP, on top of a respectable 3% dividend. Both investment vehicles have their charms, but I'm drawn to the bigger upside inherent in the latter.

Extremely cheap
Next up is an optical networking equipment provider that has tried the patience of many waiting for a turnaround. In fact, the best CAPS pitch on Extreme Networks came from gcastelBDS, a player who threw in the towel already:

With the situation the new executive team find themselves in [having] missed some SEC deadlines [and suffered] some significant losses in the DOD space to Cisco, my guess is they are up against a wall to either turn things around or look for a buyer. With Juniper and other players (Foundry) looking to improve their positions against the incumbent leader Cisco, Extreme could be the best candidate in the market for a buy-out. They are dirt cheap right now and have very solid and proven products in the network switching arena.

OK, this company isn't even current on its financial filings because of its options-backdating investigation, so how can we say it's cheap? No matter the result of the investigation, Extreme is sitting on a big pile of cash. That means that when you strip out the cash, the business is being valued at a huge discount to its peers, based on trailing sales.

I'm also encouraged by the track record and vision of new management. The new CEO is a Sun Microsystems veteran who seeks to shift Extreme's focus from a product-based sales strategy to a services-oriented one. This approach implies both greater revenue visibility (as a result of recurring revenue, versus lumpy sales) and better margins.

They have to want to change
Lest you forget, today's two-star stocks can become tomorrow's five-star stocks. Since I began typing this article, Alexander & Baldwin has already notched a third star. So don't turn your nose up at every company that's unloved today. Take some time to get to know its flaws, and think about not just how it can change, but equally important, whether it wants to change. If there's a credible story there, you just might have yourself a two-star sleeper.

Come on over to the Motley Fool CAPS community and rate your favorite (or least favorite) stocks. It's 100% free to use.

Fool contributor Toby Shute likes investing in beaten-down companies that want to change. He doesn't own shares in any company mentioned. Dawson Geophysical is a Motley Fool Hidden Gems pick. The Motley Fool has a five-star disclosure policy.