Let's hear it for Miss Congeniality
As my Foolish colleagues tell tales of individual companies and funds that just missed their personal cut for Stocks 2006, I feel a bit left out. I really didn't have a runner-up for this year's book. The stock I ended up choosing had, to my mind, odds so long that nothing else I watch came close.
So, in the interests of one-upmanship, and a little investing lesson, I'm going to tell the story of the one that got away from me last year. And it's a story that's more than a little embarrassing. Here's how it starts.
My official pick for Stocks 2005, Ceradyne (NASDAQ:CRDN), did quite well. In fact, it beat the market soundly, tacking on 38% versus the S&P 500's mere 7.5% return over the same period. But my runner-up, SanDisk (NASDAQ:SNDK), ran up from $23 to $56 over the same period, for a 143% gain.
Doh! Which would you rather have? Yeah, I thought so.
A trip in the way-back machine
It was October of 2004 when I had SanDisk on the bench, backing up Ceradyne. It was there because recent earnings at the time had come in light, but also because management was in the doghouse with me. I don't mind the occasional earnings "miss," and I can even tolerate margin pressures, but I sure didn't like the feeling that the news had leaked ahead of time, allowing folks in the know to dump shares before the data hit the streets. And that's what it certainly looked like at the time. But I (grudgingly, I assure you) let my cooler head prevail, and I held my stock, though I kept the firm in my personal penalty box for a time.
Adding to the problems at the time were similar crummy results from competitors, and predictions from flash memory watchers that the entire industry would be in a glut for the coming year. Since the firm had been soaring in the prior year, the stumble sent one of those growth-stock shockwaves through the market, causing people to wonder if the firm could ever return to its winning ways.
To make matters worse, many retail analysts were predicting a bad holiday gift season, meaning fewer sales of the Canon (NYSE:CAJ) cameras, Nokia (NYSE:NOK) and Palm (NASDAQ:PALM) phones, and other gadgets that spur a lot of the demand for flash memory cards.
In short, investors feared the overall economy, slower sales, and falling prices, and they abandoned the stock, leaving it, at times, down 50% from its highs that year. That meant a company with a track record of excellent returns at double-digit growth was trading at a P/E in the low teens, with substantial free cash flow to boot.
But things tend to turn around quickly for the leaders in industries, and by January, things were looking up for SanDisk, though the Wall Street crowd following the stock had yet to appreciate what some of the amateurs could see. By summer, when Apple (NASDAQ:AAPL) had been selling loads of flash-consuming iPod Shuffles, I thought we might be seeing the paradigm shift that would make flash memory a much hotter commodity, a situation that was sealed when Apple rolled out the iPod nano a few months later. In addition, there were indications of very strong results for SanDisk's chips in the rapidly expanding market for feature-rich cell phones.
Thus it was little surprise when SanDisk reported excellent results in October -- though the magnitude of the outperformance was certainly unexpected. Instead of the $0.35 per share that the analysts were looking for, SanDisk earned $0.55, and it had better margins than anyone had expected.
By October 18 (the admittedly arbitrary deadline for the Stocks 0X books), the good news had been absorbed and rewarded by the market, pushing the shares to about $56 each, roughly 143% better than they were just a year earlier.
Reviewing the obvious
Is that kind of return simply unpredictable market craziness? I'm not so sure. Let's review the ingredients that went into this hot sauce:
(1) A fallen highflier.
(2) A strong underlying business with a record of good profits and cash flow.
(3) A healthy dose of investor and analyst pessimism.
(4) An added dose of angst about the overall economy.
(5) A reversion to more normal (then better-than-normal) operating results.
(6) Capitalizing on potential new markets and products that the market didn't fully appreciate.
This year's model
Let's just say I learned my lesson this year. I looked at what made last year's No. 2 reality's No. 1, and I chose this year's pick accordingly. For Stocks 2006, I selected a company that has a ton in common with the SanDisk of fall, 2004. True, it's a company in a very different business, selling completely different products.
But here are the similarities: It is a recently former (if that makes sense) Street darling, a leader in its space, with excellent profits and free cash flow. It is suffering from worries about its short-term performance, plus predictions that its entire sector is going to suffer the fate of the Grinch. It has opportunities to enter lucrative new markets, and best of all, it's trading a long way from its recent highs, because the market has given it up for lost. Granted, I don't expect 143% returns for this stock in a year, but I do believe it's undervalued by as much as 50% these days, and that's about as sure a bet as I can find.
Foolish bottom line
If you'd like to take a look at the fruits of last year's lesson, Stocks 2006 is just a click away. If you think I'm full of it -- and please, feel free -- I'm sure you will find something in there you do like, as my clever colleagues have also been scouring the market for the best ideas for the coming year. (And if you completely hate it, hey, we have a guarantee that covers that, too.)
For related Foolishness:
- Here's another peek at one for 2006 and beyond.
- Take a look at the fund that got away.
- SanDisk stank, but I didn't sell.
Seth Jayson likes to buy high and hold for higher, but he'll take cheaper any time. At the time of publication, he held shares of his Stocks 2006 pick, as well as shares of Ceradyne and SanDisk, and covered calls on the latter, but he had no position in any other company mentioned. View his stock holdings and Fool profilehere. Palm is aMotley Fool Stock Advisorrecommendation. Fool rules arehere.
