Are These Cinderellas Worth a Shot?

With the NCAA men's basketball season ending in a blowout final between two high-ranked opponents, we didn't get to see the thrill of a major Cinderella on the run this year. Similarly, there have not been a whole lot of Cinderella stories in the dreadful market of this past year. However, despite the wholesale carnage of the past 18 months, investors might find themselves surprised by some of the companies that will bounce back. And they can use Motley Fool CAPS to grab those rebounds.

Many investors make very solid returns by going against the trend. One of the greatest investors of all time, George Soros, has made a killing by finding unloved stocks right before the market turns on them. For evidence of his contrarian tendencies, witness his purchase of HSN, a 1-star CAPS stock! Time will tell whether this move proves prudent, but it wouldn't be the first time Soros has found huge bargains in the stock market's trash bin.

Let's see whether the CAPS screener can help us find any potentially interesting contrarian plays. Here are my search criteria:

• 1- to 2-star CAPS rating
• At least 60% below 12-month high
• Price-to-book ratio above 0.2, but below 1.5
• Return on equity greater than 10%

The CAPS rating should help us find companies on which the market has soured, while a 10% return on equity should help ensure that these companies have some history of providing returns for investors. A price at least 60% below the 12-month high, and a price-to-book ratio below 1.5, should allow us to find stocks that have factored in bad news already. For good measure, I also set a minimum price-to-book of 0.2 to filter out strong bankruptcy candidates, and a minimum market cap threshold of $100 million to eliminate some of the micro-caps that might not have much information available.

Here were some of the more intriguing results I found using this screen:

Data from Motley Fool CAPS as of April 8, 2009.

Undoubtedly, some of these stocks are duds, and their low ratings are completely justified. All the same, at least a few of these stocks probably offer significant value to contrarian investors.

Discover Financial Services jumps out as an intriguing play to me. Many analysts have named credit cards the next victim of the credit crunch, and some even believe we could be seeing “the death of credit cards.” However, credit cards serve a very useful function for consumers, and many people use them solely to expedite and track their own purchases. Since companies such as Discover generate significant revenue from the transactions themselves, it seems unlikely that credit cards will die off completely.

Discover has been a profitable company, raking in significant cash flow recently. Its net tangible assets amount to $11.51 per share, yet the stock has recently been selling in the $5-$6 range. With a $28 billion balance in total loan receivables and a $1.9 billion allowance for loan losses already included on its balance sheet, Discover could potentially absorb a 12% default rate and still have more value than the market is giving it credit for.

Will Discover prove to be a true Cinderella and shock the masses? Are there other underdogs in our screen that might have more bite that the market gives them credit for? Check out the commentary in Motley Fool’s CAPS community, where you can find other insightful investors looking to grab a a great stock on the rebound.

Further contrarian Foolishness:

• Dream Stocks for Contrarian Investors
• Is It Time to Buy the Banks?
• 10 Stocks Under Attack