Sour Stocks, Sweet Returns

Here's a bright neon sign you'll never see in the stock market: "Stocks 50% off today!" The market just doesn't advertise bargains -- so we have to go find them.

I'd like to share one way the Motley Fool Inside Value team looks for potential bargains: By following stocks with changing analyst sentiment.

Looking for bargains
In "Herding Among Security Analysts," Professor Ivo Welch of the Yale School of Management found that in stocks of widely followed companies, when one analyst changes a recommendation, the next two analysts have a tendency to follow suit. Professor Welch also found that the consensus opinion influences other analysts to join the crowd rather than stand apart from it, and that the most recent changes come from trying to exploit short-lived information rather than a fundamental shift.

Sour stocks
This herding behavior tends to drive prices too high during bullish times and too low during bearish times. Paying a high price for stocks tends to lower returns, so we should avoid chasing rising prices during bullish run-ups. Instead, we want to take advantage of analyst sentiment turning negative -- souring, if you will. The trick is to figure out if the bearish sentiment is warranted or not. If it's not, we could have a bargain on our hands -- determined by comparing the current price to our estimate of fair value -- that can generate market-beating returns when expectations change and positive sentiment returns.

Using data from Jaywalk, I found five stocks where analyst sentiment has turned or seems to be turning negative over the past four months (from January 2006 to May 2006).

Online travel provider Expedia (NASDAQ:EXPE), mega-market-maker eBay (NASDAQ:EBAY), women's fashion retailer Urban Outfitters (NASDAQ:URBN), chip maker Intel (NASDAQ:INTC), and power management products provider American Power Conversion (NASDAQ:APCC) are all hovering around new 52-week lows. From the data above, there has been a change in analyst sentiment at Urban Outfitters, Intel, and American Power Conversion. As such, these are certainly candidates to investigate as bargain opportunities -- there seems to be some definite herding behavior.

The jury is still out on Expedia and eBay. However, we should definitely keep our eyes on these two if analysts' recommendations continue to move from "buy" to "sell." Prices could come down further, improving the odds of either company becoming a bargain opportunity.

Sweet returns
I know you're asking, "Dave, what about those sweet returns?" Don't worry, I didn't forget.

I want to take you back to the Internet bubble, when Amazon.com's (NASDAQ:AMZN) stock price kept going up, up, up. Analysts were tripping over themselves to put a buy rating on Amazon.com, thereby reinforcing the frenzy by making some ridiculously high price targets.

The second half of 2000 was not a good time for the company. Growth started to slow, and there was an informal investigation into its accounting practices. Analyst downgrades came in droves -- and, predictably, the stock price plummeted. Analysts' bullish sentiment may have sent the price too high to begin with, but their bearish outlook drove the price too low in 2001.

Despite the issues, Amazon.com continued to strengthen its business model by adding new categories, attracting and keeping customers, and improving operations. It also became free cash flow positive in 2003. Investor who saw a strengthening business model with a falling price in 2001 have been amply rewarded -- the stock is up 475% since its low of $6.08 in October 2001.

Fundamental analysis is the key to sorting out the value opportunities from the value traps. That's because if a company's competitive position is permanently damaged, the analyst revisions could be completely reasonable, making it difficult for the market to turn sweet on the company in the future. But as we have seen, sometimes the crowd can get it wrong, and that's the opportunity we want to exploit.

The Foolish bottom line
Stocks that have moved from analysts' buy piles to their hold piles aren't the only place to look for opportunities. You can also look in the 52-week-low list as well. But Professor Welch's herding research provides a better understanding about why prices could be depressed.

As I mentioned earlier, the key to profiting from a bargain opportunity is performing a fundamental analysis of a company that's seen its stock price fall. That's where Philip Durell, advisor/analyst for Inside Value, can help. Not only is he looking for bargains, he's doing the right research and recommending the value plays (not the value traps). Intel, in fact, is one of Philip's latest recommendations.

So the only thing standing between you and some sour stocks that could generate some sweet returns is a click for a risk-free, 30-day trial.

Inside Value team member David Meier does not own shares in any of the companies mentioned.Amazon.com and eBay are Stock Advisor recommendations. The Motley Fool has adisclosure policy.