Yesterday's Losers, Tomorrow's Winners

Everyone loves a winner. It's trite, but true. For every Washington Nationals fan, 20 New York Yankees fans loam large. Every major metropolis has a watering hole for Pittsburgh Steelers fans, but few have one for Detroit Lions fans. Tiger Woods is the automatic bet in golf, Roger Federer in tennis. The smart money follows the leaders. 

Or does it? The Pittsburgh Steelers are unquestionably good and popular, as this year's Super Bowl showed. After the Steelers and Arizona Cardinals vanquished their respective conference challengers, gamblers awarded the Steelers an immediate seven-point advantage. The Steelers were perceived as the better team, and they were, winning the Super Bowl 27-23. They just weren't as good as many had perceived. In short, it can be hard to find a "good price" on the Steelers, Cowboys, and Yankees, because they're so popular.

Perception is a problem for investors as well. Many firms are good -- just not as good as their stock price reflects. Hence, investors overpay, sacrificing portfolio performance in the process, a concept expounded upon by noted Wharton School professor and Yahoo! Finance author Jeremy Siegel.

In short, the price you pay matters. Granted, price isn't always synonymous with value, as anyone who has ever purchased a used appliance can attest. But many times, price is associated with value, as anyone who has ever shopped at Wal-Mart can attest.

The beauty of underperformance
Margaret Stumpp, chief investment officer at Quantitative Management Associates, studied the price performance of the nation's 2,000 largest capitalization stocks from 1971 to 1994. According to Stumpp, stocks whose five-year returns landed them in the bottom third of their industry surpassed the top-third stocks in the sixth year of performance. What's more, these losers won decisively, by an average of 10 percentage points a year.

Stumpp's research suggests that the longer the loser, the better the odds for remunerative recovery. The logic is sound. When a company continually exceeds expectations, expectations ratchet higher (like the Steelers) and become more difficult to exceed. The flip side holds as well; low expectations beget easy-to-exceed expectations (like the Lions).

I prefer investing in Lionesque companies over Steeleresque companies. I also prefer longer intervals of lower expectations to shorter intervals. Specifically, I focus on underperformers trading at a 50% or greater discount to their five-year high that have experienced a slow, languorous slide south (evinced by the price chart). That means I generally ignore sudden disasters like Fannie Mae (NYSE:FNM), CIT Group, and American International Group.

I like name recognition and a minimum $1 billion market cap, too. Both increase the odds that someone will eventually notice and care. A nameless small-cap can underperform and toil in anonymity longer, because its below-the-radar status attracts fewer powerful agitators.

Lost in the numbers
Finding long-term losers with the potential to be winners is tricky -- the standard quantitative valuation measures, P/E ratio, and discounted cash-flow analysis tell you where the company's been, but not where it's going. Besides, return on equity, sales and EPS growth, price-to-earnings ratio, and dividend yield will more likely indicate a sell than a buy. Low prices correspond with a poor outlook. These companies are priced low for a reason. 

The analysis leans heavily on the qualitative. There is no easy answer to the question "Can this company turn around?" To increase the odds it can, I generally avoid sectors where ease of entry and competitive pressure impede turnarounds -- technology, specialty retailing, sit-down restaurants, airlines -- and focus on companies whose output is difficult to replicate. I believe the following stocks adhere to the template; they're long-term price losers, bottom-third sector dwellers, difficult to replicate producers.   

Source: Yahoo! Finance.

It's an ugly group of underperformers, with ugly numbers, to be sure. But ugly numbers coupled with attractive purchase prices have produced very profitable investments: Kirk Kerkorian with Chrysler; Carl Icahn with USX; Edward Lampert with Sears Holdings; and Warren Buffett with GEICO, to name just a few.