By Jeff McConnell | 11-15-99 | 12:00 AM | Email Article
Last week, I wrote about CKE Restaurants CKR, a stock that illustrates some of the potential pitfalls of contrarian investing. With that example in mind, I'd like to go through some of the steps in finding good contrarian stock picks-companies on which the market has been unduly tough but that have a good shot at getting back into investors' good graces.
Jeff McConnell, CFA, is an analyst with Morningstar.com.

The first hurdle, of course, is that the stock must be cheap. In today's narrow, growth-driven market, finding such companies isn't a monumental task. Many stocks that aren't in the market's favorite industries have seen their price/earnings, price/book, price/sales, and price/cash-flow multiples fall dramatically in recent years. And when the market truly dislikes a company, the stock's valuation ratios will be low not only on an absolute basis but also relative to their historical norms. In addition to those traditional measures, Morningstar's appraisal ratio can be a good tool for helping investors estimate whether a stock is cheap relative to its long-term prospects.

A true contrarian play has more than just a low price tag, though. As we've seen, investors often have legitimate reasons for turning their backs on a company. Thus, here are a few questions to help you determine whether a downtrodden stock has comeback potential.

Are the troubles industry-related or company-specific?
The best contrarian picks often come from finding the most-attractive companies in industries the market is ignoring. Good examples are pharmaceuticals and financials in the early 1990s. Both were sectors that most investors abhorred, but both saw strong rebounds in the middle and later years of the decade. Of course, an industry in real danger of becoming obsolete (like every Internet junkie's favorite example, buggy-whip manufacturing in the early 1900s) won't yield many legitimate investments.

How viable will the franchise be over the long haul?
A stock that was bid up for reasons that don't exist anymore is a good one to avoid. Specialty retailers often fit this bill; they tend to grow quickly and often slow down just as quickly when customer sentiment changes. In those cases, it's going to be tough for the company to return to form. On the other hand, if a stock is depressed for temporary reasons but its business model remains viable, it could make a great long-term investment.

How strong are the company's financials?
This might be the most important question to answer. If a company's balance sheet is robust enough, it can withstand tough times and could make a great rebound candidate. If the company has a large debt burden, however, a slowdown in its business will force it to spend a great deal of its cash flow on interest payments rather than investing in its growth. The key factors here are the size of the company's debt burden, measured by such things as its debt/equity ratio, and how much free cash flow--the cash remaining after subtracting capital spending from operating cash flow--the company is producing.

How competent is the company's management team?
This can be a tough question to answer, but it's also a vital one. After all, if you're going to bet on a stock turning its fortunes around, you'd better have faith in the management's ability to engineer the turnaround. One way to get a sense of this is to watch how well the management allocates capital. Is the company generating good returns on equity and returns on assets relative to its peers?

Notice I haven't said anything about growth. Most contrarian plays involve companies that have been hit so hard they won't need to produce world-beating growth to generate a boost in their stock prices. That's because the market expects so little from such companies that even a small positive surprise could mean a big jump in the stock's price.

One company I think fits the contrarian bill well is Brunswick BC, a stock for which I've pounded the table in the past. The company sports rock-bottom price multiples and an appraisal ratio of 1.4, meaning that by Morningstar's methodology, the stock is about 40% undervalued. In addition, the company has little debt--its debt/equity ratio is a mere 0.4--and it has produced strong free cash flows in each of the past several years. It's also the leader in many of the industries in which it operates, including bowling equipment, marine engines, and pleasure and recreation boats.

The reason a market leader with a stable of brands as powerful as Brunswick's is so cheap is that the company has a series of lawsuits outstanding against it, involving its marine-engine segment. One court has already ruled against Brunswick, to the tune of a $133 million judgment. The company is appealing the decision, but it gives investors a good idea of how severe the hit might be. Because the judgment involved dealers that represent 20% of Brunswick's market, the likely ceiling on the company's liability is about $665 million (or about $425 million after tax). That's not chump change, to be sure, but it's not going to put a company that generates $200 million in free cash flow per year (and that has little long-term debt) out of business.

Of course, finding companies that meet these criteria is just a starting point. Like any type of investing, contrarian stock picking requires investors to do lots of homework. It also requires a great deal of patience: If the market dislikes a company, investors can sometimes be slow to warm to it even after it starts to turn the corner.

But when these stocks begin to win back market sentiment, the rewards for those who were brave enough to get in when things looked bleak can be enormous.
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Jeff McConnell does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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