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Embrace Your Inner Contrarian

Use this screen to scoop up good businesses that the market fears. In a few years, your clients may thank you.

Justin Fuller, 06/16/2008

When you look back at history, investors who have been willing to lean into the wind during times of distress usually have been the ones who have produced superior returns over the long term. Berkshire Hathaway BRK.B chairman Warren Buffett--perhaps the most successful investor of our time--put it best in his 2006 letter to shareholders when he said that he tries to "be fearful when others are greedy, and be greedy when others are fearful."

This screen aims to uncover a few stocks that the market dislikes but that we believe over the long term will create wealth for owners. The screen was performed on Feb. 19 in Morningstar Principia, but an equivalent screen can be created in Morningstar Advisor Workstation Office Edition.

First, we want a set of companies that are unloved by the market and whose share price has declined over the past year. To find these, we ran a search for all companies whose share price had a negative one-year total return.

Total Return 1 Year < 0.00

Second, we want to eliminate companies that fall into the micro-cap space. Micro-caps can be tricky investments to judge and may not be appropriate for most investors. Thus, I want to include only companies that have a market cap of more than $100 million.

And Market Cap > 100.00.

Third, we want to look for businesses with good financial returns over the past year. Return on equity is my favorite measure of profitability, as it encompasses a business' complete financial performance. For this screen, we'll use a relatively high 15% ROE or greater.

And ROE % Year 1 > = 15.00%

Next, we want to look at valuation. Valuation essentially comes down to cash flows and the price that you are willing to pay for those cash flows. One of my favorite metrics that encompasses valuation is cash return (or cash flow yield). Cash return is simply the operating cash flow the business has generated in the past year divided by its current price. The higher the cash return the lower the price you are paying for the particular business' abil ity to generate cash. For this screen, we'll use a cash return of 11% or greater, which can also be thought of as an investor's opportunity cost.

And Cash Return % > = 11.00%

Finally, we should layer the Morningstar Rating for stocks against the names generated by the quantitative metrics above, looking only for 5-star stocks. We rate offerings based on the comparison of a stock's price to our estimate of its fair value. The cheapest offerings based on this qualitative assessment get 5-star ratings.

And Morningstar Rating = 5 Stars

While you can change the above metrics to fit your own investing preferences, these six names are attractive starting point for investors with the right temperament to lean into the wind during times of market stress.

Boeing BA
Boeing's dominant position in the small widebody jetliner segment should help it capture a majority of commercial aircraft demand during the next five years. Also, the jet maker's vision into future market developments and revolutionary use of composite materials has given it a lead over Airbus that could eventually extend beyond the 787 program. In fact, Boeing's spot-on foresight in developing the 787 and its greater experience working with composite materials only widens the jet maker's narrow economic moat.

CSG Systems International CSGS
CSG's software-focused business model is highly profitable and requires few fixed assets, leading to good free cash flow. Advanced Convergent Platform, CSG's backbone offering, is a software solution that incorporates many of the data-processing services demanded by cable and satellite operators. CSG must allocate a steady stream of cash to research and development to keep Advanced Convergent Platform fresh, but upgrades tend to be evolutionary in nature instead of large unpredictable expenditures. Further boosting profitability, CSG keeps company-owned computer hardware to a minimum, as it outsources one fourth of its processing capacity needs to former parent First Data.

Gevity HR GVHR
Gevity is a one-stop shop that provides a wide array of human resources services to small and medium-size businesses, including hiring employees, processing payroll, and managing business risks. In the past, HR companies took a modular focus, outsourcing just a fraction of each of their client's HR needs. However, because of the complexity that comes with managing several outsourcing relationships, consolidation with one HR vendor has merits. This bodes well for Gevity, because it offers only bundled solutions, allowing it to further penetrate its clients' operations and create high switching costs.

K-Swiss KSWS
Despite its history of inconsistent sales growth, K-Swiss has been able to maintain healthy gross profit margins. We believe that this remarkable accomplishment further validates K-Swiss' disciplined distribution strategy, which aims to aggressively limit supply rather than resort to discounting in periods of weak demand. Since the Classic shoe was introduced in 1966, K-Swiss has maintained a select distribution policy to preserve the brand's premium image. Because the firm does not sell to discounters, price points stay fairly constant and profit margins remain high.

Micrel MCRL
We like Micrel's focus on analog chips, which tend to have longer product lives and higher margins because of their complexity. In addition, analog chips can be produced in trailing-edge wafer fabrication plants that cost a fraction of the modern ones, which means Micrel does not have to spend a lot on equipment. Micrel produces about 95% of chips in its own plants in California. On top of margin and cost advantages from analog chips, Micrel also benefits from a less-concentrated customer base, which exerts less pricing pressure. The top 10 direct customers account for less than 20% of total sales. For the past 10 years, Micrel's gross margins averaged a respectable 50%, higher than a lot of semiconductor peers.

Trimeris TRMS
Trimeris recorded its first annual profit in 2006, as sales of HIV drug Fuzeon reached $250 million. Despite this success, however, Trimeris is still a one-product company, and risks remain. Approved in 2003, Fuzeon rose quickly to success as the first and only drug that attacks HIV before it enters a host cell. There are more than 120,000 treatment-experienced HIV patients in the United States who have developed resistance to one or more of some 30 different medications currently on the market. Fuzeon's unique method of action makes it highly effective against resistant HIV and has reinvigorated treatment for thousands of patients. However, Fuzeon has one major flaw: It requires twice-daily injections. Therefore, doctors use it as a last resort for patients. This severely limits the potential market for Fuzeon and makes the drug vulnerable to competition from new oral HIV medications.

Justin Fuller, CFA, is a Morningstar equity strategist.

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