Stuff Your Stocking With Out-of-Favor Bargains

This article first appeared in the December 2010/January 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

It's holiday time, and to go along with the bombardment of advertising, promotions, and articles about must-have toys, here's a screen that looks for attractive consumer-related investments.

With high unemployment and a weak housing market, it's easy to see why an investor's initial reaction might be to avoid consumer- dependent companies. We have yet to see significant and definitive signs of an economic recovery, and every economist has a different opinion on how long the weak economy will prevail. The uncertainty presents a good time to go shopping for bargains, and investors can pick up some high-quality companies at discounted prices.

(Sector = Consumer Services
Or Sector = Consumer Goods)

We start our screen by restricting our list to only consumer-services or consumer-goods stocks. This will leave us with more than just traditional consumer discretionary companies, it will also include everything from auto manufacturers to grocery stores.

And Total Return 1 Year < 0

Next, we look for stocks that have been laggards so far in 2010. Most stock indexes have posted middle- to high-single-digit returns, so stocks meeting our criteria will have underperformed by a meaningful amount. Buying stocks that are temporarily unloved or out of favor by the market can be very profitable; of course, this strategy assumes that the underlying business is still healthy and future prospects are attractive.

And Morningstar Rating > 3

We turn to Morningstar's equity analysts to make sure that we are finding good stocks, rather than stocks that are positioned to lag the market for years. Searching for stocks with Morningstar Ratings of 4 or 5 stars will only find stocks that Morningstar analysts think are attractively valued relative to the analysts' forecasts of the companies' future results.

And ROE % Rank Industry Year 1 < 50%

Although we are looking for companies with stock prices that have lagged, we want firms with strong business performance. By looking at returns on equity, we can find companies that are highly profitable and efficiently using their equityholders' money. This criteria required companies to have an ROE in the top half of all companies in its industry, ensuring that we are picking up high-quality businesses.

And PCF Ratio Current < 10

When looking for consumer stocks, it's important to avoid overpaying for a fad or a hot growth stock. The last thing we want in our portfolio is the next Crocs-like stock. Limiting our search to stocks with a price/ cash-flow ratio of less than 10 will help make sure we aren't paying too much of a premium for a hot stock.

This screen, performed in Morningstar Principia, leaves us with 12 companies (as of Oct. 19) across a variety of industries--everything from apparel stores to a NASCAR race track operator. Here are a handful that stand out.

Collective Brands PSS
Collective Brands' Payless Shoe Source is one of the largest shoe retailers in the world and provides shoes at great prices that are faster on trend than mass discounters. Nonessential spending by middle- to lower- income consumers remains under pressure, and customers are reluctant to make marginal purchases of new shoes. Payless stores, which represent 62% of Collective Brands' total sales, are struggling to hold comparable-store sales, but the impact on the shares has been too great. We believe that fear has blinded investors to the long-run cash-flow potential of Collective Brands.

We forecast 2010 revenue to be just slightly negative, as wholesale momentum continues to mitigate negative comparisons in the Payless domestic segment. After several years of inconsistent results, we expect gradual improvement in operating margins during the next few years and believe operating margins will come in above 5% during 2010. Gross margins should benefit from a more efficient supply chain and higher merchandise margins. We anticipate average operating margins in the low 6% range over the forecast period, reaching 6.7% in out years.

Toyota Motors TM
A weak dollar, slowly recovering global demand for light vehicles, and a recall crisis have created a very difficult environment for Toyota. Although its image has suffered, the automaker is one of the best positioned in the industry. Product is what drives consumer demand for Toyota vehicles, with sales increasing at a 4% compound annual rate since fiscal 2001. Toyota's strength is simple--it makes many types of high-quality vehicles that people want to buy. The Lexus luxury brand has done very well in the United States, and the midsize Camry has been the top-selling U.S. passenger car since 1997.

Toyota's other strength is its manufacturing expertise, which is so good that Ford F CEO Alan Mulally cited Toyota as a model of how Ford should operate. Using the Japanese philosophy of continuous improvement, or kaizen, Toyota partners with its suppliers and constantly revamps its floor operations to save material and labor costs. This manufacturing expertise is now being applied to quality in light of the more than 8 million vehicles recalled in early 2010.

Supervalu Inc. SVU
Supermarkets have felt pain from the downturn in the economy, but Supervalu has been particularly hit hard, as it is laggard and more leveraged than its peers. Although this fiscal year will be difficult, Supervalu should become a more effective competitor thanks to its centralization efforts. In addition, weakening results from the traditional supermarkets have masked margin improvement from the supply-chain services segment and likely improving performance for Save-A-Lot, which has compelling long-term prospects. Save-A-Lot has the wind at its back as more consumers embrace limited-assortment grocery stores at which they can save as much as 40% on their grocery bills versus conventional supermarkets.

International Speedway ISCA
International Speedway benefits from barriers to entry that prevent other track operators from competing in its markets and substantial intangible assets that keep fans loyal to its tracks. These competitive advantages give the firm a wide economic moat. NASCAR has strong traditions. Fans and drivers are accustomed to having certain races at certain tracks on certain dates, and changes would probably result in significant backlash. This provides a reliable revenue stream for International Speedway--it can count on NASCAR to distribute races in a predictable way each year. Because fans' loyalty to tracks is so strong, it would be extremely difficult for any competitor to enter a region with an existing track and usurp its races.

We expect International Speedway to have operating margins of 21% in five years, identical to its current operating margin and lower than the 28% average operating margins it's had over the past five years.

International Game Technology IGT
International Game Technology took its eye off the ball and lost market share to competitors. A new management team is breathing life into the company with an upgraded product lineup and streamlined operations that could enhance margins over time.

We think that the firm will continue to experience weak top-line growth in the near term as the domestic replacement cycle is prolonged. However, we anticipate increased growth in later years as the replacement cycle commences and casino operators refresh their slot floors. Our seven-year compound annual growth rate is 11%. We expect operating margins to expand by about 12.5 percentage points (7 percentage points, excluding 2009 one-time charges) to 27.5% by 2015 as the company eliminates operational redundancies, resizes its cost structure, and increases profitability.

David Krempa is a stock analyst with Morningstar.