Four Firecracker Stocks
These high-risk/high-reward plays could add spark to your portfolio, but investors must handle them with caution.
Our Picks
After the market turmoil of the last year, many investors fled risky assets for safer fare such as Treasuries and bank CDs. This may provide some peace of mind, but the flip-side of safe investments is low return potential. A two-year Treasury bond now yields only around 1.5% and bank rates are not much better. If inflation were to pick up, as many economists are predicting, the real return on many of these investments could very well be less than zero!
So where should more-risk-tolerant investors look for higher returns? Equities provide an obvious answer, but after the rally in stock prices since March, our team of stock analysts thinks the broad market is about fairly valued. This means investors can still expect equity returns that are higher than safer alternatives, but huge runups in stock prices are unlikely.
However, stock investors with the stomach for it can potentially boost their returns by combining a core portfolio of wider-moat companies (bought at a reasonable price) with some riskier satellite holdings. These riskier stocks have a lot of question marks surrounding them. Will they be able to refinance their debt? Will their potential blockbuster drug be FDA approved? Will consumers be able to pay back their credit cards?
No one knows the answers to these and other questions for sure, so the market must guess the probability of each outcome. If reality is better than the market is currently expecting, such stocks could rise several-fold from current levels. However, if things turn out not so rosy, these high-risk stocks can easily take a dive.
Our equity analysts are constantly weighing the potential outcomes for firms like these, and sometimes they see the market weighing the downside scenarios too heavily. We've screened for stocks that have very high uncertainty, but that are trading at such deep discounts to our fair value estimate we think they may be attractive buys.
These high-risk/high-return stocks look cheap, but they face considerable risks. Investors who consider these or similar names should exercise caution in making sure that such positions don't become a large part of a portfolio.
SunPower Corporation (SPWRA)
Star Rating: 
From the Analyst Report:
The future of the immature and rapidly growing solar industry remains fraught with uncertainty. Still, we believe SunPower has the technology and business model that will allow it to become one of the industry's strongest companies.
Solar is still a nascent industry, and its future path remains highly uncertain. SunPower does best the majority of its competitors on cost, but First Solar (FSLR) remains the industry low-cost leader, and Chinese players Suntech and Yingli Green Energy are not far behind. The company also has a great deal of execution risk, as the rapid expansion required to meet future demand will be daunting. Additionally, as government subsidies are the biggest driver of solar adoption in the near term, the pullback or elimination of incentives could significantly affect the short-term prospects of the industry. Finally, enormous amounts of capital are being invested in both the solar industry and alternative energy in general. SunPower may be unable to compete with newer technologies.
Capital One Financial (COF)
Star Rating:
From the Analyst Report:
Several acquisitions [have] transformed Capital One into a collection of good businesses that operate alongside one another. More than 70% of the profits come from the consumer lending segment, which includes the legacy U.S. credit card business, auto finance, and credit card businesses in the United Kingdom and Canada. We think Capital One's scale and brand name are competitive advantages that will benefit the firm in the long run.
Capital One depends on the securitization market to fund credit card and vehicle loans. This market came to a halt in 2008, which led the U.S. government to introduce the Term Asset-Backed Securities Loan Facility that is aimed at restarting this market. If this facility fails, Capital One will most likely struggle to find alternative funding sources for its credit card and vehicle loans, forcing it to stop loan originations and to run off existing loans. This would result in lower profitability and could even cause a liquidity crisis. While Capital One is very profitable and is expected to remain so in the current downturn, the firm will lose money if the U.S. unemployment rate reaches 10% and stays at that level for three to four quarters. Capital One also faces regulatory risk. New rules introduced in 2009 limit certain credit card fees and the right to reprice credit card loans. With the sharp increase in loan losses, Capital One might cut its dividend to preserve capital. If the U.S. government reintroduces its proposal to change bankruptcy laws, such a move would most likely lead to a surge in bankruptcies that would result in much higher loan losses for all credit card lenders, including Capital One.
USG Corporation
Star Rating:
From the Analyst Report:
Continued declines in new residential construction will pressure USG's sales, but we still believe the company's narrow moat will help it generate solid returns over the long term.
That said, the short-term prospects for the company's wallboard segment don't look promising. The business is highly cyclical, as revenues rise and fall along with construction activity. The residential market doesn't appear to be recovering anytime soon, and commercial construction appears to be slowing, as well.
USG addressed its most pressing risk of possibly breaching its credit agreement by issuing notes and amending its bank agreement with a new covenant. However, demand for the company's products looks to be weak in the short term, as the company relies heavily on the residential and commercial construction sectors.
Lexicon Pharmaceuticals (LXRX)
Star Rating: 
From the Analyst Report:
Lexicon Pharmaceuticals' large-scale mouse genetics technology is being tested in several clinical-stage programs for a wide range of diseases. However, despite positive results in mouse models, we have yet to see definitive evidence that this technology will result in safe and effective commercial drugs--and the failure of the firm's first drug candidate only highlights the uncertainty surrounding this promising but young biotech.
Almost all of Lexicon's current revenue is tied to up-front payments and milestones from its main collaborative partners, and the research stage of all four key drug-discovery collaborations have recently ended. If the drug candidates discovered in these collaborations aren't eventually approved, Lexicon's revenue streams could dry up. Several other firms are also using a genetics-based approach to find promising drug targets, and Lexicon's technology may not prove viable. Although Lexicon has enough cash on hand to cover drug development in the near future, its reorganization won't lower costs enough to prevent the need for a new partnership or equity offering by early 2010.
All data as of July 2, 2009