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You might think that, from time to time, I get a stock idea or two from Wall Street analysts. It’s true that I do get ideas but not in the way you might imagine. I actively look for companies that analysts do not like, not for ones that they do.

If a company is universally admired, if analyst reports are full of praise and compliments, then the stock will usually sell at a premium. The good news is generally priced into the stock, and then some. When a company is widely criticised by analysts, when bad news is emphasized in their reports, that, too, will be reflected in the stock price.

Wall Street analysts, like most investors, tend to overreact to both good news and bad news. It is the analytical bias toward linearity that gets them into trouble. Whether a particular company is enveloped by good news or bad news does not matter. More of the same, whether good or bad, is projected, in a linear fashion, into the future.

Bargain hunters can take advantage of Wall Street analysts and their bias by sifting through reports looking for companies where negativity is pervasive. When the negativity is concentrated around temporary, fixable problems, there’s a good chance the investor has found a bargain.

In the face of some temporary bad news in late 1994, the stock of leading hospital provider HCA was hit with eight consecutive analyst downgrades. After the fifth of these, the stock hit a 52-week low at $34.70 and started to rise. About six months later the stock was higher by 50 per cent.

Did the analysts miss something when they downgraded HCA en masse in late 1994? The group was, in fact, suffering temporary problems such as an increase in uninsured hospital patients. Getting the facts right, however, is just the first step in the process. The second is to determine whether or not the negative information is already discounted into the stock price. In the case of HCA, the bad news was not only fully discounted, it was overly discounted.

When analysts are acting in unison they become a proxy for the crowd on Wall Street. Contrarians understand there is money to be made by going in the opposite direction from the crowd. When the crowd is uniformly positive, it is time to get negative. When the crowd is uniformly negative, it is time to get positive.

Even when there are numerous analysts covering a stock, there is often a uniformity of opinion. One year ago only one out of 19 analysts was bullish on the stock of insurance broker AON. The negativity surrounding it was uniform and substantial. But the negative sentiment was more than reflected in the too-cheap stock price. The stock has doubled in the last year, from $21 to $42.

Overstock, which I mentioned in this column two months ago, is a company we have continued to buy recently in the face of uniform analyst negativity. Over the last month, every one of the five analyst reports published on Overstock has been negative. The negativity is overdone. This is one of the most undervalued companies I have seen in many years.

Overstock is an internet retailer. Analysts put internet retailers in one of two brackets based on profitability. Profitable internet retailers win plenty of praise from analysts. If the internet retailer is profitable, a rich valuation is attributed to the stock – a value equal to two or three times sales is the norm. If an internet retailer is unprofitable, negative reports are the norm. Market values equal to half of sales are common for unprofitable internet retailers.

Blue Nile is an example of an internet retailer in the first bracket. This leading jewellery retailer sells at three times sales. Overstock is in the second bracket, selling at half of sales because the company is unprofitable.

To analysts of internet retailing it is an all or nothing proposition. Either you are profitable and deserving of a rich valuation or unprofitable and deserving of a big discount. There is ample opportunity for astute investors, then, in owning unprofitable internet retailers that are on the cusp of profitability.

The mindset of analysts is a significant handicap here. Rather than extrapolating a lack of profits into the future in a linear fashion, an analyst has to take a more flexible, anticipatory view. It is not that difficult. For example, prior to profitability certain components of the income statement show demonstrable improvement.

Evidence of impending profitability for Overstock is to be found in the growth in gross profit dollars. Gross profit dollars have grown from $26m in 2003 to $66m in 2004 (up 154 per cent), and to $121m in 2005 (up 83 per cent). As the company grows, many of these dollars will drop to the bottom line, or net profit. The benefit to the share price will be substantial. I expect shares of Overstock to at least triple in value by 2010.

Arne Alsin is a portfolio manager for Alsin Capital and for the Turnaround fund


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