Keep an eye out for hidden gems under the $5-mark

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There is a never-ending conflict among investors. It is not “growth versus value”, which may have been resolved by Warren Buffett essentially saying he likes both. It is “momentum versus contrarian”. Do you buy what is hot? Or what is not?

If a stock is hot and cruising through 52-week highs, the one thing you know is that there is a reason it got there – investors think it’s good. And the company probably is solid. Google comes to mind. The flip side, as we see every day, is that the company has to constantly fire on all cylinders or shareholders get disappointed and start selling the stock. Similarly, when a stock is hitting 52-week lows, it’s usually because management has consistently missed earnings expectations and is in the penalty box. Getting out of the penalty box can cause a stock to double or more.

In 2003, I was talking to Tim Melvin, an investment writer. He told me about a system he tested for 2002: each month he bought every stock on the New York Stock Exchange that was trading below $3. At the end of the month, he would sell the stocks, and then begin again the next month. “The result,” he told me, “was an over 200 per cent return for 2002, the worst year in 30 years in the market.”

I was impressed and over the past few years I have tested the theory. I also included in a chapter on stocks below $5 in my book Trade Like a Hedge Fund.

My criteria for the stock are: it has to be listed on the Big Board and must be trading below $5, the company has to be profitable, and it must have a buy recommendation from Wall Street analysts.

These companies require a little more homework than most because there is a reason why they are trading below $5. That said, the potential for gain, and even for safety (as the Tim Melvin example attests), is enormous.

One company on my list is Solectron Corporation (SLR), which is trading at about $3.32 a share. If you’re a big electronics company and you just designed a new device, you can outsource all the manufacturing to SLR. The company provides electronics manufacturing and supply chain management services to original equipment manufacturers in the electronics products and technology markets worldwide. The company is sitting on $1.04bn of cash and has $641m of debt – so nearly $400m of net cash in the bank. A market cap of $3bn and earnings before interest, taxes, depreciation and amortisation of $334m gives Solectron a multiple over cash flows of just eight times, putting it in buyout territory.

Three very good hedge funds own shares in SLR. In particular, I’m a big fan of Forest Hill Capital, run by ex-Morgan Keegan banker Mark Lee. It specialises in semiconductor chip companies and obscure public companies from the south-east of the US.

Value investor David J. Greene and Company, a private investment manager founded in 1938, is also a shareholder in SLR. Greene focuses on companies that are trading at low price-to-book ratios or at low multiples of cash flows that have fast-growing divisions. The theory is that Wall Street might not understand these divisions and misprice the stock as a slow growth company.

A good source of information for playing the contrarian game is the 52-week-low list. Motorola, the second-largest mobile phone maker after Finland’s Nokia, made it onto the list last month when its shares fell to $17.90.

Some investors are worried that the super-slim Razr phone, which Motorola introduced two years ago, is running out of momentum and that the improvements in Nokia handsets and the recent introduction of iPhone, Apple’s long-awaited entry into the mobile handset market, will cut into Razr sales.

The stock was trading for less than eight times cash flows, completely in buyout territory, but nobody trusted it. Until Carl Icahn came long. Last week, the veteran activist investor disclosed a 1.39 per cent stake in the struggling US telecommunications equipment maker, or 33.5m shares, and informed the company he would seek a board seat for himself.

In August 2005, when Mr Icahn started pressing Time Warner for measures to boost the media company’s shares, the stock was about $18. Today the shares are closer to $22.

Be on the lookout for low-priced NYSE stocks and those that make it onto the 52-week low list. And do not forget about the Dogs of the Dow – solid, long-established companies that are selling at bargain prices and have enough cash flow to support high dividend yields.

For instance, Citigroup is trading at just 11 times next year’s earnings, gives a 3.5 per cent dividend and has a history of increasing dividends every year. There are many catalysts that could drive Citigroup higher, including spin-outs of underperforming divisions or a management change at the top.

While not trading near a 52-week low, it is worth noting that this this is the lowest p/e (11) that the stock is trading at in over a decade. Meanwhile, 10 years ago, Citigroup had a book value per share of just $9 and now its over $24.

If one looks through the dregs and the garbage can one often finds hidden gems. I tend to prefer this to looking for momentum, although sometimes this is to my detriment.

james@formulacapital.com

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