About two weeks back I did some bottom-fishing with these five seriously unloved small caps. The average decline in those stocks year-to-date was 35%, but four of the five actually did the (seemingly) impossible and are up as of late. Perhaps Avatar (AVTR) and Steve Madden (SHOO), among others, just got lost on their random walks - I realize two weeks isn’t much of a test - but there can be some life in otherwise unpopular/detested/hated stocks.

Case in point: at the end of August, I was looking for a new stock to profile (I ended up settling on American Eagle - AEO - read the stock report), so I had my quant models up, I’m looking through the quick stats on a bunch of them, and I come across a very well-known but unpopular name. I later found out it was one of a dozen stocks in the S&P 500 without a buy recommendation from anyone, but even though the financials were very compelling, I just couldn’t find a reason to love Lexmark (LXK). Since the start of September, the stock is up 12%. Go figure.

I say this because LXK was near the very top of my quant model, and as I set it up today I hoped to write glowingly about one or more of the top handful of names. And right now, I simply can’t do that because these are quite possibly the ugliest collection of ideas I’ve ever gotten from it. Three of the top eight are down more than 40% in the last six months. Nutrisystem (NTRI) has over 50% of the float short. It trades for 5x EBITDA and 8.5x free cash flow. In the last year, the company turned each dollar in sales into 14 cents of FCF. Because of how lean the operating structure is, ROA and ROE are above 60% and 80%, respectively. Notable Calls has some good commentary on the risk-reward here; of particular interest is the fact that Nutrisystem could buy back half the shares outstanding not held by insiders. Are the near-term trends with the company nice? No, certainly not. Did the momentum go too far here? Nutrisystem isn’t a proven company in that they have a very short operating life, but their liquidity position is fine and this looks much more like a short squeeze waiting to happen than anything else.

In a field that I find slightly more interesting - land drillers - Patterson-UTI (PTEN) and Grey Wolf (GW) show up right next to each other. Both stocks are at 52-week lows. Both stocks are at 1.7x book value, and while weakness in dayrates for their drilling rigs have been in the headlines, I see this as more a temporary correction before another pickup in demand than the start of prolonged weakness. Oil keeps getting more expensive - I don’t want to hear anything about rate cuts and the dollar here, it is primarily a supply issue - and there is going to be a lot of drilling with these kind of oil prices. At 2.6x EBITDA for Grey Wolf and 2.8x for Patterson-UTI (remember, I typically don’t use EBITDA except to make very quick comparisons like this), along with the corresponding low earnings and cash flow multiples, these stocks are not priced for continued high oil prices. I said the same thing about Exxon Mobil (XOM) and Chevron (CVX) back in June 2006. We’re getting closer to high-value oil with the majors, but many other related companies still lag. Drilling is one of them.

I already mentioned Avatar (AVTR), a homebuilding in Arizona in Florida, in my first column linked to above. Along with Avatar on the list is NVR, which is actually one of the better-positioned homebuilders thanks to its use of land options. NVR is the rare homebuilder now in that it sells for more than 2x book value - because it has a better financial position than basically everyone else, but again, nothing to love here. It’s homebuilding, and we in America aren’t going to buy houses anymore… or so the market would lead you to believe.
I don’t know when the trough in homebuilding is going to occur, if it is occurring now, etc., but I do know if you buy a cyclical at a huge discount relative to normal earnings, you should get good results. Stocks like AVTR, NVR, and a similar pick I profiled last week all look to fit this criteria.

And, since good things come in pairs, Holly (HOC) and Frontier (FTO) both make an appearance in the top 10. While these stocks don’t have the short interest many of the others have, when you consider the sustainability of refining (i.e. what are the odds we’ll need oil refined in 10/20/30 years), it is odd that the market is valuing these companies with homebuilders, potential fad-diet purveyors, and politically nuclear companies like Advance America (AEA). Faisal Laljee has an interesting take on timing buys with refineries, and while he likes Western Refining (WNR) in particular, I don’t have a clear cut favorite in the complex of WNR-HOC-FTO-Valero (VLO), I just think you should pick one or more and go for it.

I haven’t scratched the surface of my latest quant screen run, but unexciting stocks that seemingly have no catalyst can sometimes perform very well, and I think there are some winners to be had from among these names.

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