Wake Up to Sleeper Stocks

Out-of-favor and overlooked shares can generate big returns. The trick, of course, is finding them before the crowd

By Alan Hughes

Call them the Joe Montanas of the stock market. Just as the Super Bowl legend was the 82nd overall pick in the 1979 National Football League draft, so have many investors passed up opportunities to own issues that, while not the subjects of lots of hype, may still become tomorrow's hot properties.

Let's call them sleeper stocks. Virtually unnoticed by the financial community at large, these gems quietly outperform the greater market even as the spotlight remains focused on mega-cap tech stocks and other high-profile issues.

Spotting a potential sleeper isn't all that difficult. The first thing to look for is a downtrodden, underpublicized company with turnaround potential and solid fundamentals. Next, keep a sharp eye for a company with a share price that is considerably off its 52-week high, off its long-term average, and that has been hit harder than the market average.

Finally, there are the related issues of market sentiment and whether the company and its management have weathered downturns in the past -- downturns in both their sector and the overall economy. If the company's industry and fundamentals are solid, yet most investors seem afraid to touch the shares with a 10-foot pole, you have a sleeper candidate.


  Which stocks fit the profile? Auto-parts retailer Pep Boys (PBY ), which saw its stock drop from the $20 range in 1998 to a low of 3.31 in January, was a classic example. Investors left the company by the side of the road amid fears that economic sluggishness would wipe it off the map.

Yet in May, Pep Boys beat Wall Street estimates by posting earnings of $9.1 million, or $0.18 per share, on revenues of $551 million. The stock is now up more than 200% and trading near $12. In a similar vein, auto-parts makers Johnson Controls (JCI ) gained 60% for the year, Delphi Automotive Systems (DPH ) added 56%, and Magna International (MGA ) is up 55%.

Service Corp. International (SRV ), Rent-Way (RNY ), Mattel (MAT ), Bank One (ONE ), and Fleetwood Enterprises (FLE ) also fit the criteria. Most investors turned their backs on these outfits when the U.S. economy went south.

"These are the ones that everyone's given up on but have doubled or tripled while nobody was looking," says Timothy Vick, senior analyst at Arbor Capital Management. "They have a history of pulling themselves out of these cyclical problems." Even some big names in their respective industries can be sleepers: JC Penney (JCP ) is up 164%, while Kmart (KM ) has gained some 116%.


  Or what about consumer novelty jewelry stocks, which are up an average of 91% year-to-date. Granted, that number is skewed by an 826% gain in Action Performance (ACTN ), which dipped to about $2 per share before rocketing past $20, but there are healthy gains all around this unsung sector.

Other jewelry gainers include A.T. Cross (ATX ), up 68%; Mayer Jewelry (MYR ), up 44%; Enesco Group (ENC ), up 38%; Russ Berrie (RUS ), up 31%; and Fossil (FOSL ), which has gained 26%. "We've had a pretty decent environment for some of these companies, especially when they have a little bit of a niche and they're not slugging it out with the Wal-Marts of the world," says Richard Marone, editor of the Dow Theory Forecast newsletter.

Most of the less-famous issues garner very little -- if any -- attention from the media or the bulk of the investment community. "Every time I'm on TV to do [interviews], I always ask them off the camera how come they don't talk about other groups or try to point out value," says Larry Rice, chief investment officer for Josephthal & Co. "The answer is, 'That's not what the public wants.'"


  Still, a good sleeper stock doesn't remain unnoticed for more than a couple of years. Generally, they fly under the analytical community's radar until they've doubled or tripled from their lows, when they become darlings. "It's like you're a .200 hitter at the start of the year and now you're hitting .330, then everyone knows your name," says David Sowerby, vice-president and portfolio manager for Loomis, Sayles & Co.

In a momentum market, few investors want to bother buying the more obscure or out-of-favor issues. There was no need to do so in 1999 and early 2000. Investors could just put their money into highflying big-cap tech stocks, sit back, and count the profits. The market was that easy. Even portfolio managers fell into the trap as mutual funds began "style drifts" to justify owning such stocks.

That thinking doesn't apply anymore. These days, the market is more turbulent than hurricane season in the Caribbean. Plus, if history is any guide, the sectors that lead the market out of a downturn are almost never the ones that were in the vanguard on the way down.


  That's not to say the former darlings of the Nasdaq won't become winners again, just that they seem unlikely to regain their former rates of rapid growth. And with all the exposure the mega-caps receive, timing the bottom is virtually impossible.

"There's so many people around the world reading all the articles on [big-cap tech stocks], that the chance that you're going to get it at a rock-bottom, bargain-basement price are going to be pretty slim," says Vick. "There are people willing to jump in at a moment's notice and buy several million shares and bid the price back up."

The $64,000 question: What are the sleeper stocks that are just now starting to rise from their slumber? Rice says his favorite unsung stock is Aztar (AZR ), which owns resort casinos in Atlantic City and Las Vegas. The stock is up about 10% year-to-date, with Rice believing it could rise further, since he sees the company as a possible acquisition target. "It's been reducing its debt levels, it has a good cash position, it's been buying back its own stock, it's been blowing out all the numbers, and frankly, nobody cares," Rice says.


  Sowerby thinks ADC Telecommunications (ADCT ) and Merck (MRK ) could be future sleeper hits. The portfolio manager says he finds both compelling on a valuation basis. "If you think the semiconductor sector is going to recover, ADC Telecom is a higher quality semiconductor stock that's still trading pretty far off its 52-week high."

Although Merck is far from obscure, Sowerby contends it is still a "semi-sleeper" because "it's on fewer radar screens these days." Sowerby argues that, as a general rule of thumb, companies in the drug industry may be undervalued. Most now trade at price-earings ratios equal to the market average, rather than the considerable premium that history says is the norm. Merck shares, for example, are down some 28% for the year.

Despite the possible gains in sleeper stocks, most investors will continue to ignore them. Instead, the investment community will likely continue to focus on a handful of big-cap tech stocks. "My history of watching the market is that whatever seems to be the least sexy one year tends to give you one of the best returns next year," says Vick. "But I think people still focus on the S&P 100 or Nasdaq 100 because that's what they're comfortable with."

If there's one thing this market has shown investors, it's that going with the hotshots is no guarantee of success. Unless, of course, the hotshot started out as one of the Joe Montanas of the stock market.

Hughes covers financial markets for BW Online in New York

Edited by Thane Peterson

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