10 mutt stocks that will shine in 2007

By Jim Jubak

It's hard to find a truly hated stock in the midst of the current rally.

How hard? Well, most of the stinkers that I fingered for potential inclusion in my Dog Stars 2007 portfolio on Oct. 20 don't make the cut anymore. Some Dog Star candidates that were in the bottom 20% of the market then have turned into true stars. Navteq (NVT, news, msgs), for example, which was underperforming 89% of all stocks in mid-October, is now beating 91% of all stocks. Talk about a turnaround.

Even a stock like Yahoo (YHOO, news, msgs), a true stinker two months ago, isn't stinky enough to make the Dog Stars final cut now. Then it was underperforming 87% of all stocks; now it's underperforming just 75% of all shares. And that's just not bad enough.

For the upcoming year, to have a chance of matching the 14.9% return that the first Dog Stars portfolio returned in 2005, you've got to own the true dregs of the market. The bottom of the bucket. The scorned and the reviled.

Even in this rally, stocks like that do exist. Running my Dog Stars screen on Dec. 14, I found 10 stocks so hated even now, when everything else is going up, that they pass my test. I give you my final list of the Dog Stars of 2007: AnnTaylor Stores (ANN, news, msgs), A.O. Smith (AOS, news, msgs), Crane (CR, news, msgs), Intermec (IN, news, msgs), Micron Technology (MU, news, msgs), Motorola (MOT, news, msgs), Quest Diagnostics (DGX, news, msgs), Red Hat (RHAT, news, msgs), SanDisk (SNDK, news, msgs), and Sierra Health Services (SIE, news, msgs). Only Quest Diagnostics and Red Hat were on the original October list of potential Dog Stars.

Loving the unloved

So what is a Dog Star and what is my Dog Stars strategy?

The Dog Stars strategy is a straightforward attempt to build on two very successful buy-'em-when-they're-hated strategies.

First, there's the Dogs of the Dow strategy, the most famous example of a buy-'em-when-they're-hated approach. It works like this: Every Dec. 31, you buy the highest-dividend-yielding stocks in the Dow Jones Industrial Average ($INDU). Because a stock's dividend yield goes up as the price of a share falls, this is a simple way to buy shares of the 10 most battered stocks in the index. You then hold the shares for a year and rebalance the portfolio by selling these stocks and buying a new group of losers next December.

This extraordinarily simple strategy has yielded market-beating returns decade after decade. From 1928 to the end of 2003, the Dogs of the Dow strategy returned an average annual compounded rate of 13%. That was almost 2 percentage points a year better than the return on the Dow industrials and 2.5 percentage points better than the return on the Standard & Poor's 500 ($INX).

But, and this is a big but, returns from the strategy haven't been very predictable in recent years. I don't know if this represents a long-term problem or simply normal volatility in the performance of the strategy. In 2005 the strategy lost 5%, a worse performance than the Dow Jones industrials as a whole. In 2006, as of Dec. 14, a Dogs of the Dow portfolio would have returned 22.64%.

Clearly the strategy is worth revisiting.

Which is just what Yale Hirsch and Jeffrey Hirsch did. The Dogs of the Dow strategy turns in its best monthly performance in January. That led the Hirsches to propose an improved approach, called the "Free Lunch" strategy. As laid out in the Stock Traders Almanac, their strategy calls for buying all the New York Stock Exchange stocks selling at their lows in mid-December and holding them until Feb. 15. The average gain on the strategy since 1974 comes to about 13.7% in six weeks. That compares to the average 3.9% gain in the NYSE Composite ($NYA.X) for the period.

My Dog Stars strategy is designed to take advantage of the two reasons these successful strategies work.

• First, the Dogs of the Dow strategy works because the 30 stocks that make up the Dow Jones Industrial Average tend to be long-term survivors. These companies have enough financial strength to weather short-term troubles without going out of business. They survive bad times long enough to see the return of better times. Boeing (BA, news, msgs), up 28% in 2004, is an example of the benefits of being financially strong enough to survive the worst of times.

• Second, the two strategies work because they buy already beaten-down stocks that decline even further in the last days of the year as investors sell their losers to lock in tax losses for the year. When the selling pressure is relieved in January and February, these stocks bounce back from deeply depressed to simply depressed levels.

In the screen I've built to identify potential Dog Star stocks, I've replaced membership in the Dow Jones Industrial Average with a series of tests to ensure that these are stocks of companies with the financial strength to stick around long enough for a rebound. That results in a bigger universe of potential Dog Stars but retains the "survival bias" of the Dow stocks. In my Dog Stars screen, I required a market capitalization of at least $1 billion; a debt-to-equity ratio of 1 or less, so the company has plenty of access to the capital markets to raise new cash if necessary; and a quick ratio of 1 or more. The quick ratio divides liquid assets by current liabilities. The higher the quick ratio, the more liquid assets the company has to meet current liabilities from liquid assets on hand even if all revenue dries up.

Then, in my Dog Star screen, I looked for beaten-down stocks by requiring:

• A relative strength of 20 or less in the past three months. A stock with a relative strength of 20 has been outperformed by 80% of the stocks in the market. I think membership in the lowest fifth of all stocks is a good sign that investors hate these shares.

• And a previous day's closing price within 20% of the stock's 52-week low. That, one of my two original price rules, assures me that I'm buying shares that are not just hated but also cheap when judged by their recent history.

As of Dec. 14, 22 stocks pass that screen. (You can find it here.)

The list

I've picked 10 from the list that seem most worth watching. Why these 10? I took a stock-by-stock look at such price gauges as price-to-sales ratio (looking for cheap stocks with low ratios) and StockScouter subratings that showed solid fundamentals despite lousy technicals. And finally, I read through recent news and company reports looking for signs that the company had the potential to improve performance in 2007 or warnings that problems were getting worse.

Company name	12/14 price	52-week low	3-month relative strength	StockScouter rating
AnnTaylor Stores (ANN, news, msgs)	$34.10	$32.00	15	8
A.O. Smith (AOS, news, msgs)	$34.39	$33.93	19	3
Crane (CR, news, msgs)	$36.10	$34.61	20	4
Intermec (IN, news, msgs)	$22.97	$20.50	17	4
Micron Technology (MU, news, msgs)	$13.80	$13.62	13	3
Motorola (MOT, news, msgs)	$20.69	$18.66	20	8
Quest Diagnostics (DGX, news, msgs)	$52.46	$48.59	18	10
Red Hat (RHAT, news, msgs)	$16.22	$13.70	10	4
SanDisk (SNDK, news, msgs)	$42.66	$37.34	11	7
Sierra Health Services (SIE, news, msgs)	$34.56	$30.61	17	7

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