Four Stocks That Illustrate Contrarian Investing in This Market

Friday, April 9, 2010

Contrarian investing is a key approach to earning superior returns. Most often considered appropriate for a value approach, “contrarian” aids all successful investors and investment managers, regardless of their particular style.

I have written about contrarian investing and its importance in past articles (e.g., see the four-part series beginning with “It’s Time To Be a Contrarian Investor” – December 9, 2009). Today, I will use four stocks as examples of the kind of contrarian investments available in this market.

Contrarian stock #1: Alcoa (AA)

Alcoa kicks off the earnings reporting season on Monday (April 12). That leadership position is important because the company’s results are closely tied to the economy’s health and growth.

The price is about $15 – a level first reached fifteen years ago in 1995. The stock lost a price support last March when the company, to conserve cash, slashed its annual dividend from $0.68 to $0.12. Its stock price is so low that, even though Alcoa is the world’s largest aluminum company, its market capitalization is comparable to Activision and the Las Vegas Sands.

So, will Monday’s earnings report be a positive surprise? Management isn’t talking. But they will Monday. I expect that, regardless of first quarter’s results, what they see coming could be the catalyst for increasing interest in the stock. Key industries for them are auto and aircraft, and both are showing renewed life. Spread those improvements across the economy, and Alcoa could be looking at some good revenue and earnings growth.

Contrarian stock #2: Merck (MRK)

Merck has the looks of a true value stock: A forward price/earnings ratio of about 11 and a dividend yield of over 4%. At about $37, its stock price is at a level first reached fourteen years ago in 1996. It, like other pharmaceutical companies, suffers from worries about drug patent expiration and the pressure to push drug prices down.

What makes Merck a good contrarian investment starts with the fact that the company is a well-managed drug research, manufacturing, marketing and distribution firm. And its strong financials give it the means to invest, expand and grow.

To me, the pharmaceutical industry’s key success driver is the fact that drugs remain the most cost effective medical treatment in the health care field. Yes, there are the stories of high-priced, specialty drugs and people faced with high cost drug regimens. But the alternatives (hospitals, surgeries and the results of non-treatment) are higher cost, not to mention less desirable.

Miracle drugs aside, there remain the two promising growth routes of prevention (think Lipitor) and “life-enhancement” (think Viagara). In addition, research continues to push forward on new delivery methods.

Contrarian stock #3: NVR (NVR)

My guess is no one will argue that homebuilders can be thought of only as a contrarian play. With so many investors uncertain about housing’s future (or certain it will be bad), homebuilder stocks remain unloved. And that is the crux of this decision.

As I wrote earlier, there are reasons we could see a revived housing market earlier than many expect. The challenge of participating in such a move is that homebuilders are a mixed bag, financially. And they operate in different regions and communities, so, even in an improving market, their results could be quite different.

I believe NVR has a good set of characteristics. Its stock (which sells at an unusually high price of around $700 per share) has recouped much of its loss from a high of around $950. The company is financially strong, with positive earnings and virtually no debt. Importantly, it operates in twenty-two metropolitan areas in twelve states (Maryland, New York, North Carolina, Virginia, Ohio, South Carolina, Pennsylvania, Tennessee, Delaware, West Virginia, Kentucky and New Jersey). NVR, therefore, avoided many of the new home problem areas such as Florida, California and Nevada.

Contrarian stock #4: Exxon Mobil (XOM)

“Exxon Mobil is a contrarian investment?” you ask. Yes, but not as we typically think. It is well known, widely followed and liked for its earnings, dividends and share repurchase. However, it just lacks – well, excitement. So, it sells at a mediocre forward price/earnings ratio of under 12 with a 2.5% dividend yield.

But the company could have excitement:

  • It enjoys earnings leverage as the economy grows
  • It gets the benefits of vertical integration
  • It skillfully operates globally in true global markets
  • It has tremendous financial resources, with huge cash flow and no debt

“Those are laudable qualities, but where will the excitement come from?” That is what management is working on. (It’s why I have said not to own commodities, but to own companies that use the commodities. Managements work to add value beyond simple commodity price gains.)

Let me phrase it a different way. Investors expect ho-hum. That, then, is the base case: collecting dividends and watching earnings and the stock price gradually rise. The problem with that scenario is that it paints a picture of a comfy management group, content with the status quo. Exxon’s history reflects activity, so I believe a better assumption is that things will happen. Actions will be taken to boost Exxon Mobil’s prospects, thereby raising investors’ perceptions and valuations.

So… These are four stocks that offer a contrarian viewpoint in today’s market. Note that none of the choices represents a risky bet. Rather, they are companies where investors currently have low or mediocre expectations. The contrary view, then, is that the future looks brighter than that, and so returns could be higher.

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April 2010