Are Low Quality Stocks of Today the High Quality Stocks of Tomorrow?

At Ascendere Associates LLC, we like to look for potential stock ideas on companies that show relative strength in ROIC and potential cash flow growth while also demonstrating value relative to their peers. We provide a model long/short portfolio and detailed individual stock analysis.

We usually generate about 80 stock ideas each month, roughly half long and half short. The list could be used as an actual portfolio strategy, or a way to generate potential stock ideas for further study. We were inspired in part to develop this model upon reading a 1997 Harvard Business Review case study on Numeric Investors. This approach was probably cutting edge at the time but it's now considered quaint by today's standards.

However quaint, the Ascendere Long/Short model portfolio seems to work very well in aggregate, with a compilation of a backtested and real-time results showing a return of roughly 180 per cent over 5+ years. But the approach is far from perfect - witness the outperformance of "low-quality" stocks for most of 2009 and for the month-to-date in February. We would note the back test does not include slippage, commission fees or whether a stock is available to short or not - though we here there may be ways around these short comings with access to a prime brokerage.

On another level, the model portfolio can be used to generate ideas for more in-depth research coverage. For example, our recent detailed reports on McKesson Inc. (MCK), Joy Global (JOYG) and Starbucks (SBUX) demonstrate one way a data-intensive approach can be used to shed deep insight into the detailed long-term assumptions that the sell side consensus is embedding in various stocks, and the ways that long-term valuation can be affected by changes in the various assumptions.

These reports can be used by corporate managements and institutional investors alike to help with developing various performance targets or valuation scenarios. As we have demonstrated, intensive use of data, industry knowledge, experience and intuition make for a powerful combination.

From a short-term perspective, we have observed that many "new" stock ideas on our list tend to do well, though we have not backtested this. This may be because the model captures new information regarding operating momentum or relative valuation before the overall market does. Why this is can be true in a market dominated by thousands of sophisticated quant programs we can only guess - maybe we are geniuses, maybe we are lucky, or maybe the quants are just chasing noise on an intraday basis letting old fashioned and slow moving simple relative valuation methods work.

However proud we are of our work, the problem with any model is that they fail. Take a look at the month-to-date performance of our short ideas list for February, for example. This could indicate that poor operating results have reached an inflection point, and are starting to bounce back.

A closer examination of some of the most recent "short" ideas generated by the strategy (see below) could bear this out. It is in fact the correct "contrarian" calls that show the most explosive stock price appreciation. However deep a model's failure, very often they act as a valuable tool in which an analyst can direct his or her efforts with further analysis.

From that perspective we offer the following new stock ideas that deserve a closer look this week:

Possible long ideas:

Mattel Inc. (MAT) - Good operating momentum and relative value, more cash than debt on its balance sheet, an attractive dividend yield of 3.4%. Consensus estimates may imply continued improvements but a slowing in the rate of operating momentum.

NBTY, Inc. (NTY) - Manufactures, markets, and retails nutritional supplements. Consensus estimates show that good operating momentum will probably continue, and relative value is very good. A caveat is that insiders recently sold a significant amount of shares and this stock has been recently highlighted by a high number of technical trading systems.

BBVA Banco Frances S.A. (BFR $6.14) - Argentinean bank showing improving ROE and price-to-book of 1.6x versus an average of 3.1x for all diversified banks that trade on major U.S. exchanges.

Possible short or contrarian long ideas

Abercrombie & Fitch Co. (ANF) - Non-compelling though not drastically poor relative valuation against a backdrop of declining ROIC and downward estimate revisions. May not be the best short idea given its very strong balance sheet and a consensus high estimate which could indicate an ability to reverse its recent misfortunes. In fact, this could be a good "contrarian" long idea to work on.

Camden Property Trust (CPT) - A 5.2 per cent yield attractive, but consensus estimates indicate that negative ROE levels could persist in the near term. Debt level almost equal to its market cap. May be appropriate to revisit this at $46, which is the sell side consensus high price target.

Lazard Ltd. (LAZ) - Poor recent results, but ROE could turn positive again by the June 2010 quarter. A possible short idea that we would avoid acting on for now.

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