Four beaten-down U.S. stocks to watch

July 06, 2010

John Dorfman

BOSTON — The deafening hiss we’ve been hearing for the past five weeks was the air going out of the U.S. stock market at the end of the second quarter.

For those who still have the nerve to buy equities, I present my quarterly Casualty List—a roster of stocks that have been banged up severely and that I think can recover and go on to new heights.

Microsoft, which I never thought I would see on this list, exemplifies the latest batch of casualties. Many of them are well-known companies with solid balance sheets and long histories of profitability.

The Standard & Poor’s 500 Index, a decent gauge of the overall U.S. stock market, lost 11.4 per cent for the last three months, even after taking dividends into account.

To me, things seem less grim than many investors think. The European debt crisis of 2010 -- and probably 2011 -- may pass without lasting damage, as did the Asian currency crisis of 1997-1998. That, too, provoked fears of a worldwide financial meltdown. The Gulf of Mexico oil spill is a tragedy for wildlife, shrimpers, fishermen and tourism. Yet its economic impact will be diluted with time.

Investors seem to forget that in the past 70 years we have gone through World War II, a cold war with the Soviet Union, radioactive fallout from nuclear testing, the Vietnam War, the 2001 terrorist attack, the AIDS crisis and numerous recessions.

And yet for the 70 years from 1940 through 2009, the U.S. stock market has provided a compound annual return of 10.8 per cent. We have always had problems, and always will—yet enterprise, innovation and economic progress somehow continue.

Investors are fixated on whether we are about to have a double-dip recession. Double-dips are rare creatures, and not the most likely outcome in my view. If you see stocks such as Microsoft and EBay on the bargain counter, the wise thing in my opinion is to buy.

Microsoft fell 21 per cent last quarter. You can now pick up the shares for 12 times earnings. Over the past 10 years, Microsoft has sold for an average of about 23 times earnings.

I think there is room for positive surprises, as Microsoft benefits from demand for its latest operating system upgrade, Windows 7.

EBay, the online auction firm, is trading for less than $20 (U.S.), down from about $27 three months ago. In recent years, it has lost market share to Amazon.com in online retailing, but still is growing strongly.

The company has become the leading retailer in mobile commerce, in which people order merchandise using Blackberry, iPhone, Droid or similar smartphones, Colin Gillis, a New York-based analyst at BGC Partners said.

The company is debt-free and the stock sells for 13 times earnings.

General Dynamics, down 23 per cent in total return for the quarter, has been slammed as more people become convinced that defense spending will have to be sliced as Congress tries to address the large federal deficit. The military contractor makes planes, ships, weapons and information systems.

I agree that General Dynamics faces a difficult environment, but that is why its stock sells for less than 10 times earnings. The company increased its earnings in eight of the past 10 years; last year they were unchanged at $6.17 a share, a record.

Investors also punished American Eagle Outfitters in the last quarter. The clothing retailer for teen-agers and young adults declined 36 per cent, including dividends.

The stock faltered after American Eagle forecast second-quarter earnings below analysts’ expectations. Yet I would put some faith in the company’s long-term record, including positive earnings for 14 consecutive years.

I also like its international expansion push. It opened stores this year in Dubai, Kuwait and Israel. It plans to enter mainland China and Hong Kong in 2011.

Disclosure note: I own shares of General Dynamics personally and for clients. I have no long or short positions in the other stocks discussed in this week’s column.

John Dorfman is chairman of Thunderstorm Capital in Boston.