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Investing in Unloved Stocks Requires Vision, Patience

Rachel Koning Beals

Hanging out with the wrong crowd can ruin your rep. Or sometimes it elevates your status.

The same can be said of certain stocks whose affiliation with a downtrodden sector might lead investors to snub a company that shows fundamental strength and long-term earnings potential. For some investors, stocks that are a little rough around the edges shout possibility. But those buyers must have the risk tolerance and the patience to wait out a turnaround.

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Buying unloved stocks starts with three principles, says Preston Athey, manager of the T. Rowe Price Small-Cap Value Fund, in a research note. First, focus on a company's potential without being overly concerned with short-term issues. And, if you own a stock that isn't working in the short term but you can still see its long-term potential, you're less likely to sell at the bottom. Finally, if your thesis is working, there's a good chance it will work for a while. The biggest mistake a value investor can make is to sell winners too quickly.

Investors should view stock performance and company performance separately. After all, crowd mentality drives share prices. Even negative research can work to the advantage of brave value-seekers; a negative report might drive down the cost of bulking up on the shares you expect to do well over time.

"Take an industry like housing," says Robby Bryant, a financial planner with Magnolia Financial Planning Services in Seneca, S.C. "During the real estate slide, home-improvement retailer Lowe's saw its shares depressed in step with general bearishness. But we liked Lowe's as a company, so we used the share drop to buy more. We might not have been upbeat on the builders, but that doesn't mean we shunned every corner of housing."

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T. Rowe's Athey offered oil-tanker stocks as an example. The sector's skid shows the importance of studying longer-term supply-and-demand conditions.

"The sector has been horrible and it's hard to say when it will turn around. We can't say with certainty when the demand and prices for their services will rise again. But we do know that there have been few new tanker orders for two years, so the supply of new tankers is likely to top out later this year," he said in the note. "Meanwhile, some ship owners are going bankrupt, tankers are being idled, and some are being scrapped, including even ones that aren't that old. No one is doing well. What I want to invest in are the oil tanker companies that we think will survive, the ones with little debt and enough cash on their balance sheets that can survive."

What's a value investor with a slightly pro-cyclical stock bias interested in now? Financials, for one. There's a category that takes some homework.

Athey's T. Rowe Price Small-Cap Value Fund included a nearly 23 percent weighting to financials, 22 percent weighting to industrials/business services, 12 percent weighting to consumer discretionary, and a 12 percent weighting to information technology, as of March 31, 2012. The rest of the fund's assets are spread across materials, energy, healthcare, utilities, consumer staples, and telecom. Top 10 holdings include: Landstar System (LSTR); ProAssurance (PRA); Raven Industries (RAVN); Aaron's (AAN); East West Bancorp (EWBC); Genesee & Wyoming (GNWR); 3-D Systems (DDD); Carpenter Technology (CRS); Kilroy Realty (KRC); Markel (MKL).

Russel Kinnel, Morningstar's director of mutual fund research, looks at mutual fund and ETF style rather than focusing on individual stocks to construct his "buy the unloved" strategy.

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Kinnel crunches fund-flow data. The basic idea is that the categories with the greatest inflows in the prior year are overbought and those that had the most redemptions are oversold and thus, due for a rebound. For instance, the market-leading 2011 redemption levels in the "large growth" and "large blend" categories earned these two the top honors on Kinnel's early-2012 unloved (worthy of love) list.

Performance results validate the approach. Going back to the beginning of 1994 through the end of 2011, the unloved funds returned an annualized 8.98 percent, versus 7.42 percent for the S&P 500, Morningstar data shows.

Certainly, success with betting against the crowd is not new. Warren Buffett has famously said that a simple rule guides his stock buying: Be fearful when others are greedy, and be greedy when others are fearful.

Just be sure to jump in for a reason beyond the discount.

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