Five Stocks Ready to Wake Up and Smell the Coffee

Dig a little deeper, however, and you'll find that Marker shares some strategies with the hyperkinetic Jim Cramer. No, he's not throwing chairs or mugging for the camera. But he is using some stock-picking strategies that his peers in the value-investing world may find alarming: Marker closely monitors Wall Street analysts' earnings forecasts, for instance, and tracks the momentum of share prices. Traders use such data to capitalize on a stock's short-term movements, which is a far cry from the fundamental analysis that value investors perform to find stocks at bargain prices.

These days it's not easy for a value investor to find a bargain. In recent years the line between value stocks and growth stocks has become increasingly blurred, with value investors scooping up traditional growth stocks such as Cisco Systems and Oracle, while growth investors are buying value stalwarts such as Caterpillar and Boeing. Meanwhile, investors like Marker are digging through the sleepy discount bins for stocks that are ready to rise and shine.

And therein lies the challenge: You can be right in your analysis that a stock is deeply undervalued, but without a catalyst it can take years for the investment to wake up. That's where the day-trading strategies come in. While value managers seldom pay attention to Wall Street's buy and sell ratings, they do take notice when analysts raise or lower their earnings forecasts — and with good reason. A change in expectations often indicates tangible changes are under way that will affect the stock price. According to Emory University finance professor Narasimhan Jegadeesh, stocks of companies whose earnings estimates have been raised outperform those of companies whose estimates have been cut — by six percentage points over the following six months.

The research is even more compelling when applied to value stocks alone. Josef Lakonishok, a professor at the University of Illinois, pioneered this investment strategy in the 1980s and later made it and other behavioral-finance principles the basis of LSV Asset Management, a firm he cofounded in 1994. Since little is expected of battered stocks, Lakonishok found, it doesn't take much good news to boost them. Investors, meanwhile, expect growth stocks to be perfect, leaving them vulnerable to even the slightest disappointment.

Another technique borrowed from short-term investors: seeking out stocks that have been marching higher. While it might seem that value managers would avoid stocks that have already begun to move up, research has shown that stocks in the early stages of a rebound tend to keep rising.

This sounds like a beautiful combination to us, so we started our search for stocks that were undervalued according to one or more traditional metrics, such as price/earnings, price/sales or price/cash flow. We then narrowed the list by looking for companies for which analysts have been raising their 2007 earnings estimates and whose stocks have been climbing in the past three months. All signs suggest these companies are awakening from their slumber.

After spending two decades spinning off divisions like Abercrombie & Fitch and Limited Too, the company agreed in November to buy Canadian intimate- apparel retailer La Senza for $628 million — its first major acquisition since the mid-1980s. The purchase sets the stage for a push abroad. While Victoria's Secret enjoys international recognition, thanks to its scantily clad models, it does not yet have a retail presence abroad. The La Senza purchase brings in a management team with global experience that will help with an international push, says James Benson, who covers the company for Harris Associates.

Bath & Body Works and Victoria's Secret make up about 70% of Limited's $11 billion in expected 2006 sales, and recently, the two chains have been posting eye-popping gains in sales at stores that have been open at least a year — 13% and 18%, respectively — levels not seen in years. Even the company's more staid chains, like Express and The Limited, are improving as new management tries to reconnect with customers who were alienated when the brands moved too far upscale.

Perhaps the most exciting news for investors is the company's plan to expand existing Victoria's Secret stores, signaling that it's not just a mega-brand but also one with growth still ahead of it. Benson expects the retailer to create more stores within stores, focusing on its youth brand, Pink, for example, and on beauty products. "Its opportunities are probably bigger than people think," he says, noting that these changes should continue to drive growth for the next three to five years. If analysts' estimates are any guide, Wall Street has begun to share Benson's optimism. Earnings estimates for 2007 have risen 7% in recent months, to $1.94 a share. That's 12% over what the company is expected to report for 2006.