Contrarian Stocks to Watch

By Sham Gad | October 11, 2011 AAA

There is a lot of value that can come from a contrarian investment approach. When Internet stocks were soaring in 1999 and early 2000, contrarians who decided that valuations were absurd, watched from the sidelines as market watcher called them out of touch for missing out on big gains. The contrarian had the last laugh, however, as those same market watchers watched with embarrassment as those gains vaporized quicker than they accumulated.

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The Intelligent Contrarian
Yet, being a contrarian merely for the sake of going against the crowd is not smart, if there is no intelligent basis behind it. After all, the collective wisdom of a crowd can often be more useful than one individual's information; the market is usually an efficient arena. But every so often, market pessimism gets so extreme that emotions trump rational thinking.

Today, the housing industry is so depressed that valuations are at rock bottom levels. To be sure, virtually any business that derives a significant portion of its sales from residential real estate, is losing money today and has been for a few years now; the picture doesn't look encouraging next year. As a result, very few people want to own housing related stocks and for good reason. A contrarian, at the minimum, will look a little closer to see if going against the grain here is a worthwhile endeavor. (Contrarian investors find value in the worst market conditions. For more, see Buy When There's Blood In The Streets.)

Survival of the Fittest
The housing problem is really a simple supply/demand economics problem. Demand for housing remains depressed while the supply of housing is currently running at about 500,000 units a year. While that figure is well below the peak of about 2 million starts several years ago, it will take a while for the imbalance to shift. When that happens, businesses leveraged to housing will likely benefit more than actual homebuilders.

So, instead of owning the homebuilder, why not own a supplier to them like Builders FirstSource (Nasdaq:BLDR). Shares now trade for about $1.40, down significantly from the good old days. At a market cap of $130 million, BLDR would be deemed cheap during any type of housing recovery. To own it, you have to have a long-term view, but that view could pay off in the form of a $5 share price, in three years. A stable recovery could see BLDR earning $100 million in EBITDA.

Comfort Systems (NYSE:FIX) installs and repairs HVAC systems. The company has increased its commercial business during the residential construction downturn. The company has a market cap of $366 million and nearly $22 million in net cash. The business is profitable, though it currently trades around 40 times earnings, which are likely depressed.

More conservative investors looking for income will like Lowe's (NYSE:LOW), the nation's second largest home improvement retailer, after Home Depot (NYSE:HD). LOW and HD have effectively navigated this tough environment; both are profitable and sales are stabilizing. A housing recovery would be like a call option on the share price. While you wait, Lowe's yields nearly 3%. (For more on calls, see The Basics Of Covered Calls.)

The Bottom Line
A contrarian bet can have a substantial payoff for patient investors, but offsetting the huge reward is finding out the crowd was right. Contrarian investors, by their nature, are very research intensive. Before going against the grain, make sure you are well equipped with facts.

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