News Analysis date published New: 
Thursday, June 2, 2011 - 09:00
New Date created: 
Thursday, June 2, 2011 - 09:00
New Date last updated: 
Thursday, June 2, 2011 - 09:00

3 Underperforming Stocks that Could Jump as Much as 50%

Thursday, June 2, 2011 - 9:00am

When it comes to stock-picking, it's better to be early than late. I'd rather buy shares in a promising company and have to wait for the stock to jump than buy in long after others already have. So from time to time, I like to look back on stocks that I have been bullish about in the past to find cases where I was simply too early with my investment thesis. As long as the fundamental thesis remains intact, shares should still hold appeal, even if the stock has failed to rise thus far.

With that in mind, I looked over all of my stock picks from 2010 to see which ones haven't panned out yet. I focused on stocks for which the companies still appear like solid long-term holdings, but simply stumbled in 2010. These three stand out as stocks that should remain in focus for investors.

1. Charles Schwab (Nasdaq: SCHW)
I profiled this leading brokerage firm in January 2010, noting that the company's steadily building market share throughout the downturn would lead to much better results when the economy was humming again. After all, a similar pattern played out in the recession of 2001. The company's results went on to rebound nicely, pushing shares up sharply in 2005, 2006 and again in 2007.

In hindsight, my bullish view of Schwab was quite premature. Shares have dropped 7% in the past 16 months, while the S&P 500 rose 17% in the same period. The underperformance is simply due to poor results. Sales grew less than 2% in 2010 and remain well below peak 2008 levels. Much of that is attributable to the low interest rate environment, which has resulted in very weak profits at Schwab's money market funds.

But signs are emerging that an upturn is finally at hand. Schwab earned $0.20 a share in the first quarter, its best quarterly showing in nearly three years, as the broker's rapid buildup of new clients has finally started to pay off. Most importantly, Schwab continues to attract new clients (net new accounts rose 3.7% in the first quarter).

To be sure, Schwab's results will only sharply improve when interest rates begin to rise, as the company makes a very nice profit spread when rates rise faster than the money market yields the firm offers. Goldman Sachs thinks that may not come before 2013 at the earliest. But they also think results can improve anyway: "Even as we continue to assume short-term rates will not move higher in 2012, we believe EPS [earnings per share] can grow 24% (in 2012) to $1.10, an attractive growth story within a financial services group that remains plagued by limited top-line growth." The Goldman analysts also see EPS jumping another 35% in 2013 to about $1.50.

So even though Schwab has been underwhelming at the start of the economic upturn, you can still spot the beginning of a turnaround. Shares, which trade in the upper teens, could move into the mid-$20 or even $30 once investors start to focus on the brighter profit picture for 2012 and 2013.

2. MEMC Electronics Materials (Nasdaq: WFR)
In a bid to diversify its business mix away from the highly-cyclical semiconductor industry, MEMC entered the solar-power industry. But that industry also became mired in a cyclical slump, pushing shares down by 25% since I recommended them in March 2010.

That's a far cry from my prediction of 50% upside. At that time, I figured shares would claw back to above $20 (they had been above $80 in early 2008). Nowdays, a dependence on two cyclical industries is likely to put a lid on potential appreciation, and my $20-$25 target now looks closer to $15. That's cold comfort to those who bought shares in the mid-teens in early 2010, but still represents 40% upside from current levels.

MEMC's income statement is a mixed bag. Revenue is surging, but weak gross margins are keeping it from boosting the bottom-line at a commensurate rate. MEMC earned at least $1 a share from 2004 to 2008, but made just $0.15 a share in 2010. Yet as margins stabilize and revenue keeps growing (sales are expected to rise nearly 60% in 2011), EPS is expected to move back up above $1 this year and approach $1.50 by next year. Part of that gain will simply come from a drop in losses at MEMC's Sun Edison solar division. The semiconductor business already earns more than $1 a share, and an upturn in profits in solar should finally get this company firing on both cylinders in 2012. When that happens, look for the stock's price-to-earnings (P/E) ratio to rise to around 10, putting the stock near the $15 mark.

3. Greenhill & Co. (NYSE: GHL)
This stock gets the distinction of being my worst stock pick of 2010, dropping roughly 33% since I recommended shares in April 2010.

The rising tide of mergers and acquisitions (M&A) should have created a powerful tailwind for Greenhill's business model (it advises companies on mergers, acquisitions, restructurings and financing deals). Frankly, the firm's legion of investment bankers failed to bring in as much business as expected, leading Greenhill to miss out on some of the biggest deals in 2010. Equally troubling, the company lured top talent with very attractive contracts and was forced to pay out 57% of revenue to staff compensation in 2010, up from an historical average of 46%.

First-quarter results were especially disappointing. Greenhill announced just six transactions after advising on 46 deals in the prior four quarters. As a result, shares have tumbled from $80 to $55 in the past four months. But it's important to remember that the broader M&A picture remains quite bright, and Greenhill's recent market share losses are partially attributable to simply sniffing around in the wrong areas for deals.

In coming quarters, results should begin to stabilize and year-over-year comparisons should turn positive by the third quarter as the company picks up its deal-making activity. Analysts expect revenue to rebound more than 20% in 2012, as they generally assume the company's backlog of deal discussions will start to rise in coming quarters. (Deals need to be completed for the company to earn a fee, so more deal talk in 2011 sets the stage for a better 2012.) Shares could move as much as 50% higher, back to the $80 mark (or break-even level from my April 2010 recommendation) as the rebound starts to take root.

Action to Take --> All three of these companies posted 2010 results well lower than I expected, and 2011 isn't off to a great start, either. But each still holds a strong reputation in its respective field and the stage looks set for all to post improving results during the rest of 2011 and 2012.

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.