Possibly the Best Comeback IPOs of 2011…

There is a clear downside to the impressive bull market we’ve seen during the last 22 months: it’s getting harder and harder to find real bargains. To ferret out value plays, investors are increasingly turning to stocks that have lagged the market, hoping to find turnaround candidates. One fertile area for research is the IPO market, where mediocre newly-public companies can see their shares fall sharply because of their relative anonymity.

I’ve looked at the class of 2010 IPO market on a number of occasions, but what about the class of 2009? There must be some unloved and undersold names populating this group of stocks. So, I decided to take a look at the 2009 IPO market’s worst performers. I narrowed the list to include stocks off at least 30%, yet I also wanted to focus on companies that are expected to see sales rebound at least 10% in 2011. The stocks should ideally sport single-digit price-to-earnings (P/E) multiples (though I made a couple of exceptions). I will then discuss why some of these stocks have been so sharply dismissed by investors. Later, I’ll suggest the best rebound candidate of the group.

Guilt by association
When a company sporting a similar name is accused of accounting fraud, you know investors are likely to tar you with the same brush. Shares of Duoyuan Global Water (NYSE: DGW) plunged more than 40% in September 2010 when Duoyuan Printing (NYSE: DYP) owned up to some accounting problems. The two companies are unrelated except that they have the same chairman. Duoyuan Global Water makes a range of filtration products, water softeners and ultra-violet sterilization equipment. It’s not a sexy business, but in light of China’s myriad water quality issues, demand for the company’s products and services is reasonably robust. [My colleague Andy Obermueller, editor of Game-Changing Stocks, says water is even more valuable to China than oil.]

To clean up its tarnished image, Duoyuan Water recently hired auditing firm Grant Thornton. That’s a wise move and one that is likely to be followed by many Chinese firms that currently are mistrusted by U.S. investors.

Shares of Duoyuan Water have fallen from $40 to $12.50 during the last 15 months and certainly look quite cheap on a price-to-earnings (P/E) basis. However, investors looking to play the China water clean-up might be better off sticking with Tri-Tech Holdings (Nasdaq: TRIT) — which has jumped 20% in a matter of days since Andy mentioned it. The stock was also a 2009 IPO that lagged in 2010 — but is showing signs of a continued rebound in 2011. [For a more detailed look at Tri-Tech, see my Top 3 Chinese Stocks for 2011].

Lots of promise and lots of frustration
With electric and hybrid cars moving into the spotlight, you’d think that battery maker A123 Systems (Nasdaq: AONE) would be a hot stock. Well, it was when it first went public, but shares really hit the skids in 2010 as investors realized the advanced battery market would be slow to materialize.

But A123 is starting to benefit from the trend — sales are likely to more than double this year — but it will still be several years before the company can generate positive cash flow. That means that it will likely need to raise more money. I like this company’s business model, but you’re best off keeping this stock on your watch list until the capital-raising efforts have completed, which may happen in coming quarters.

Pain now, gain later
The health care industry is going through a host of wrenching changes, as reimbursement schemes come under pressure and major players sort out their business models to adjust to rising cost pressures and falling revenue. Over time, industry analysts expect a balance in supply and demand, and, consequently, a between revenue and expenses, will strike. In effect, they expect income statements to remain under pressure in 2011, but conditions to return to normal in 2012 and beyond are good– especially for treatments and services that are vital and cost-effective.

That issue surely applies to Select Medical (NYSE: SEM), my favorite pick of the group. Select is the leading provider of Long-Term Acute Care (LTAC) services. Many chronically ill patients need this kind of specialized service and demand is only likely to grow as our society ages.

But right now, Select Medical is a victim of lousy timing. A 2009 IPO was followed by a subpar 2010. And the company should see only slowly improving results in 2011. Even though insurers reimburse many LTAC services, other services aren’t covered and the economic downturn has led to a sharp pullback in this large out-of-pocket expense. But as the economy improves, so should utilization at the company’s 111 LTAC centers and six LTAC rehab facilities. As a result, the outlook for 2012 and beyond is likely to improve on the heels of a rebounding economy.

Meanwhile, Select’s shares are off 30% from the September 2009 IPO, which has led management to initiate a hefty $100 million stock buyback that could reduce the share count by about 10%. As long as shares remain below $8, management is likely to keep buying back stock throughout 2011.

Analysts expect revenue to rise about 15% in 2011, about half of which is coming from acquisitions. That should help sustain the company’s strong level of cash flow, which could approach $400 million this year. Shares appear to have minimal downside at this point because they have already absorbed a litany of challenging operating factors in 2010. Trading at around six times the projected 2011 EBITDA, shares look to have roughly 30% upside as they move closer to historical multiples.

Action to Take –> In a market now dominated by ever-rising P/E ratios, you have to look deeper for cheap stocks. Select Medical is my favorite name on this list, but the others certainly merit consideration.

These companies have had forgettable years in 2010, but much of the bad news appears to be in the past for many of these names. Low P/E ratios could help boost their profile among value investors in 2011 and lead to rising share prices.

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