Markets

Oversold Stocks Yielding Up To 5.1%

We are nowhere near April 15th on the calendar. Still, for millions of taxpayers seeking to limit their liability this spring, the clock is ticking. The deadline to close out trades that went south to deduct capital losses is December 31.

Given the natural inclination of procrastinators to wait until the last minute, there is always a flurry of activity as millions of investors dump their losers in the final weeks of the year. Institutional mutual fund managers are also busy removing laggards and adding winners to window dress their portfolios.

This doesn't do much for performance -- it is purely a cosmetic enhancement right before annual reports go out.

So many stocks that struggle during the year are beaten down even further in December. Once the loss is harvested, the proceeds usually rotate back into the market shortly after, sometimes into the same stocks, as investors anticipate a rebound.

Aside from tax harvesting in December and reinvesting in January, many workers also plow year-end bonuses into their accounts shortly after the New Year begins. All of this means that January is typically a good month for inflows into stocks and equity mutual funds. In fact, market observers as far back as 1942 noticed an anomalous pattern of strong investment returns after the beginning of the year.

This phenomenon is called "The January Effect," and it's far more pronounced for small-cap stocks than large-caps. There have indeed been long stretches of bullish market performance in January, including gains in 13 out of 15 years between 1985 and 1999. But returns have been mixed since then.

I don't put much faith in such trends. Plus, arbitrageurs quickly exploit such opportunities. Nevertheless, I do believe strongly that last year's laggards often become next year's leaders -- and vice-versa.

I've seen it numerous times with almost every major asset class. Money will always flow toward relative value.

That's why it pays to look for stocks that may have been oversold. There are certainly plenty of candidates. More than 11,500 stocks have lost money 2015, versus just 8,100 in positive territory.

But I'm specifically interested in stocks that have been driven lower in December. So I screened for stocks that have lost 15% or more over the four weeks ended December 18. Now, we can't know investors motivations. But odds are good that some (or even most) of these year-end pullbacks were based on 1040 returns, not business fundamentals.

To make sure we're dealing with quality candidates rather than truly troubled businesses, I singled out stocks with upbeat earnings growth outlooks, superior returns on equity (15% or better) and a proven track record of beating the S&P 500 for an extended 10-year period -- that doesn't happen by accident.

Of course, they also had to have above-average dividend yields. Here's what I found:

This screen is just a starting point from which to conduct further research. While they show promise, these stocks should not necessarily be considered portfolio candidates at this time.

Action to Take:

That being said, I'm intrigued with Outerwall (Nasdaq: OUTR ), which owns all of those Redbox kiosks you see everywhere, including malls, drugstores and your neighborhood Wal-Mart (NYSE: WMT ). There are 43,680 of these movie and video game rental stations in the United States and overseas.

Without a doubt, video streaming services from Netflix (Nasdaq: NFLX ) and others are a serious competitive threat. But nearly every business on the planet has competition, and I think there is room for both distribution models to co-exist. I am a Netflix subscriber, and yet I still frequently rent movies from Redbox -- and I'm not alone.

The company is expecting to generate $1.75 billion in sales in 2015 and churn out $250 million in free cash flow. That's a bit below previous forecasts, and business is weak right now. But Wall Street has more than compensated by cutting the stock price by more than half, to $38 from $85.

Transactions per kiosk are down from a year ago, but that's largely because of the lack of big box office releases the past few months. That happens from time to time -- but certainly won't be the case next quarter, once Star Wars leaves theaters.

The company is currently generating a monster free cash flow yield of 36% ($250 million/$690 million). For context, 10% usually gets my attention as it can easily support a dividend yield of 6% to 8%.

I can't think of many other assets that return one-third of their face value each year. A private buyer could recoup his entire investment in OUTR in less than 3 years (5 including debt).

With some minor restructuring, this would be a valuable business in the hands of a private equity group -- I believe it's a prime buyout candidate. If not, some analysts have price targets in the upper-$50s, implying upside of nearly 50%.

Let's be perfectly clear: This is a high risk/high reward stock. The company has an uphill fight against Netflix and Amazon (Nasdaq: AMZN ), and conservative investors should look elsewhere. But for those who want to take a chance with a small portion of their portfolio, this turnaround candidate could post big gains in 2016 and beyond.

Editor's Note: These 'Hall of Fame' stocks beat the market 3-to-1: We've uncovered eight elite -- yet little-known -- that returned more than 300% on average in the past decade; more than 3x the S&P's total return. But the best news -- their upside is only just beginning. Get the names of each of these stocks by accessing our new report here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.