Where to look for the next melt-ups

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(Editor's note: A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Nov. 16.)

There are always values in the stock market. One place to find them is among sectors and companies that have been distressed and hated for a long time--especially those with lots of debt. They tend to be underowned and heavily shorted, which can provide some nice fuel for a rally.

Many of the gains we enjoyed coming off the lows in 2009 resulted from these kinds of melt-up trades, especially financials and auto-part makers. Plenty of other companies, however, enjoyed only a fleeting bounce and continued to struggle. Some of these now look interesting.

The first are ocean shipping companies . Many of these stocks, such as Frontline, Overseas Shipholding, and Eagle Bulk Shipping, are now trading far below their 2009 lows. This is not a surprise because shipping rates remain far below their peaks in early 2008. And, after an initial bounce in 2009, they trended lower for more than a year.

Now the situation is quietly turning positive. The Baltic Dry Index, a key metric of shipping rates, has been trending higher all year and made higher lows at the same time that the S&P 500 dropped in early October. Reports this month also suggest that demand is improving and a glut of ships is easing.

This improvement is visible on our new researchLAB service, which makes it easy to follow dozens of industry groups. Headlines in the last week have an average bullish-to-bearish score of +1, meaning that they're all positive.

This stands in contrast to a +0.5 rating in the previous month, indicating that sentiment is getting better. Stock performance matches this improvement because shippers are up 14 percent in the last month versus a gain of just 4 percent for the S&P 500.

Another consideration is that the some of these companies are now at truly distressed levels, thanks to their messy balance sheets: EGLE and OSG are trading for less than 0.3 times book value while FRO is at 0.65 times. DryShips is at 0.36 times book value.

While investors have a reason to fear companies with too much debt, they can still rally hard simply by failing to go bankrupt.

Homebuilders seem to be turning as well. Several companies in this industry, such as Beazer Homes, D.R. Horton, and Toll Brothers, cited better orders this earnings season. Margins have also been improving for others, including PulteGroup.

In a related story, famed investor Kyle Bass recently bought a stake in mortgage-guarantor MGIC Investments. Bass made a fortune betting against mortgages back in 2008, so it's noteworthy that he's now taking the other side of the trade.

The final idea is a single company, Rite-Aid , which has been a punching bag for better-run competitors such as CVS Caremark and Walgreen for years. But headlines have been showing more optimism in the last few months, as new customer-loyalty programs result in better same-store sales and earnings estimates inch higher. RAD also trades at less than 0.05 times sales, about one-tenth the multiple for its rivals.

Let me end with a reminder that these are ideas, not recommendations. Back-from-the-dead companies can significantly outperform the market when they turn. However, because they're beholden to forces in the credit market, it's a good idea to learn more about their obligations.

When are their next big bond maturities, and do they have any covenants (strings attached to loans) that might hurt equity investors? Do they have pension obligations?

Some work does need to be done, but it can be well worth the effort.

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

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.

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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