"Mean" Selections: Worst-to-First

01/14/2005 12:00 am EST

Focus:

Charles Carlson

Editor, DRIP Investor

"Do you want to know what stocks should do well in 2005?" asks Charles Carlson. "Then check out the losers for 2004. This ‘worst-to-first’ strategy can produce stellar returns." Here, he looks at his favorites for 2005 based on the principle of "mean reversion."

"The worst-to-first strategy relies on the concept of ‘mean reversion,’ which states that stocks that move to extremes (either to the upside or downside) in one year tend to revert the following year. Mean reversion works especially well with Dow stocks since Dow companies are seasoned, financially strong firms that have historically stood the test of time and have demonstrated the ability to rebound. T he best-performing stock in the Dow in 2003 was Intel (INTC NASDAQ). But mean reversion says that what moves to an extreme level in one year should revert the next. True to form, Intel was one of the worst Dow stocks in 2004. Now, after getting beat up in 2004, I would consider the stock as a top Dow pick for 2005. 

"Of course, no system is infallible. Indeed, Merck (MRK NYSE) had a miserable performance in 2003. In the following year, instead of reverting to the mean, the firm's situation went from bad to worse. Its Vioxx problems slammed the stock, knocking these shares down to their lowest level since 1995. That’s why I’m sticking with Merck, along with Intel, as my top Dow picks for 2005. It is hard for me to see these shares going much lower. The yield of nearly 5% should provide some support. True, I don’t expect Merck to skyrocket in 2005. But I do believe these shares could get back toward the $40 level.

"Outside of the Dow, two stocks in our Editor’s Portfolio have caught my eye, based on the strategy of reversion to the mean. Lucent Technologies (LU NYSE) has certainly had its share of extreme price moves in the last five years. This stock, which traded for $84 in 1999, fell to under a $1 per share in 2002. Since that low, these shares have crept higher. Still, I believe Lucent remains in the process of ‘reverting to the mean.’ While I don’t believe its equilibrium price is in the $80s, neither do I believe it is in the $4-$5 range. Operating results continue to improve for the company. Its profit rebound should continue in 2005, which should provide support to the stock price. Successful stock investing is all about looking forward, not backward. And when you look at Lucent’s future, it merits a stock price higher than its current valuation.

"The same goes for Motorola (MOT NYSE). These shares traded at $61 in 2000, only to collapse to $7 in 2002. Motorola has put together a decent rally since that time. But these shares merit a higher valuation given their improved earnings picture. Motorola’s spin-off of its semiconductor unit should allow it to focus on its other operations as well as reduce its cost structure. The consensus earnings estimate for 2005 is $0.92 per share, giving the stock a p/e multiple based on 2005 earnings of just 18. That multiple seems on the low side given the leverage in Motorola’s bottom line. True, Motorola has had a tendency to shoot itself in the foot, and these shares will exhibit big volatility. However, I like the direction of the company and would feel comfortable buying the stock for the speculative portion of a portfolio."

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