No Bargain: A Look at Beaten-Down Stocks That Just Might Stay That Way

Last week, you heard here about fallen angels in techland.

Since then, admittedly a blip in time, some of those stocks have done pretty well. In particular, CareerBuilder (CBDR) and HotJobs.com (HOTJ), which rocketed on news that the former company was being bought by a newly formed company owned by media giants Knight Ridder (KRI) and Tribune (TRB). The rest of the picks are mostly flat since we wrote about them, with the exception of Citrix Systems(CTXS), which has fallen.

Are there similarly attractive fallen angels in the Old Economy? Yes, but they can be even trickier to play than high-growth cherubs.

There are two significant challenges.

Challenge No. 1: It's Tough to Turn an Old Battleship

Turning around a giant company with a century of history and corporate culture can be a far more difficult proposition for management.

Look at Stanley Works (SWK), the world-famous toolmaker founded in 1843. More than a few smart value investors have been taken for a ride to nowhere in this stock.

It's a Poor Stock That Blames Its Tools Stanley Works vs. the S&P 500, five years

What's the problem at Stanley? Top management has failed to maximize the great brand recognition of its hammers, tape measures and other more complex tools. At the highest levels of the company, a sense of urgency appears to be lacking. Revenue growth has been slow, as have cost-cutting efforts.

The company has had great difficulty reorienting itself to the growing do-it-yourself retail market. For example, a recent report from Credit Suisse First Boston analyst Ivy Zelman notes that there are 23,000 hardware stores Stanley could sell to, yet it deals with only 3,000. Even today, company executives say they are having trouble generating 3% to 5% revenue growth, according to Zelman. This has caused her to lower earnings expectations.

Zelman still rates the stock attractive, but she sure isn't pounding the table. "Nevertheless, we believe the shares could continue to come under pressure short term, given softer consumer sales and the negative impact from the euro," she writes. (The company has large European operations that have suffered from the falling currency.) "Therefore, we would prefer to accumulate on weakness."

Private investor Paul Isaac, who has years of experience investing in such companies, compares Stanley to "a kid who is a particularly good club tennis player. He is never going to Forest Hills." You don't want to have unrealistic expectations of what can be made of a mature company.

Challenge No. 2: The Glory May Be Gone for Good

Old growth companies might never reclaim their glory days.

Have you ever looked at a long-term chart for Xerox (XRX) and Eastman Kodak (EK)? Not a pretty picture. Xerox spent 10 years flat-lining, peaked in January 1999 and has now stumbled back to 1995 levels. Yikes!

Kodak's is a similarly bad picture. It, too, did nothing very good for 10 years, topping out in 1997 and then slinking back to '95 levels.

Tattered Copies, Faded Pictures Xerox and Eastman Kodak vs. the S&P 500, five years

Once upon a time -- in the 1960s and '70s -- these companies were hot growth stocks when copiers were new and cameras were going mass market. But they will probably never be again. When is the last time you rushed over to the Xerox machine at work only to find a line? When is the last time you went to the store and asked for the little yellow box instead of Fuji or some other brand? Xerox and Kodak have been trying with limited success for well over a decade to reinvent themselves. They have yet to succeed.

The inability of Xerox management to boost sales led the board to replace the company's chief executive in May. According to a source close to the board, directors pushed the CEO out because he failed to convince the company's inside sales force of the need to reorganize and focus more of its efforts on selling printing service contracts instead of copiers.

Says the source, "This company has to make these changes simply to survive." Implicit in his comment is an awareness that Xerox may never return to high double-digit revenue growth rates.

Merrill Lynch analyst Steven Milunovich detailed the company's problems this way in a new report:

We believe deeper issues are involved as well. Xerox is being disrupted by low-end copier and printer technologies. Moreover, it appears that the document market is decentralizing as evidenced not only by Xerox's problems but by slowing in high-end mono laser printers at H-P and Lexmark.

The point here that you could have invested in a "turnaround" at either Xerox or Kodak in the past 15 years because they seemed cheap. Their price-to-earnings ratios rarely if ever stood above the market average. (Today, Xerox trades around 14 times 2000 earnings and Kodak at 11 times earnings.) But you still would have made precious little money and you might well have lost hard won savings.

Paul Isaac urges investors to demand extremely low valuations before they jump into such turnaround candidates. "Often, the best you can hope for is that the company stabilizes -- not that it can be brought back to its former luster," he says. "So, you really need to buy them cheap to get a pop. Companies like this are unlikely to get premium valuations ever again."

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