A potentially lucrative (and high-risk) strategy: Bet on multiple misfit stocks

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Betting on a turnaround at Valeant Pharmaceuticals International Inc. comes with a lot of uncertainty. But what about diversifying your risk and betting on a bunch of Valeant-like stocks that are priced for failure?

Buying one or two beaten-up stocks comes with a lot of risk. But spreading out your bet among a number of stocks is more compelling because it reduces the downside risk while preserving much of the reward should a few of these dogs survive.

I wrote about this quirky strategy in 2009 – borrowing the concept from Cam Hui, a blogger – not long after the stock market had bottomed out following the financial crisis. Major indexes had fallen 50 per cent, but a number of former blue-chip stocks were down considerably more because investor fear was particularly entrenched.

Citigroup Inc., Bank of America Corp., Liz Claiborne Inc., Gannett Co. Inc., Great Atlantic & Pacific Tea Co. Inc. (or A&P grocery stores), MGM Mirage and Saks Inc. made the list, given that share prices were down as much as 98 per cent during the downturn.

A&P was delisted in 2012, wiping out shareholders. But the survivors have done very well, producing an average gain of more than 1,000 per cent, or 870 per cent after factoring in A&P.

The catastrophic bear market of 2008 may have been ideally suited to this strategy, given how pronounced and widespread investor fears were.

However, there are deeply troubled stocks in any environment, from Chysler in the 1980s to Magna International Inc. in the 1990s to Netflix Inc. in 2004. Stocks that defy death and turn fear into greed can reward intrepid investors with huge gains during their recoveries.

But enough with the 20-20 hindsight. What Canadian stocks should we consider today?

Ideally, we want stocks that satisfy four requirements: Share prices have been hammered, the company is still worth more than $100-million, investors have lost all hope and there is at least one path to recovery.

Valeant looks like an ideal candidate. The stock is down 96 per cent since 2015. Hedge fund investor Bill Ackman bailed on the stock, taking a $3-billion (U.S.) hit on his investment.

Yet, the company is still valued at $4.8-billion (Canadian) and there is at least one way investors can make money: Valeant succeeds in selling its assets for prices that exceed its massive debt.

Also consider Sherritt International Corp., the nickel miner that has large operations in Cuba. The share price has fallen 27 per cent this year and is down 84 per cent over the past four years.

The company is worth $285-million. A recovery in nickel prices or enthusiasm about Cuba's economy will surely raise that value.

Baytex Energy Corp. has fallen more than 90 per cent with the decline in crude oil prices over the past three years, the dividend has been eliminated and analysts have been slashing their target prices to keep up with the falling stock.

But higher oil prices will drive the stock higher and asset sales will help the company – valued at more than $1-billion – reduce its big debt load.

Lastly, consider Hudson's Bay Co. Nobody likes department stores any more, and HBC appears to be doubling down on its exposure to the sector. It bought Saks Inc. in 2013 and Germany's Galeria Kaufhof in 2015. Rumours in February suggested it was circling Macy's Inc.

The stock market isn't rewarding this persistence: The share price has fallen 66 per cent since 2015, including an 8-per-cent drop on Monday ahead of the release of its fiscal fourth-quarter results.

But the company is valued at $1.8-billion, it holds valuable real estate that it hopes to spin off and sometimes it's nice to try on clothes before you buy them – offering upside potential to this beaten-up stock.

Not all of these ideas are likely to pan out, which is why they're probably best held as a group of misfits rather than individual bets. As history shows, the rewards can be big.

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