INDICATOR 3.  A HIGHER RATE OF EARNINGS GROWTH THAN THE S&P 500 IN THE IMMEDIATE PAST, AND THE LIKELIHOOD THAT IT WILL NOT PLUMMET IN THE NEAR FUTURE.

Such future estimates are not an attempt to pinpoint earnings, but only their general direction.  Remember that we are dealing with stocks in the bottom quintiles, for which only the worst is expected.  Unlike conventional forecasting methods, we do not require precise earnings estimates, but need merely note their direction, and only for short periods, usually about a year or so.

In my initial contrarian work, I was more of a purist on this subject.  I thought, since contrarian strategies worked at least in part because of analysts' errors, why bother with forecasting at all?  Some rather harsh experiences have caused me to modify this position.

If, for example, the Street estimates that a company's earnings are likely to be down for some time, I would not rush in to buy, no matter how positive my indicators appeared to be.  Often, as we’ve seen, analysts are overoptimistic.  All too frequently, an estimated moderate decline in earnings turns into a drop off a cliff.  This was the case with Chrysler in the early 1990s when the initial estimates were for relatively small declines.  The actual drop in earnings brought the company to the brink of Chapter 11.  The stock fell over 80% before rebounding.  If earnings are declining, stock prices often follow them down for some time.

The important distinction between forecasting the general direction of earnings and trying to derive precise earnings estimates is that the former method is far simpler and thus more likely to succeed.

                                                                                            David Dreman
                                                                                            Contrarian Investment Strategies:
                                                                                            The Next Generation


I wish I had read that before I bought Trans World Entertainment Corporation (TWMC).  But then again, I probably would not have noticed the quote if it wasn’t for TWMC.  So there I learned an invaluable lesson.

I was originally attracted to TWMC because it had all the classic value indicators: low P/E, low P/B, low P/CF, share repurchases, CEO owns 40%, and no debt.  The market was being ridiculous, I figured, and the selling overdone.  But now that the stock has fallen 30% under my purchase price, I find myself at a loss for confidence.  One question is:  What will stop it from dropping to $2.50 like it did back in 2003?  After all, there is no dividend support.  But the real question:  What will cause the stock to recover?

What I have realized is that just being cheap is not good enough.  You need something else.  Before buying a cheap stock, you need a solid reason why it will eventually recover.  This reason must be strong enough to give you confidence.  Confidence to buy even more if the price drops further.
 
Value investors call this reason a “catalyst”.  Catalysts come in various forms: growth in cash flows, growth in earnings (see Dreman quote above), hidden assets like real estate (unfortunately TWMC does not own the land under their 800 stores), temporary setbacks soon to be corrected, misunderstood information, activist shareholders, new management, spin-offs, favorable litigation, or insider buying.  In theory, catalysts will eventually unlock value.  Other investors, for example, could realize business conditions are improving and bid up the stock; or assets could be sold/spun-off; or the company itself could be an acquisition target.  All of which usually leads to a stock premium.

Unfortunately, TWMC has none of the features above.  It is just a dirt cheap stock.  In fact, the current price is now less than its NCAV of $6.17 (although most of that is inventory).  Therefore I still maintain the market has overdone this one.  Especially since the company has positive cash flow.  But, like I said, I do not have confidence to buy more.