This beaten-down stock is my pick as a deep-value buy

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J.C. Penney Co. Inc. was given up for dead earlier this year. But the struggling department store chain is starting to show signs of life, suggesting that it could become a poster child for deep-value investing.

Make no mistake, this is one troubled company. It has lost money in 11 of the past 12 quarters. Sales in the second quarter of this year were down 28 per cent – or $1.1-billion (U.S.) – from the second quarter of 2011.

The share price has tracked dwindling optimism, sliding more than 75 per cent over the past two years.

Analysts have more-or-less followed the share price: "Sell" recommendations, a rarity elsewhere in the market, now outnumber "buy" recommendations and the average target price implies a gain of just 0.5 per cent over the next 12 months.

Bill Ackman, the activist hedge fund manager at Pershing Square Capital Management who swooped down on JCPenney in 2010 in the hope of scoring a big turnaround, jettisoned the last of his holdings last year, at a loss of $500-million.

In other words, you have every reason to look at more upbeat investing opportunities elsewhere, leaving the risks associated with the retailer to the crazies. But there's one good reason to resist that urge: The news at JCPenney is getting better, which could point to strong gains ahead.

Its second-quarter results, released on Thursday, hinted at a recovery. Its net loss shrank to 56 cents a share, marking a huge improvement from a loss of $2.66 a share last year and well ahead of analysts' expectations.

Sales rose 5.1 per cent, also topping expectations. That's a remarkable feat, given the strong competitive environment in retail and the fact that Wal-Mart Stores Inc. reported flat same-store sales in its quarterly results.

At the same time, JCPenney's gross margins improved and the company generated $76-million in free cash flow.

These are hardly the results of a company circling the drain. Quite possibly, they point toward further improvements in the quarters ahead as new chief executive Mike Ullman abandons a shift toward wealthier shoppers and reacquaints himself with the middlebrow.

"As we approach the completion of our turnaround, we are focused on reestablishing JCPenney as the premier shopping destination for the moderate consumer," he said in a statement accompanying the second-quarter results.

The share price is reflecting a shifting attitude toward the company: It has risen more than 85 per cent since touching a three-decade low in early February, making it one of the hottest stocks in the Russell 1000 since then.

There are a few reasons why the gains should continue. First, the rebound hasn't exactly put the stock into sky-high territory; the price, at $9.50, is essentially flat this year and significantly lower than where Mr. Ackman sold his shares, above $12.

Second, the stock is cheap when you compare it with its peers. Its price-to-book ratio is just 1.1, or less than half the average for U.S. department stores. Its price-to-sales ratio is 0.2, versus an industry average of 0.5.

It isn't hard to see the stock doubling from its current level if sales continue to improve – and even then, the price would still be a fraction of its former glory.

Third, sentiment is still dour. Analysts haven't changed their views on the stock and big-name hedge fund managers haven't jumped on board the rally.

That makes a bet on JCPenney anything but popular. But deep-value investors, who look for opportunities in out-of-favour corners of the market, prefer to focus on the upside opportunities in struggling companies – and JCPenney looks like a good fit.