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So-called “broken” stocks have proven to be an attractive place to find outsized returns – but there are specific techniques to successfully buy into these companies.Getty Images/iStockphoto

This year – 2013 – has been a strong one for many stocks. Most world indices have enjoyed double-digit gains, with U.S. markets having one of their best years ever. While the rising tide has lifted the majority of stocks, some of the best performers have been companies that have rebounded dramatically after having been beaten down by investors. So-called "broken" stocks have proven to be an attractive place to find outsized returns – but there are specific techniques to successfully buy into these companies.

Shares of electronics retailer Best Buy Co. Inc. began 2013 trading around a nine-year low. An attempt by its founder to buy the company and take it private had fizzled, the CEO had been shown the door, its earnings were coming in well below analyst forecasts, and the company was warning of more tough times ahead.

But something unexpected happened. The new management team cut costs, closed poorly performing stores, exited lackluster foreign markets and tightened up the efficiency of its back-office functions such as inventory management and product returns. The result was a surprising jump in quarterly profits. Best Buy shares have more than tripled this year – making it a candidate for best-performing stock in the Standard & Poor's 500.

Two examples in Canada involve companies that were considered far more "broken" than Best Buy.

Yellow Media Ltd. (formerly the Yellow Pages Group) began the year having narrowly avoided a bankruptcy proceeding. Instead it converted most of its outstanding debt into equity and effectively consolidated its shares (which had fallen to just pennies apiece) on a 200-for-1 basis. While the company's new CEO promised a continued shift to digital information, as well as cost cutting, Yellow Media fell off the radar of most investors.

"The situation was pretty scary before the reorganization," says Keith Richards, a portfolio manager at ValueTrend Wealth Management in Toronto. "You had to have confidence that the company would be able to swing a deal with the banks to allow their value to emerge. Before that, it was a gamble."

Mr. Richards's firm had an ownership stake in Yellow Media through the debt conversion. They decided to hold onto their shares because the reorganization left the company in much stronger shape. Mr. Richards notes the company's debt was drastically reduced, and the stock showed signs of breaking out to the upside.

The Yellow Media example is typical of how Mr. Richards's firm looks for underpriced stocks to buy. First they watch a stock's price movement for signs it is breaking out to the upside. Then they look at the company's fundamentals to see whether there is a genuine catalyst to keep the trend going. That can include a change in the company's business model, balance sheet or industry trend. "Low valuations are not necessarily the reason to buy a fallen stock," Mr. Richards says. "You need a catalyst to move it forward."

Robert Brown, director of research at Lake Street Capital Markets in Minneapolis, takes a similar approach. "I look for companies where changes have been made but are either not understood by investors or the results of the changes have not yet shown up in reported results," he says. These changes include new management, a different product strategy, or cost structure adjustments.

That analysis led him to placing a "buy" rating on shares of Ballard Power Systems Inc. Ballard is the Vancouver-based company that first drew attention in the late 1990s through partnerships with automakers such as Ford and Daimler. It seemed Ballard's environmentally friendly fuel cells would soon power many of the vehicles on our roads – and the company's stock price soared. However those hopes never materialized, and the company's shares plummeted, beginning this year at less than a dollar apiece.

But this stock has also tripled in 2013. Mr. Brown sees a number of reasons for the rebound. He notes the company has streamlined its operations and refocused its product efforts on markets where fuel cells have a strong value proposition, such as backup power supplies and battery replacement for heavy machinery such as forklifts. Mr. Brown says this strategy should help Ballard become a profitable company with $200-million in annual revenue. He sees a further upside of about 50 per cent for Ballard shares.

Investing in "broken" stocks in the resource sector presents its own set of risks. Many junior exploration companies raise money and watch their stock price climb based on initial prospects or preliminary drilling results, only to see their outlook peter out well before any minerals or energy comes to the surface.

John Kaiser is a mining analyst with more than 25 years of experience. He is the publisher of the Kaiser Bottom-Fishing Report, an online investing service specializing in junior resource stocks. His technique combines what he calls a "bottom-fishing strategy" with a "rational speculation model." He fishes for bargains in beaten-down resource stocks that are either out of favour or are missing key elements and whose shares have been languishing. His recommendations are based on a strategy that involves buying stocks while they are quiet and selling them off in stages when the stock launches into a speculation cycle.

Mr. Kaiser acknowledges it is currently a tough environment for junior resource stocks.

"My own strategy heading into 2014 is to assume that we will get no upside help from metal prices, and to focus on juniors that have projects with fundamental potential to be valuable at existing metal prices," he says. When it comes to gold-mining stocks, he is looking for companies with large deposits, little or no need to raise funds in the next year, and all-in costs of production below $1,000 per ounce. One example is Midas Gold – a company that meets Mr. Kaiser's criteria, but has seen its share price cut by 50 per cent in the past year.

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