So far, I’ve made eight picks for subscribers of my Skeptical Advisor newsletter (beginning with the first issue in May 2005).

If you had acted on my first three recommendations, you would have had a return of 19.3% on two of them and a loss of 5.6% on the other one.

If you had acted on my next three recommendations, two of them would have brought you total gains of 45.3% and one would have given you a loss of 13.3%.

My most recent two picks are too new to show any meaningful results.

You can see a couple of things right away: (1) My overall returns were much higher than the S&P 500. (2) For every two winners, I also had a loser. (But they were losers that issue generous dividends of up to 8%-plus. So with these stocks, as long as you’re not selling, you’re still earning a nice return.)

All my stock picks went for absurdly low prices. That’s because – as I’ve mentioned many times before in ETR – I’m a value investor. And, as a value investor, I pick beat-up (or “ugly”) stocks that, for one reason or another, have had their prices driven down.

Two of my picks have fallen even further since my recommendation – but I’m not worried. Let’s take a close look at one of them – a stock in the newspaper sector.

A Cautionary Tale

The newspaper sector doesn’t get much respect these days. Circulation is falling, and ad revenues are being siphoned off by online media.

But the company I recommended was developing its online business, from within, by coupling online offerings with the traditional hardcopy issues. And the strategy was working. Revenues from online operations were making a fast-growing contribution to overall revenue growth.

So what happened?

Nobody noticed. Or cared. The company failed to make a dent in the widely held misconception that newspaper companies are terminally stuck in a business model that no longer works.

My newspaper-sector pick had great cash numbers, nice margins, and superb valuation numbers. However, its revenue and earnings growth was a notch below the previous year’s. Though I believe the three B’s (beach, bathroom, and bedroom) will prevent printed newspapers from ever sliding into oblivion, investors usually don’t give companies in struggling sectors the benefit of the doubt.

Even the venerable Warren Buffett weighed in against the newspaper industry.

I remember asking myself at the time, “Does a receding tide sink all ships?”

The answer was and still is “no.”

Beat-up sectors turn things around when some of their companies begin to bounce back – doing things better or figuring out a different way to make money. So if more newspaper companies can figure out a way to make money from selling their content to online providers, revenues would immediately pick up and investor sentiment could change in a hurry.

How Two Ugly Companies Changed Investors’ Minds

One of my biggest winners – a company that owns amusement parks – did just that. It figured out how to make more money by tweaking its cost structure.

Investors don’t like the amusement park industry much, because they think this kind of entertainment peaked long ago. But this company had the brilliant idea to let a restaurant chain make all the food at its parks – and to get part of the profits and a sizable fee in return for granting the privilege. Now, investors see a bright light at the end of the tunnel that’s impossible to ignore. And that has made all the difference in the world to the share price of this company.

One step up from the lowly status of a beat-up sector is a sector that is slowing down. That pretty much describes where I found one of my other big winners: in the real estate investment trust (REIT) sector.

Before last year, this sector was making some of the highest returns – over 30% a year – in the market. Many market observers expected REITs to slow down … and they did.

Then, last May, a certain REIT that was getting no respect from Wall Street caught my attention. It had exciting ownership with a strong record of success and a simple plan on how to grow revenues in a real estate market that was getting more competitive by the day.

It hasn’t carried out its plan flawlessly, but well enough to significantly increase revenue and reduce costs. As a result, in barely 7 months, the company’s stock has risen 14%. Plus, it gives out a big dividend of over 7%. Needless to say, Wall Street likes it a lot more now.

3 Things You Need to Know to Get the Most Out of Your “Ugly” Picks

This year, we’re dealing with a sluggish stock market that could be further weighed down by more struggling sectors than last year. So here’s how I recommend approaching it …

1. If you’re choosing a value company in a beat-up sector, you have to choose a truly exceptional company – a company with strong performance numbers in earnings and cash flow growth (as opposed to only outstanding value numbers).

2. When you select a beat-up company in a beat-up sector, understand that you’re going against prevailing Wall Street sentiment … not once, but twice. Because investors are even more wary of companies in sectors that just keep on underwhelming, these stocks have to beat out longer odds.

3. Take away the top 10% and bottom 10% of the way any company is performing in the stock market, and you can paint the rest with an optimistic or a pessimistic brush … and probably make a compelling case either way. Is the company poised to reach new heights? Or has it seen its best days and a slow decline is right around the corner? You don’t really know, of course, until you take a hard look at the company.

But if you’re looking at a company in a sector that’s beat up – or a sector that isn’t quite beat up but that makes investors nervous – the situation is a little different. In those cases, most investors would gravitate to the pessimistic story. And because of that – even if you have good reason to believe the optimistic story – that stock is going to take longer to go up, because the Wall Street crowd is not investing. At least not now.

This all adds up to the bar being set higher for companies in the really beat-up sectors. It’s no coincidence that my biggest winners (so far) for The Skeptical Advisor have been in middling sectors (amusement parks and real estate) that made investors nervous but did not trigger their flight impulse.

Not all my picks have been in downtrodden sectors or sectors easing into a period of slower growth. (My stock selections in the oil & gas and commodity sectors are doing quite nicely.) But as a value investor, you also must be willing to troll the second-tier sectors and below to find potential winners.

“Why not invest your assets in the companies you really like? As Mae West said, ‘Too much of a good thing can be wonderful.'”– Warren Buffett

[Ed. Note: Andrew Gordon, ETR’s financial expert, is the editor of The Skeptical Advisor, our investment newsletter. Check it out at ).]

Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn’t traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.