Controversial Stocks To Buy And Sell

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For some reason or another, direct selling stocks have been bashed left and right. In some cases, shares have become substantially undervalued as a result. In other cases, shares haven't fallen enough. But how do you discern one from the other? I recommend looking at operational trajectory based on growth opportunities, free cash flow generation relative to the market cap, and corporate performance. Below, I present my outlook on three companies using these 3 variables.

Why Avon Products's (NYSE: AVP) Management Needs To Go… Now

Although the removal of former Andrea Jung from CEO was much needed (as was her agreement to step down as the chair of the board), last I checked, she was still Chairman. Officially, she agreed to give up the position by the end of the year, but lousy performance like this warrants immediate removal. In addition to rejecting the $10.7 billion buyout offer from Coty (company is now worth $6.1 billion), Avon has systematically missed earnings quarter after quarter. In 3Q11, EPS of $0.38 was 17.4% below consensus; in 4Q11, EPS of $0.39 was 25% below consensus; in 1Q12, EPS of $0.10 was 64.3% below consensus; in 2Q12, EPS of $0.20 was 4.8% below consensus; and in 3Q12, EPS of $0.17 was 26.1% below consensus. Results have been so poor that management had to effectively axe its dividend--formerly a major buying point--by 73% to an uncompelling yield of 1.5%. Surprisingly, shareholder value only fell 19.4% during this time period.

Perhaps the best thing in the third quarter was volume rising 1%. Management announced that it would cut costs by $400 million, but this isn't a long-term fix to the company's woes. In fact, I would argue that it is the less optimal solution. To drive greater shareholder value, management should consider leveraging its dominant position in emerging markets to get out more products to the market. Cost cutting should be used to drive greater promotional spending and help win back any of the lost luster.

A series of misses, a rejected buyout bid, and an international bribery investigation later and Avon still has failed to win back the Street's trust. Although none of the 13 reporting analysts recommend selling the stock, 9 of them only put the stock at just a "hold". Return on invested capital stands at 12.6%, which is below the industry average of 20.3% and the S&P 500 average of 15.6%. With the business in decline and poor relative value creation, I recommend avoiding it. My hope is that an activist shareholder replaces management and restores the fundamental positives.

Einhorn Wrong On Herbalife (NYSE: HLF), Citron Research Wrong On Nu Skin Enterprises (NYSE: NUS)

In my view, Herbalife and Nu Skin represent compelling "buys". First, they trade at very low multiples. Herbalife is valued at a respective 12x and 10.2x past and forward earnings while Nu Skin is valued at corresponding figures of 13.5x and 11.5x. Second, both generate tremendous free cash flow. Herbalife generated $425 million in FCF for the TTM ending 3Q10--this is up by a CAGR of 18% over the last half decade and is now at a 8.5% yield. Nu Skin generated $257.9 million--this up by a CAGR of 50% over the last half decade and is now at a 9.8% yield.

Both also are generating substantial value and growth opportunities. Herbalife has a return on invested capital of 58.8% and is forecasted for 25.3% annual EPS growth over the next 3-5 years. Needless to say, the 0.95x PEG ratio at this growth easily warrants an investment. Nu skin has a ROIC of 23.3% and is forecasted for 35% annual EPS growth over the next 3-5 years. At a 0.91x PEG ratio, it too has a lot to gain.

Performance has also been excellent. Herbalife has solidly come out ahead of earnings expectations in all of the last 5 quarters with an average of 11.7%. Nu Skin has beaten expectations in 4 of the last 5 quarters (a nominal miss in 3Q11) with an average beat of 9.4%.

So, with compelling multiples, excellent free cash flow trajectory, strong ROIC (the driver of value creation), and better-than-expected performance, why are Nu Skin and Herbalife down 8.2% and 10%, respectively, from 12 months ago? Well, Einhorn implicitly accused Herbalife of being a pyramid scheme, and Citron Research explicitly accused Nu Skin of running illegal MLM-marketing operations in China. None of the allegations are true and, if they are true, have any chance of being deemed true in the next few years. The market will recover from the shock of these two famous short sellers’ criticisms, and it won't take "the next few years" for that to happen. Growth alone will sink multiples to impossibly low levels if the share price refuses to budge, or, worse yet, heads south.

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