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How
to Maximize
the January Effect
Note to readers:
this article was written in November and the strategy described should
only be followed in November and December.
This is the
season when many investors dump their losers to take the tax write-off.
They can balance those realized losses against capital gains they’ve
enjoyed during the year.
Since, in
many cases, an investor’s tax situation is more important than a
stock’s long-term outlook, such tax loss selling can create investment
opportunities. Indeed, some experts point to tax loss selling as the
reason for the “January effect,” the tendency of small company
stocks, especially those that suffered losses in the previous year, to
move up in January.
But taking
advantage of the January bounce is not a slam-dunk. Research on the
topic has turned up mixed results. Some years it works, and some years
it doesn’t.
But it
occurred to me that not all beaten-down stocks are created equal. Some
have better chances of recovering than others, and there ought to be a
way to identify the best prospects.
With that in
mind, I’ve devised a selection strategy that I hope will pinpoint
those diamonds in the rough. In essence, it seeks out stocks that
although down this year, have solid balance sheets, strong historical
growth, good future growth prospects, and know how to make money. I’ll
explain further as I describe the search program I used to find my
“January bounce prospects.”
I used MSN
Money’s Deluxe Screener for the task because it’s the only free
stock screener I know of that can search for stocks based on year-to
date price performance. You can access the screener from MSN Money’s
homepage (moneycentral.msn.com)
by selecting Investing
and then Stock
Screener.
Although a
great resource, MSN’s screener takes some time to learn. So if you
don’t want to spend the time, you can use my rules to evaluate the
January bounce prospects for any stock.
Bounce
Prospects
My first step was to define all January bounce candidates. For me,
that means stocks that have suffered a minimum 25 percent share price
loss this year. As of last week, 976 stocks met that requirement.
Next, I
refined that definition to rule out the obviously high-risk stocks.
For instance,
while we want stocks down enough to trigger significant tax loss
selling, very high losses signal potentially fatal problems.
Consequently, I set a maximum 80 percent year-to-date loss to weed out
those stocks. Similarly, many consider stocks trading below $5 per share
as high risk, if for no other reason, mutual funds and other
institutional investors won’t buy them. So, I set a minimum $5 share
price.
Finally,
since research shows that small companies benefit most from the January
bounce, I limited the field to small-cap stocks (market capitalization
is share price multiplied by shares outstanding). Definitions of
small-cap stocks vary, but I set my upper limit for market-cap at $1
billion.
Adding those
requirements reduced the field to 332 stocks.
Financially
Strong
High debt-servicing costs
complicate a troubled firm’s recovery prospects, thereby increasing
risk. I applied two debt measures to rule out high-debt companies.
Current ratio
compares a firm’s current assets such as cash and inventories, to its
current liabilities. Ratios above 1 mean that current assets exceed
current debt, which is good. Conversely, ratios below 1 signal that the
firm may be strapped for cash. I specified a minimum 1.1 current ratio,
which assures that passing stocks have enough cash to pay their current
bills.
The debt to
equity ratio compares a company’s long-term debt to its shareholders
equity (book value). The higher the ratio, the higher the debt. Ratios
below 0.5 reflect low debt. So, I used that figure for my maximum
acceptable DE ratio.
The financial
strength tests cut the number of qualifying stocks down to 224.
Track
Record
Next, I limited the field to consistently profitable companies with
a solid growth record.
I used Return
on Equity (ROE), which is net income divided by shareholders equity
(book value), to check profitability. The five-year average ROE will
only be positive if the company has, on average, been profitable over
that period. So, I looked for a minimum value of 1 for ROE.
Solid growth
implies both revenue (sales) and earnings growth.
I required
that passing companies grew revenues at least 10 percent, on average,
over the past five years. Generally, I prefer to see 15 percent sales
growth, but recent problems probably reduced the long-term average.
Similarly, a
company’s current problems probably sunk recent earnings, which would
distort its long-term earnings record even more than sales growth. So, I
required only five percent annual earnings growth over the past five
years.
Adding these
tests reduced the field to only 13 stocks.
Here's a link
to the screen so you can run it yourself and see today's
picks.
Future
Prospects
Stocks can pass all of the above tests and still be risky bets
because their business is shrinking instead of growing. I used
analysts’ earnings growth forecasts to rule out stocks in that
category. Most sites list analysts’ consensus next fiscal year’s
earnings forecasts and analysts’ long-term earnings growth forecasts.
Healthy growth candidates should be growing earnings at least 15 percent
annually, so I used that figure as my minimum requirement for both the
next fiscal year and long-term expected growth rates.
Only seven
stocks survived: Freds, Hot Topic, ICU Medical, Nam Tai Electronics,
Sharper Image, Taro Pharmaceutical Industries and Tetra Tech.
Passing my
numeric tests doesn’t mean you’ll make money buying these stocks.
Consider these as candidates worthy of further research. They could well
be facing problems that haven’t yet been reflected in the numbers.
published 11/28/04 |
