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New Screen for Finding Value Stocks.  

The stock market’s recent performance has been lackluster, to say the least. Worse, there’s no consensus that things are about to get better. Given the uncertain outlook, this might be a good time to consider value stocks.

Value investors are contrarians; they buy stocks that most investors wouldn’t touch. They believe that the market always overreacts to news, either good or bad. So they seek out former high-fliers that have stumbled, driving the share price down to bargain levels. 

But value investing isn’t as simple as buying beaten-down stocks. In fact, many will never recover.

I’ve come up with a screen for finding value-priced stocks that, in my view, have reasonable turnaround prospects.

You could run it on several different Web stock screeners. I used Reuters free Power Screener. Find it from Reuters Investing homepage (www.investor.reuters.com) by selecting Ideas & Screening and then clicking on PowerScreener.

If you’ve never used it, Reuters’ screener will take you an hour or so to learn. But it’s a powerful tool and worth the effort. I find Reuters’ terminology for labeling its screening parameters to be confusing, so I’ve included the parameter identification mnemonic (sequence of letters and numbers) in parenthesis for each of my search terms.

The first step is to pinpoint potential value candidates.

Value Universe
Many investors use low P/Es or other valuation ratios to define value candidates. But I find it works best to search directly for the one thing that all value stocks have in common; a beaten down share price.

I arbitrarily defined ‘beaten down’ as a minimum 40 percent share price drop over the past year (Pr52W%Chg). You could adjust that limit up or down to suit your needs. When I ran the screen last week, 1,447 out of 8,808 listed U.S. stocks met my requirement.

But many stocks that have taken such a hit will continue to drop. It’s best to focus on the stocks whose prices have stopped falling and leveled off in recent weeks. Given the market’s recent weakness, I cut them a little extra slack and searched for stocks that have dropped no more than five percent over the past three-months (Pr13W%Chg). That stipulation narrowed the list to 481 stocks.

We don’t want to chase stocks that have already made a big move up. So, I cut the field down to 269 candidates by ruling out stocks that have gained 15 percent or more over the past three months (Pr13W%Chg).

I’ve found that stocks trading in the $1 per share range are too risky, even if the numbers look good. So I included a search term  (Price) to eliminate stocks trading under $2 per share. Surprisingly, that requirement cut the list down to 57 stocks.

Recent academic research found that among value-priced stocks, the firms with the strongest financials are the most likely to recover. With that in mind, I added two requirements to pinpoint the candidates with the strongest balance sheets.

Strong Financials
The current ratio compares a company’s current assets (cash, inventory and receivables) to its short-term liabilities (current expenses).

The ratio is greater than one if current assets exceed liabilities. Conversely, ratios below one mean that the company is strapped for cash. I isolated the strongest prospects by requiring a minimum current ratio (CurRatioQ) of 2, which means that current assets must be at least double current liabilities.

Even if its current ratio is high, a firm might still be burdened by long-term debt. The debt/equity ratio compares long-term debt to shareholders equity (book value). The higher the ratio; the higher the debt. Definitions vary, but generally, ratios above 1.0 signal high-debt, and ratios below 0.5 denote relatively low-debt.

For value stocks, the lower the debt the better. I set the maximum D/E ratio (DbtLT2EqQ) to a very stringent 0.2.

Only 22 candidates survived the two financial strength tests.

So far, I’ve identified stocks with beaten down share prices and the financial wherewithal to survive tough times. But, I could still end up with the proverbial ‘buggy whip’ maker that happens to have a strong balance sheet.

I use analysts’ consensus long-term earnings growth forecasts to rule out that possibility.

Growth Ahead?
The best value prospects are the firms likely to resume growing earnings after they recover from their current problems.

How much growth is enough? It takes around 15 percent annual earnings growth to get the market’s attention. But, even if that’s likely, analysts probably took a pessimistic view when the company stumbled. So I required 10 percent forecast long-term average annual earnings growth (LTG CM).

Only six stocks passed all of my tests. Not surprisingly, four were tech stocks.

The only non-tech stocks were perfume maker International Parfums and Web-based auto marketing services provider Autobytel. Of the techs, two, SupportSoft, and Performance Technologies, are software makers. The remaining two were chip makers Centillium Communications and Silicon Laboratories.

If you’re by nature a growth stock investor, none of these stocks will look good to you. That’s why they’re trading far below their year-ago highs.

The fact that they passed my screen simply means that these stocks are worth researching, not that they will prosper, or even survive.
published 3/20/05

 

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