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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 |
