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Finding Stocks in the Value Bin
With the market looking weak, this might be a good time
to hold off for a while on you quest to find the next Google, and instead,
focus on relatively low-risk value stocks.
Value investors are contrarians. They know that the market always overreacts
to news, either good or bad. They seek out former high-fliers that have
stumbled, driving the share price down to bargain levels.
But picking worthwhile value candidates isn’t as simple as buying beaten-down
stocks. In fact, many will never recover. Here’s a screen for value candidates
that, in my view, have reasonable turnaround prospects. If you’re not familiar
with the term, screening is a process for scanning the market for stocks
meeting your specific requirements.
I’ll use the free and easy to use screening program provided by FINVIZ.com to
do the job. Find it from the FINVIZ homepage (finviz.com)
by selecting Screener. FINVIZ calls its selection parameters “filters.” On the
Filters bar, select “All” so that you can see all of the available filters at
the same time. I’ll include the actual screening term I used in parenthesis
after each description. The first step is to isolate potential value
candidates
Value Universe
Many investors rely on valuation ratios such as price/earnings to pinpoint
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 meaning a minimum 30% price drop over
the past 12-months (Performance: Year minus 30%). Feel free to adjust
that limit up or down to suit your needs.
Since most stocks that have taken such a hit will continue to fall, it’s best
to focus on those whose prices have leveled off and have already moved up a
least 10% from their lows (52-Week High/Low: 10% or more above low).
In my experience, stocks trading at exceptionally low prices are riskier than
stocks trading at higher prices. Thus, I require a minimum $5 trading price
(Price: Over $5).
Strong Financials
Recent research has found that among value-priced stocks, the firms with the
strongest financials are the most likely to recover. The next two requirements
pinpoint those candidates, starting with low-debt.
The long-term 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.
However, for value stocks, the lower the debt the better. I set the maximum
long-term D/E ratio at a very stringent 0.3 (LT Debt/Equity: Under 0.3).
Try moving that limit up to 0.5 if you want to see more stocks or down to 0.2
if you want to cut your risk.
Profitability is another financial strength measure. Return on equity, which
compares net income to shareholders equity is the most widely used
profitability gauge. Any positive ROE signals a profitable firm, but the
higher the better. Growth investors typically require a minimum 15% ROE, but
since they’ve recently stumbled, most value candidates wouldn’t pass that
test. I set my minimum ROE at 5% (Return on Equity:
Over +5%).
Got Growth?
So far, I’ve identified profitable, low-debt stocks with beaten down share
prices. But that’s not enough. The best value prospects are the firms likely
to resume growing earnings after they recover from their current problems. We
can use analysts’ consensus long-term earnings growth forecasts to pinpoint
those stocks.
How much growth is enough? It takes around 15% annual earnings growth to get
the market’s attention. But, even if that’s likely, analysts are likely to be
cautious with companies that have recently stumbled. So I only require 10%
expected long-term average annual earnings growth (EPS Growth Next five years:
Over 10%).
Here's a
link so that you can see what the screen turns up today. When I ran it,
only four stocks passed the tests. The screen would probably list more
candidates in a stronger market.
• Cal Dive International (ticker DVR):
provides construction services for offshore drilling platforms.
• Genoptix (GXDX): provides diagnostic
laboratory services to doctors.
• Kongzhong (KONG): a provider of games
and other entertainment services to mobile phone users in China.
• STEC (STEC): maker of semiconductor
storage devices.
None of these stocks will look good to you if you normally focus on in-favor
growth stocks. That’s why they’re trading far below year-ago highs.
Consider the stocks listed by the screen as research candidates, not a buy
list. The more you know about your stocks, the better your results.
published 7/4/10 |
