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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

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