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| The Basics | Spot the comeback stocks of tomorrow
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Anyone can recognize a winner in hindsight, but how many people can spot the leaders among todays troubled stocks? Heres a 6-step process for finding stocks taking a turn for the better.
By Harry Domash
It may be the most prized quarry in every investors hunt: the turnaround stock.
Ideally, you buy a stock when its limping badly, abandoned and left for dead. But then, as the stock heals and regains its stride, you ride that precious turnaround stock to the heavens.
Just in recent years, investors astute enough to have bought Amazon.com (AMZN, news, msgs) at its low back in September 2000 and not sold scored a better-than-600% return on their money by 2003. Yes, theres serious money to be made by picking the right turnaround stocks. But, as the saying goes, hindsight is 20/20. The hard part is spotting the Amazons of the world before they make their 600% moves -- and avoiding the bankruptcy-bait stocks that never recover.
But how? Ive devised a stock screen to spot turnaround candidates using MSN Money's Deluxe Screener. The strategy is to find beaten-down stocks and then pick out those most likely to recover based on fundamental factors. Of course, many of those fundamentally sound stocks wont recover, so the final step involves pinpointing candidates that are actually turning the corner and starting their move up.
Ill take the easy shot first by finding beaten-down stocks.
1. Stocks left for dead
I define beaten-down stocks as those currently trading at least 50% off their five-year highs. If youve been in the market any length of time, you wont be surprised to hear that more than 2,000 stocks meet that requirement. I also require that passing stocks trade at least 10,000 shares daily, on average. Most stocks trade hundreds of thousands, if not millions of shares daily. Very-low-volume stocks are unlikely to recover, for a variety of reasons. For one, you need mutual funds buying your stock to push the price up. But funds wont buy these stocks because they cant move into and out of positions in lightly traded stocks without upsetting the market.
Screening Parameter: Last Price <= 0.5*5-Year High Price
Screening Parameter: Average Daily Trading Volume, Last Quarter >= 10,000
Finding beaten-down stocks is the easy part. Unfortunately, most of those are more likely headed down than up. But we can improve our odds of success by using fundamental factors to eliminate the weakest candidates.
2. Balance-sheet checks
Well start by weeding out candidates with weak balance sheets using two reliable balance-sheet checks: current ratio and debt-to-equity ratio.
Current ratio is current assets, which includes cash, inventories and accounts receivable, divided by current liabilities. In accounting parlance, current means short-term, i.e., within a year. By that standard, your credit-card bill is a current liability, but the mortgage on your house is a long-term debt. The current ratio is greater than one if assets exceed liabilities, and its below one if liabilities exceed assets.
Just like you and me, companies have a problem when their current debts exceed their current assets. Something has to give. Either they raise additional cash by borrowing or by selling assets, or they dont pay their bills on time. Obviously, none of these alternatives bodes well for a company scrambling to recover from the problems that sank its stock. So our first step is to weed out companies facing such a short-term cash crunch.
Screening Parameter: Current Ratio >= 1.2
No company is able turn all of its inventories and receivables into cash, so I specified a minimum 1.2 current ratio (assets must equal at least 120% of liabilities), instead of 1.0, to build in a fudge factor.
Current ratio gives you only half of the picture. We also must consider long-term debt. Troubled companies weighed down by long-term debt are less likely to recover than are low debtors. The debt-to-equity ratio, which compares long-term debt to shareholders equity (book value) works to weed out high-debt candidates.
Unlike the current ratio, lower is better for debt/equity. Most experts consider 0.5 D/E as the divider between low- and high-debt. To be on the safe side, I set the maximum D/E at 0.4.
Screening Parameter: Debt-to-Equity Ratio <= 0.4
3. Show me the cash flow
Next, I added two more fundamental requirements: cash flow and profitability.
Operating cash flow is the amount of cash that flowed into, or out of, a companys bank accounts from its main operations during the reporting period. Many times, companies report positive earnings, when, in fact, they are burning cash. Conversely, some companies reporting negative earnings are actually profitable on a cash basis.
Turnaround candidates usually need lots of cash to fix their problems, so cash burners are best eliminated. The price-to-cash-flow ratio is negative if cash is flowing out instead of in, so I use it to screen out cash burners.
Screening Parameter: Price/Cash Flow Ratio >=0
4. Profitability is primary
Your best turnaround candidates are formerly high-profit companies that stumbled, as opposed to companies that were never very profitable.
Return on equity is the most widely used profitability gauge. It is total net income divided by book value, and higher is better. Many investors consider 15% as a minimum acceptable ROE and many money managers avoid stocks that dont meet that bar.
Turnaround candidates, however, must be given a little slack. The problems that caused them to stumble probably also reduced their net income, and hence, their recent profitability. Fortunately, MSNs Deluxe Screener includes a 5-year average ROE parameter, and I use that to gain a longer-term perspective. And because that long-term average ROE was probably brought down by the recent problems, I set my minimum acceptable ROE at 10%.
Screening Parameter: 5-year average ROE >= 10%
The final fundamental factor to be taken into consideration is revenues (sales).
5. Reach for revenue growth
Earnings come from sales, so companies with shrinking sales make awful turnaround candidates. Because turnaround candidates problems often stem from faltering sales, my only long-term requirement in terms of sales is that they havent declined over the past five years.
However, stocks on the comeback trail should be seeing recent sales increases. So I require a small amount, 5%, of year-over-year sales growth in the most-recent quarter.
Screening Parameter: 5-Year Revenue Growth >=0
Screening Parameter: Rev Growth Qtr vs. Qtr >=5%
When I ran the screen, 50 stocks met all of these requirements, and in theory, they should all be winners. But that will not turn out to be the case, of course, at least within a reasonable timeframe.
6. Find the sweet spot
Our final step is to pinpoint the stocks among this group that others, hopefully in-the-know investors, see as on the road to recovery. We do that by picking out the stocks that have already started moving up. Of course, in many instances, we will be too late to the party because the stocks have already made their move.
Well use the Deluxe Screeners relative-strength parameters to find stocks in the sweet spot. That is, theyve started moving up, but they are still in the early stages of their recovery.
In case youre rusty on your definitions, relative strength compares a stocks price performance to the entire market. A relative strength of 90 means a stock has outperformed 90% of all stocks over a specified timeframe. Conversely, a stock with a 10 relative strength has underperformed 90% of all stocks.
The screener provides relative-strength parameters for three timeframes: three-, six-, and 12-months. Because were looking for stocks early in their move, I focus mainly on the three-month RS, requiring minimum value of 60, meaning that the stock is moderately outperforming the market.
Because we want stocks that are gaining momentum, I require the three-month RS to be at least 20% higher than the six-month number. I also set maximum values for both to rule out stocks that have already made a big move.
Screening Parameter: 3-month relative strength >= 60
Screening Parameter: 3-month relative strength <= 90
Screening Parameter: 6-month relative strength <= 75
Screening Parameter: 3-month relative strength >= 1.2*6-month relative strength
I relied on an educated guess rather than some sophisticated statistical formula to come up with these relative-strength parameters. So you may want to experiment with the values to suit your requirements.
Out of more than 2,000 beaten-down stocks, it's possible that only a few will meet all the tests above.
As always, the more research you do, the better your results. Consider whatever turnaround candidates you generate with this screen worth researching, not a buy list.
At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this column.
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