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"Fire Your Stock Analyst" by Harry Domash
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Go against the grain to beat the market
Value investing experts say to buy cheap and sell on the rise. But how do you know which out-of-favor stocks are set for a rebound? Here's a screen that will help you out.
By Harry Domash
Value investing sounds good in theory. Buy stocks when they're cheap and sell when they're not. But the strategy leaves something to be desired when you try to do it.
Here's why: Value investing often means buying stocks that are inexpensive because a company's growth-rate unexpectedly slowed or something else went wrong. Adherents to the strategy know that the market overreacts to bad news, driving share prices down further than the news warrants.
But it's impossible to know when a value stock has hit bottom. Even if you pick the right stock, it will often get even cheaper because its price has so much downward momentum. It's easy to get discouraged and bail out before the recovery scenario plays out.
The strategy is called a contrarian approach because it involves going against conventional wisdom. In the stock market, going against the grain can pay healthy returns.
For instance, when Google (GOOG, news, msgs) went public in its widely publicized 2004 IPO, conventional wisdom said Google shares weren't worth more than the $85 IPO price. Being conventional, though, wasn't so wise, as Google shares now fetch close to $300.
So following a contrarian strategy doesn't require buying beaten down stocks. It simply requires some group of investors to have a negative opinion of a stock.
I'll use Wall Street analyst's ratings as my main sentiment indicator and define those stocks rated sells as having negative sentiment.
The concept is simple. Buy sell-rated stocks and hold them until their ratings improve, and then sell. The idea isn't as risky as it sounds because analysts are often late to the party. They generally downgrade a stock after the bad news is out and the share price has already taken its hit. In fact, research shows that, as a group, sell rated stocks often outperform "strong buys."
Of course, not all sell-rated stocks will recover. So here are some ideas for picking the eventual winners out of the bunch.
Doubly doubted
I'll start by screening for stocks with consensus sell ratings. But, I'll also look for confirmation by requiring that short-sellers must also be betting that the stock is headed down. Many experts consider high interest from short-sellers a contrary indicator, meaning that it signals that the share price is likely headed up.
Finding sell-rated stocks
Compiling services tabulate five categories of analysts' ratings: strong buy, buy, hold, sell and strong sell. Since many analysts are hesitant to use the sell word, hold could either mean hold or sell. But there's no doubt about the meaning of sell and strong sell. For sell, MSN's screener uses the phrase 'moderate sell.'
Screening parameter: Mean Recommendation <= Moderate Sell.
Translated, this term means that only stocks with moderate-sell or strong-sell ratings will pass the test.
An interest in the shorts
Short-sellers sell borrowed shares in the hopes that they can buy shares at a lower price later to replenish the shares that they've borrowed. They make money if the stock price drops during the time they are short. They lose if the stock price moves up.
Short interest is the number of shares that have been borrowed by short-sellers for their short trades. Since the total number of shares outstanding varies widely between stocks, short interest by itself doesn't mean much.
The short-interest ratio is a better gauge, because it compares the short interest to the daily trading volume. Specifically, the short interest ratio is the number of days it would take for the short-sellers to buy back their borrowed shares, based on the recent average daily trading volume.
Short interest ratios run from zero to 20 days, and sometimes higher. The higher the ratio, the higher the short interest. Usually, "in-favor" stocks have ratios well below 5. With that in mind, I required a minimum short interest ratio of 6 to identify out of favor stocks.
Screening parameter: Short Interest Ratio >= 6
Here's a screen for using both analyst "sell" ratings and high short interest to identify out of favor stocks. When I ran it, the screen turned up more than 200 stocks, which is the maximum number MSN's screener can display.
Isolating the best prospects
So far, we have a list of stocks with sell ratings and high interest from short-sellers. Below are my ideas for pinpointing the strongest candidates in the group.
Stay away from single-digit stocks
I don't have any research data to back me up on this, but I've found that stocks trading below $5 or $10 are bad news. I don't know all of the reasons, but I do know that institutional buyers and other pros tend to avoid them. I set my minimum acceptable trading price at $10, but you can reduce that limit to $5 if you want to see more stocks.
Screening parameter: Last Price >= 10
Adding the minimum price requirement cut my list down to 165 out-of-favor stocks.
Let the pros do your homework
Whoever coined the phrase "work smarter, not harder" had the right idea. In this case, rather than analyzing 165 stocks, I'll let mutual fund and other institutional money managers do the heavy lifting. They are better wired into the market buzz, and many employ squads of analysts to do the work.
Institutional ownership is the percentage of a firm's outstanding shares owned by the big players. Typically, for in-favor stocks, the institutional ownership figures run from 40% to 95%.
If institutional investors haven't dumped a sell-rated stock, it's probably because they think its share price is headed up, not down.
There's no hard-and-fast rule for deciding how much institutional ownership is enough. I picked 75%, because to me, that signifies strong institutional support. Lower the minimum to 60% or 70% if your screen doesn't turn up enough stocks. But don't go below 50%.
Screening parameter: % Institutional Ownership >= 75
Adding the institutional ownership requirement left me with 62 stocks.
A home-grown tool
Finally, I've enlisted MSN's StockScouter for a second opinion. StockScouter analyzes a variety of fundamental and technical factors to come up with its stock ratings. The ratings range from 1 to 10, where 10 is best. The stock ratings are distributed on a bell curve, meaning there are more stocks rated 9 than 10, and more rated 8 than 9, and so on.
Besides not having to do the fundamental analysis, an advantage of using StockScouter is that its ratings take a stock's price action into account. Stocks with downtrending charts don't get high ratings. I found that by specifying a minimum 8 rating, I can rule out stocks with weak price charts.
Screening parameter: Rating >= 8
Here's the full contrarian screen.
My Contrarian screen turned up 13 candidates. Note there were no two stocks in any one industry. One company, apartment-community owner Gables Residential Trust (GBP, news, msgs), had just been acquired, so I deleted it from the list. Some, such as hardware maker Electronics for Imaging (EFII, news, msgs), had suffered fundamental setbacks a few months earlier, that smashed their share prices. But others, such as shopping center owner Taubman Centers (TCO, news, msgs), showed relatively strong price charts over at least the past year.
| Contrarian screen results | | Company | Industry | | Gables Residential Trust (GBP, news, msgs) | REIT - Residential | | UAP Holdings (UAPH, news, msgs) | Agricultural Chemicals | | Tupperware (TUP, news, msgs) | Packaging & Containers | | Pegasus Solutions (PEGS, news, msgs) | Business Services | | SPX (SPW, news, msgs) | Auto Parts | | Moody's (MCO, news, msgs) | Business Services | | Edwards Lifesciences (EW, news, msgs) | Medical Appliances & Equipment | | Hilb Rogal & Hobbs (HRH, news, msgs) | Insurance Brokers | | Taubman Centers (TCO, news, msgs) | REIT - Retail | | Cooper Tire & Rubber (CTB, news, msgs) | Rubber & Plastics | | Advent Software (ADVS, news, msgs) | Application Software | | VistaCare (VSTA, news, msgs) | Specialized Health Services | | Electronics For Imaging (EFII, news, msgs) | Computers Wholesale |
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The stocks turned up by the screen are contrarian candidates worth researching, not a buy list.
At the time of publication, Harry Domash did not own or control positions, either long or short, in any of the stocks mentioned in this column.
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