They don’t cost much for a reason, but here’s the way to locate cheap stocks that might — and let’s emphasize ‘might’ — have a tremendous upside.
Cheap stocks, say stocks trading under $10, have an undeniable appeal: You have the potential to score big returns.
Say you hop on a stock with great fundamentals but languishing in the $5-per-share range. It’s not a stretch to imagine that stock doubling or tripling when it catches the market’s attention. It would be hard to achieve those sorts of returns with stocks like Google (GOOG, news, msgs).
Unfortunately, scoring big gains on cheap stocks isn’t easy. Most got cheap because market players spied serious fundamental problems that probably won’t go away. Thus, many are likely to get even cheaper.
Here’s a screen for spotting cheap stocks that have the potential to recover from the problems that sank their share prices.
It employs a tool — favored by the pros but neglected by most individual investors — to isolate the truly profitable companies in the cheap-stock universe and then pick the stocks in that group favored by the smart money. From those select candidates, the screen picks fast growers with the best chances of outperforming the market over the next few months. Here’s how it works.
Cheap — but not too cheap
I start by identifying stocks trading below $10.
Screening parameter: Previous day’s closing price <=9.95
There’s such as thing as too cheap. I rule out stocks trading below $2 because, in my experience, such stocks are very risky. Since I arbitrarily picked that figure, increase your minimum to as high as $5 if you want to reduce your risk.
Screening parameter: Previous day’s closing price >=2.00
Stock screeners sometimes include dead or rarely traded stocks in their results. You can avoid that problem by specifying a minimum trading volume, which is the average number of shares traded daily over a specified period.
Most stocks trade hundreds of thousands of shares daily, although small stocks get less attention and may only trade 50,000 or so shares, on average, daily. I require a minimum 40,000 shares average daily volume over the past three months. Since the lower the volume, the higher the risk, increase the minimum to 100,000 if you want to reduce your risk.
Screening parameter: Average daily volume last quarter >= 40,000
More than 1,100 stocks passed my price and volume tests. Next, I isolate the most promising suspects by employing a powerful profitability test.
Truly profitable
Simply reporting positive earnings doesn’t ensure that a company is making enough money to support its growth or to provide an adequate return to its shareholders. To judge that, you have to look at profitability ratios such as return on equity, return on assets or return on invested capital.
Of the three, you hear most about return on equity. However, return on invested capital (ROIC) is favored by many pros because it offers an especially insightful look at profitability.
Invested capital is what you’d be on the hook for if you bought the whole company. Return on invested capital is the return you’d receive on your investment if you did buy the company and paid off its debt.
What’s especially interesting about ROIC is that it tells you whether a firm can profitably employ borrowed funds. For example, a firm earning a 10% ROIC could borrow at the current 5% or so corporate bond rate and make a worthwhile profit. Conversely, a 3% ROIC company would pay more servicing its debt than it would earn on the borrowed funds.
Using MSN Money’s Deluxe Screener, I set my minimum allowable return on invested capital at 10%, double the rate most corporations currently pay for borrowed funds. Try lowering the minimum to 7% or 8% if you want to see more stocks.
Screening parameter: Return on invested capital >= 10
What’s it worth?
Valuation ratios describe the market’s expectations for a stock. Low valuations signal low expectations, meaning that most market players don’t like the stock. Conversely, high valuations connote in-favor stocks with high, possibly unrealistic growth expectations. These stocks typically suffer big losses when their growth falls short of expectations.
The price-earnings ratio (recent share price divided by 12 months’ per-share earnings) is the most widely followed valuation ratio. But reported earnings tend to be volatile from quarter to quarter, distorting the price-earnings ratio.
The price-sales ratio (recent share price divided by 12 months’ per-share sales) is a steadier gauge because quarterly sales don’t fluctuate nearly as much as earnings. Price-sales ratios range from 1 to as high as 20, and sometimes even higher. There is no hard-and-fast rule, but I’ve found that stocks with ratios above nine or so are risky bets.
I set my maximum allowable price-sales ratio at 8. Cut the maximum to 6 or 7 if you want to reduce your risk. Increase it to 9 or 10 if you don’t mind higher risk and want to see more stocks.
Screening parameter: price/sales ratio <= 8
Good to grow
Usually stocks recording strong earnings growth are the best performers. So, I isolate the best stocks in that department, starting with historical revenue growth, which, as I already mentioned, is a steadier gauge than earnings growth.
What’s sufficient in terms of historical growth is open to discussion. I specified a minimum 12% year-over-year revenue growth over the past year. Increase the minimum to 15% if you want to limit your list to faster-growing companies.
Screening parameter: Revenue growth year vs. year >= 12
While growth rates typically vary from quarter to quarter, it’s important to rule out stocks with declining growth. In an attempt to strike that balance, I require that the last quarter’s revenue growth must be at least 75% of the last 12 months’ growth rate. Given my arbitrary selection of 25% allowable fluctuation, modify it as you see fit.
Screening parameter: Revenue growth quarter vs. quarter => 0.75* revenue growth year vs. year
Next, I confirm that analysts expect the historical growth to continue. Since many investors look for at least 15% forecast earnings growth, I require that amount for expected long-term growth (we can’t screen for forecast revenue growth).
Screening parameter: EPS growth next 5 years >= 15
Stay in favor
Thanks to the huge trading commissions that they generate, institutional investors such as mutual funds and pension plans are privy to information that we’ll never see. If these big players don’t own a stock, we shouldn’t own it either.
The institutional ownership figure is the percentage of shares outstanding held by institutional investors. For in-favor stocks, percentages range from 40% to as high as 95%. Since they must invest large sums to establish meaningful positions, some institutions avoid cheap stocks. So I cut my usual 40% minimum institutional ownership requirement down to 30%.
Screening parameter: % institutional ownership >= 30
Stock analysts rate stocks as “strong buy,” “buy,” “hold,” “sell” or “strong sell.” The consensus ratings you see on MSN Money and other sites are simply the average of all analyst ratings for a stock.
Stock analysts are easy graders and award “strong buy” or “buy” ratings to most of the stocks that they follow. Thus, “sell” or “strong sell” ratings signal extra risk that you don’t need. Avoid such stocks.
Screening parameter: Mean recommendation >= Hold
No negative surprises, please
An earnings surprise is the difference between analysts’ forecasts and the quarterly earnings a company actually reported. It’s a positive surprise when reported earnings exceed forecasts and a negative surprise when earnings fall short. Positive surprises usually lead to higher share prices and vice versa.
Many research studies have found that stocks with recent negative surprises tend to underperform the market for several months, while those with positive surprises often outperform.
Screening parameter: Recent quarter surprise % >= 0
My screen turned up eight stocks, with all but one trading in the $5-to-$9 range. Surprisingly, seven of the eight are in the tech sector. However, they all serve different industries within the sector, and thus the picks are more diversified than they may first appear:
Art Technology Group (ARTG, news, msgs); recent price $2.16. Develops and sells Web site merchandising, sales and customer service software.
Actuate (ACTU, news, msgs); recent price $5.30. Develops and sells reporting and analytical software targeted mainly to large corporations.
Medifast (MED, news, msgs); recent price $6.66. Develops, manufactures and sells health and diet products online through network marketing and via doctors’ offices.
Netlist (NLST, news, msgs); recent price $7.26. Makes and sells memory products used in servers, routers and broadband switching systems.
RealNetworks (RNWK, news, msgs); recent price $7.70. Makes the ubiquitous RealPlayer digital media player that you probably have in your computer, as well as arcade games and other products for delivering digital content.
STEC (STEC, news, msgs);recent price $8.42. Formerly SimpleTech, makes memory products used in laptops, digital cameras and network routers.
Silicon Image (SIMG, news, msgs); recent price $8.74. Designs and markets digital video controllers and other video chips found in personal computers, set-top boxes, DVD players and other equipment.
Website Pros (WSPI, news, msgs); recent price $8.91. Provides software, design consulting, Web hosting and just about everything else a small or midsized business needs to implement a Web site.
This screen, like all screens, doesn’t know about everything you need to consider before buying. These are candidates worth investigating, not a “buy list.” The more you know about your stocks, the better your results.
Since the screener has an earnings surprise parameter, it makes sense to use it to avoid stocks with recent negative surprises.
Source: articles.moneycentral.msn.com
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