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Stocks For A Rebound

Despite the continuous flow of bad news, eventually, the market will recover. Today, I’ll describe a strategy for finding stocks worth considering in a rebounding market. Here’s why you should be getting ready now. 

While most experts don’t see much hope for improvement in the economy until well into next year, history shows that the market usually picks up months before the economy. Since many stocks have been beaten down to ridiculous levels, the recovery, once it takes hold, should be robust.

The question, of course, is when to jump back in? Nobody knows for sure, but here is how I look at it.

Expectations Rule
The market is all about expectations. Stocks drop when results fall short, forcing market players to reduce future expectations, and vice versa. For a stock to go up, a company doesn’t have to produce great results. It need only do better than expected. The same idea applies to the overall market.

Now, everybody expects the worst. Home sales and prices are still dropping, analysts predict a disastrous holiday season and November automobile sales fell off a cliff. Reacting to the plunging economy, companies are announcing huge layoffs. It’s hard to see how expectations could be worse.

But, sooner or later, the news will stop getting worse. Maybe department store holiday sales will be bad, but not as bad as analysts thought. Maybe the credit markets will improve. Maybe housing sales will flatten, or even pick up a bit. Nobody is going to ring a bell to tell you that the market has bottomed. You have to watch for clues that things are no longer getting worse. 

When It’s Time
Here’s a strategy for finding worthwhile stock candidates when you think the time is right. I’ll describe it using Google’s new user-friendly stock screener (program for scanning the market to find stocks meeting your requirements). I picked the Google screener it requires no learning time; you can start using it immediately. Here’s how. 

From Google Finance (finance.google.com), click on the “stock screener” link next to the “Get Quotes” button. When you get there, Google displays a default screening program using four of the 60 or so available criteria (selection choices). Start by deleting all but the Market-Cap criterion (click the “X” on the right of each criterion that you want to delete).

Company Size
Even if we do get a strong rally, we don’t want to go overboard in terms of risk. Since smaller companies are usually riskier than larger companies, you can reduce risk by avoiding very small firms. Most investors use market capitalization, which is how much you’d have to shell out to buy all of a firm’s shares, to measure company size.

Firms with market-caps below $1 billion are termed small-caps, those above $10 billion are large-caps, and those in-between are mid-caps. I set my minimum market-cap at $1 billion (type “1B” into the “Min” box, and leave the “Max” box blank). Try reducing your minimum to $500 million (500M) if you want to see more stocks, or increasing it to $5 billion if you want to cut your risk.

Cash Rich, No Debt
It’s going to take some time for the credit markets to return to normal. In the meantime, the slightest hint of a cash shortage can sink a stock. I used two selection criteria, current ratio, and “total debt to equity” to reduce the odds of getting caught in that trap. 

Current ratio compares current assets such as cash, inventories and accounts receivables to short-term debt such as payroll expenses and other current bills. A ratio of one means that current assets equal liabilities, while a two ratio means that current assets are double current liabilities.

I set my minimum allowable current ratio at 2.5. Although I arbitrarily picked that number, I don’t see much advantage in upping that limit, and I certainly wouldn’t lower it. Add the current ratio requirement to the screen by selecting Add Criteria, then Financial Ratios, and finally select Current Ratio.

In this market, the slightest fear that an otherwise strong corporation won’t be able to refinance expiring long-term debt will sink its share price. We’ll avoid that problem by ruling out firms with any long-term debt. For that, I used the “total debt to equity ratio,” which compares the total of short- and long-term debt to shareholders equity (book value). I used the total of both short- and long-term debt because some firms have found ways of categorizing long-term debt as short-term. I specified a zero maximum total debt/equity (most recent quarter). 

Profitable
As always, the best candidates are profitable firms as opposed to money losers. Return on equity measures profitability by comparing net income to shareholders equity. Most money managers that I know require a minimum 15% ROE. However, given this tough market, I required a minimum 20% return on equity (TTM or trailing 12 months). Try cutting your minimum to 15% if you want to see more stocks.

Follow the Money
Institutional buyers such as mutual funds and pension plans are more wired into the market than you and I can ever hope to be. If they don’t own a stock, we shouldn’t either. “Institutional ownership” is the percentage of a firm’s shares held by those big players. Institutional ownership ranges from 50% to 95% for in-favor stocks. I required a minimum 50% Institutional Percent Held (Stock Metrics). 

Growth Rules
While anything can happen in the short-term, over time, sales and earnings growth is what drives share prices up. Since nobody is recording much growth this year, we have to look at longer-term trends. I used Google’s Five-Year Revenue Growth Rate parameter (Growth category). Usually, you want to see at least 15% average annual revenue growth. But, considering current conditions, I required only 10%.

My screen turned up six candidates: Cognizant Technology Solutions (CTSH), FactSet Research Systems (FDS), Fastenal (FAST), Google (GOOG), Immucor (BLUD), and Intuitive Surgical (ISRG). 

Since it may be some time until you feel comfortable making a move, your screen may turn up different stocks. As always, consider the results of any screen as candidates for further research, not a buy list. Since it’s difficult to distinguish between a head fake and the start of a genuine recovery, consider a dollar-cost-averaging approach where you invest a fixed amount at predetermined intervals (e.g. one month) rather than adding all of your funds at once.

published 12/7/08

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