Alan Brochstein shares several tips for evaluating stocks in correction
The stock market has recently moved to levels not seen since 2007. While it has increased a lot from the lows set in early 2009, it hasn’t gone anywhere over the past five years. With the “breakout,” investors who have been on the sidelines and are looking to add exposure may look to play “catch up,” refusing to “pay up.” Unfortunately, this can be a recipe for disaster, as often there is a reason the stocks are down.
If you are going to try to buy stocks that have corrected (declined by 10% or more from their recent high), I believe you can improve your chances of not buying a “falling knife” by focusing on a few technical, fundamental and valuation checks. With this in mind, I designed a screen using Baseline to find some stocks that have gone down as the market has rallied since June but that might be worth investigating further. Here are the parameters I used:
- Member of the Russell 3000 Index
- Market Cap > $500mm
- 3-Month Price Return < -10%
- 12-Month Price Return > 21%
- Price < 90% of 52-week High (down more than 10%)
- Price > 110% of 52-Week Low
- Price < 200% of 52-Week Low
- 2012 Earnings Estimate Revisions – Past 3 Months > -6%
The first two parameters define our universe. The next two restrict it to stocks that have declined over the past three months but that are up as much as the market over the past year. This is our first “protection.” The stocks are performing at least as well as the market over the past year. The next two look at the price relative to the 52-week low. On the one hand, we don’t want it to be too close, as often stocks moving to new 52-week lows bring in sellers who throw in the towel. On the other hand, being too far away creates potential price risk, so we are keeping it to stocks that have no more than doubled.
All of the rules we are using for the screen so far are technical and based on price. The last one is a fundamental check: The screen allows some reduction in earnings estimates, but limits it to just 6% over the past three months. Recall that the stocks are down at least 10% over the past three months, so this rule forces the price decline to be greater than the reduction in earnings. In case it’s not clear, an example of this rule would be that if a stock was supposed to earn $1 this year three months ago, then today’s consensus estimate must be greater than $0.94.
The screen resulted in 8 companies that met the criteria:
Now, before I go on, please remember that these aren’t recommendations. This is an exercise to perhaps identify some stocks to study further, but it’s also a learning experience to help you think about your own investment process.
The stocks are sorted by price change over the past three months. While the S&P 500 has increased by 9%, some of these double-digit decliners have lost over a quarter of their value. I have included some additional information. In terms of an additional technical indicator, note that I shaded the price of Star Scientific (STSI) in red due to it being below $5 per share. This is a quick reminder that things haven’t exactly gone so well for this smokeless tobacco company over a longer time-frame.
I also included a column for net debt to capital, a fundamental attribute. Two of the stocks have what would be considered substantial debt, including trucker JB Hunt (JBHT) and generator manufacturer Generac Holdings (GNRC). I also shaded in green the four with less debt than cash, including retailer Dollar Tree (DLTR), Star Scientific, clothing company Zumiez (ZUMZ) and high-energy drink maker Monster Beverage (MNST). When buying a stock that has been declining, a high level of debt raises the bar for your analysis, as it can indicate potential solvency or liquidity risks.
I shaded in green the four stocks where the earnings estimates have actually increased, including Generac Holdings, Dollar Tree, Star Scientific and drug maker Salix Pharma (SLXP). Remember, though, that often analysts can be slow to adjust estimates, so don’t assume that these forecasts are written in stone. I also included near-term earnings growth, which suggests that analysts think that all of these stocks can grow double-digit in 2012 with the exception of Salix Pharma. As the last row indicates, the S&P 500 EPS for 2012 are currently expected to decline very slightly.
Finally, as I mentioned above, valuation can play a role in helping to decide if a falling stock is worth pursuing. If the valuation is very low, that can be a red flag. In this case, there is only one stock trading substantially below the 13.7 forward PE of the S&P 500, and I highlighted Generac Holdings in green. I also highlighted Star Scientific in red, as it is currently not profitable, which adds to my previous statement that it is somewhat speculative given that it trades below $5. The rest of the stocks, with the exception of Monster Beverage, trade at a slight premium to the S&P 500. The last column compares the current PE to the median over the past decade. Zumiez and Salix Pharma trade below their median, while Monster Beverage is still above its average valuation despite the large price decline (due, I believe, to market expectations of the company being bought by Coca Cola).
Screening is a tool to identify stocks to study more closely for potential investment. In this case, we have identified 8 stocks that might be attractive after falling sharply in price over the past few months. I like the idea of using three different gauges to help improve the odds. In this case, we used technical constraints primarily to identify stocks that have been in an uptrend and appear to be correcting. We used fundamentals, making sure that analyst estimates weren’t falling too rapidly. We also considered debt levels and growth rates. Finally, while the initial screen didn’t have any valuation constraints, we did contemplate whether the stocks were expensive potentially (or even “too cheap”). Hopefully, this demonstration can help you to improve your odds should you decide to buy a stock that has been underperforming.
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator
Disclosure: No positions in any stock mentioned
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