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Balance Sheet Bargains - A Value Trading Strategy

Over the past few months, I have published a few Balance Sheet Bargain lists with the idea to create a very basic filter set as a screen for value stocks. The results have been generally positive and at least initially it is outperforming the S&P 500.

My purpose in creating this strategy and the regular updates is to use a few basic filters to meet or beat the S&P 500 with a value approach. I have asked for reader feedback and in response to some of your great comments and requests, here is a complete outline of the strategy - how to find the stocks, how to trade the stocks and how to set entry and exits.

PART I - SCREENING FOR BARGAINS

The purpose of this screen is to identify strong companies with stocks that may have already, or very soon will be, bottoming - presenting momentary value opportunities. Trading stocks near the 52-week low carries higher risk, so this screen attempts to filter to the firms with solid financial foundations and therefore lowers the risk. It might be loosely considered a value strategy.

Here are the criteria that are used to perform this screen, which I run on finviz.com.

Technicals

Average daily volume over 1 million - This is to ensure that only the most liquid stocks are in the selection to make entering and exiting the position easier with smaller gaps between the bid and ask. This threshold could be lowered, but I would recommend going no lower than 250,000 shares per day. Lower than this makes a stock subject to more unstable swings and wider bid-ask spreads.

Trading 0% to 10% above the 52-week low - This criteria will identify stocks that are at the low end of their trading range, the crude assumption is that by being close the lows, the stock is trading below the average or fair value. Clearly this is an imperfect measure of prices below value, but if we assume that the mid-point of a 52-week range is about the fair value, then anything below will be under-valued. Definitely not a perfect assumption, but when using simple screening tools this seems a reasonable alternative.

The stock has options - This criteria is only here so we can use options as one way to leverage up the trade. It has no fundamental or technical value in the screen, this criteria only makes the stock more attractive to trade.

Asset Management / Value Proposition

Quick Ratio greater than one (1) - This screen is part of the value filter, looking for companies with strong short-term asset positions, meaning the company can cover its short term bills with liquid assets on hand. Companies with strong cash flows and strong cash and debt management fall into this group.

A gross profit of greater than zero - This shows that the company is profitable. Companies with strong cash positions and are losing money will reduce the cash reserves quickly so we want a company that is adding to its cash position.

The dividend yield is greater than zero - This generally shows that the management is further committed to managing its cash and assets in a way that benefits shareholders. This is not a guarantee that management has shareholders best interests always in mind, but it is a broadly good signal.

Price is greater than $5 - Generally speaking, stocks below $5 are there for a reason and many investment funds use this as a filter to avoid companies with potentially larger fundamental problems. By using this criteria, we are running with another rough assumption that higher priced stocks reflect better run companies. Yes, this is a huge assumption.

Sentiment

Insider trading is positive (>0%) - This criteria looks to see how the company insiders are managing their personal share of and wealth in the company. Sometimes the insider activity is driven by timed events like planned required ownership and options being exercised before expiring. In this screen, the assumption is that if the insiders are net increasing their positions, they are bullish on the company's future.

Short float less than 5% - Short sellers take positions against companies for different reasons - sometimes it is simply because the stock appears overvalued and due for a pullback, sometimes it is because the shorts believe there are fundamental problems and the business is in trouble. For the Balance Sheet Bargain strategy, the goal is to identify companies that are momentarily undervalued while still fundamentally sound. If there is a large open short position, there is a possibility that there are undisclosed problems so to minimize this probability, the screen will identify only stocks where the open short position is low.

PART II - TRADING TACTICS

Fundamentally, the strategy is looking for stocks at a low price point. This means we would look to trade the stocks from the long side. Of course, in some cases a short trade will be better. We are assuming that in most cases the price will rise.

Once a Balance Sheet Bargain has been identified, what techniques could be used to make the trade? Here are my five preferred options, in order of least to most leveraged.

First up is a straight long position - just buying the stock outright. The advantage here is that you get to participate in dividends, have higher liquidity so buying and selling is easy, movement will be somewhat smaller, up and down, and the price movements are easy to understand.

The second approach is to enter a long position and immediately sell covered calls. Known as a "buy-write," this strategy offers the advantage of entering the stock for a slightly lower price than an outright purchase. The strike price should be at a level you will be happy to sell stock for upon expiration. The expiration date should be at or before the date you would expect the stock to rise to that price. The advantage of this tactic is that the stock is the lower net entry price and if the stock closes below the strike price, you have collected some additional income on the trade - and there is a chance to sell the calls again. The downside of this approach is that if the price at expiration closes above the strike, the profits are capped or if the stock price falls, you will need to first buy back the calls before selling the long position. I generally prefer using weekly options in this tactic.

A third trade is to sell puts. The tactic is bullish in that we expect the stock price to rise above the put strike price before expiration and the profit is the premium collected. Like the straight long position, this tactic assumes a near-term price increase so the expiration would be the nearest date. In this tactic, ideally the options Greeks will be high because we are selling premium and want to collect the highest price possible. This is often for strike prices near- or at-the-money. The strike price should be at a level that you are happy to own the stock if the trade moves against you.

The fourth tactic uses options as a stock substitution. In this tactic, go long deep in the money long dated calls where there is little to no options Greek influence on the price - in other words the option is tracking to the stock price. Looking at options with six months or more until the expiration and generally about one third into the money fit this criteria.

Finally, the most risky and highly leveraged tactic are near dated at the money or out of the money calls. This trade is counting on the stock price making a quick move upward. With the low price of the options, your risk is small and defined. The downside is there is a higher risk of a worthless expiration. This approach can be highly profitable when it works however the probability is low.

When deciding which of the five tactics to use, consider your own psychological and financial risk tolerance.

The BSB strategy is primarily designed for short term trades, however, by extending the time horizon, it could also work for investors. For traders, the approach is an entry with a tight stop loss and a quick profit target. Options will work better for short-term trades. For investors, a deeper look at the fundamentals would help to determine a higher and longer term profit target. Investors may prefer to use straight long positions. As we continue to use, monitor and adjust this strategy, the long term performance will confirm if best approaches.

PART III - THE ENTRY AND EXIT

Starting with the weekly screen, we have an identified list of BSB candidates. Before placing a buy order, two other quick scans will be helpful. First, a quick review of recent headlines over the last month to see if there has been any bad news or fundamental changes in the company which would warrant the price drop. The open short interest parameter partly measures this but this data can lag 2 - 4 weeks so a manual news scan is a good step. Second, check to see if there is an earnings announcement scheduled in the next two weeks. The two weeks prior to and just after an earnings announcement can be highly volatile trading and the price action may not reflect the price movement the BSB strategy is seeking. Trading one strategy when the market is moving due to other forces will reduce the probability of success so try to avoid using the BSB strategy in this window.

Entering a position is the easy part, knowing when to exit is the hardest so the trade plan needs to start here. First, set a stop loss price. In the BSB strategy, there is an assumption that the stock has bottomed momentarily and will move higher in the near future. If the stock makes a new 52-week low, something else is happening and you should get out. So set the stop loss small distance below the 52-week low. If the price goes there, stand aside and let it drop without you.

To set the profit target, determine the percent the entry price is above the 52-week low. Take this percentage times three and set your profit target as this percentage above the entry price. Then check this price on the charts - is it reasonable that the stock could move to that price?

Once there is a stop and profit target, do a quick reward:risk calculation. If the prices work as described here, this will give a 3:1 reward to risk ratio. If these prices do not make sense, look at other options for setting the profit target based on recent price movement. If the reward to risk ratio drops below 2:1, the trade may not offer enough to take the risk.

Once you have a reward:risk ratio that makes sense, then and only then place your limit buy order at a price close to the current bid for either the stock directly or the option tactic you prefer.

There are many ways to set stop losses and profit targets. Use a method that you are comfortable with. My strong recommendation is to always always set stop losses.

This is a living strategy and I want to encourage your feedback. Like all trading approaches, to be useful it will need to continue to evolve and grow over time to adjust to shifts in the market. So please share your ideas on how to strengthen this and add to the alpha.

Source: Balance Sheet Bargains: Can This Value Trading Strategy Beat The S&P 500?

Additional disclosure: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is only my opinion based on personal research and offered for informational purposes. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any equity, do your own research and reach your own conclusion. Investing includes risks, including loss of principal.