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Investors are constantly hunting for low risk/high reward stock picks. Some look for stocks with low or high correlation to the market using beta. Others try to find stocks with high alpha, which relates to excess returns not explained by the beta. Historical fundamentals are pored over as are price charts and future forecasts.

Instead of using the above methods, we are going to combine two separate approaches to find stock picks that may see some future upside.

Combining Two Stock Picking Models

Two different approaches were outlined by Boni and Womack (2004) and Ang and Ciccone (2001). The first paper was called, "Analysts, Industries, and Price Momentum", and the second, "Analyst Forecasts and Stock Returns."

Boni and Womack used an approach to buy upgraded stocks and sell downgraded stocks. They did so across a variety of industries and sectors so that the portfolio was equal-weighted according to industry. They were not attempting to differentiate between hot and cold sectors, or any industry specific strategy. In fact, they were trying to dilute or remove the momentum associated with changing industry rank to isolate the analyst upgrade and downgrade effect. They found analyst consensus to be of little use. Their strategy returned up to 15% per year (read a Seeking Alpha artice that uses this approach).

Ang and Ciccone used a different stock-picking method. They looked for highly transparent stocks with at least two analysts. They wanted stocks with low dispersion of estimates and low error in forecast. This means tightly grouped forecasts with low earning surprises when compared to estimates. The annual return difference between these stocks and companies with wide ranges of forecasts and large surprises was 13.12% (read about 6 stock picks using exclusively this method here).

Can we partially combine the two methods for some potentially bullish picks?

Stock Scan with a Little of Both

  • At least 1 rating upgrade in the past 4 weeks
  • Minimum of 2 analysts covering this year's forecast
  • Avg EPS surprise last 4 quarters between -10% and +10%

Selected Analyst Upgrade Stock Picks

Note that stocks listed below are based on Zacks screener

  1. HR Healthcare Realty Trust
  2. DEP Duncan Energy Partners
  3. NATI National Instruments
  4. COG Cabot Oil & Gas
  5. LOPE Grand Canyon Education
  6. AMAT Applied Materials
  7. KEX Kirby
  8. ZMH Zimmer Holdings
  9. SYK Stryker
  10. LLL L-3 Communications Holdings
  11. WIN Windstream
  12. CHS Chico's FAS

HR Analyst Upgrade Stock Pick

Fundamental Concerns

Note that stock data below is from FINIZ screener and is often different than other sources such as Yahoo. Always double-check your data.

Neither approach relied heavily on fundamental data, even if there was a minimal improvement in small cap stocks. This approach worked well for all sizes, P/E ranges, and book values. Below is a cross-section of the stocks with a few metrics so you can see the variance.

Ticker Market Cap (mil) P/E Price P/B EPS growth(next 5 yrs) Dividend Yield
HR 1430.99 138.81 22.21 1.74 5.00% 5.40%
DEP 2340.37 26.15 40.54 3.08 3.65% 4.49%
NATI 2448.59 22.64 31.24 3.32 12.00% 1.92%
COG 4760.79 53.24 45.79 2.58 -11.33% 0.26%
LOPE 718.42 15.25 15.71 5.67 29.72%
AMAT 21300.65 23.03 16.12 2.84 9.67% 1.74%
KEX 2881.52 24.93 53.84 2.57 13.93%
ZMH 12241.28 21.09 62 2.12 10.37%
SYK 25042.39 19.77 63.06 3.44 11.86% 1.14%
LLL 9250.21 9.68 79.95 1.34 7.84% 2.25%
WIN 6024.48 18.87 12.45 7.59 -1.00% 8.03%
CHS 2456.21 22.31 13.83 2.34 13.75% 1.16%

One concern would be with COG and WIN since, if analysts are correct in their 5-year forecasts, there should be negative growth. After cross-referencing FINIZ data with Yahoo figures, COG is expecting 16% gains per year for the next 5, and WIN has 5.1% expected. Furthermore, the earnings surprises between quarters seems higher at times when using Yahoo data, but Zacks may be using 4 of the last quarters which usually excludes the most recent or current quarter. Many differences can be explained by which data set is being analyzed and how timely information is updated.

Keep an eye on a few of these stocks that were listed as getting downgrades by Zacks screener.

Company Name Ticker Last Close
CLINICAL DATA CLDA 30.95
FRONTIER OIL FTO 26.6
GENUINE PARTS GPC 51.83
INTEGRA LIFESCI IART 49.88
GRAND CANYON ED LOPE 15.09
MEDTRONIC MDT 39.3
NETFLIX INC NFLX 211.2
REDWOOD TRUST RWT 16.71
SATCON TECH CRP SATC 3.54
SRS LABS INC SRSL 8.84
STANTEC INC STN 28.58

Of course, Boni and Womack would likely short these stocks, but I'm still a little nervous about doing so in a bull market. Perhaps if I was a strong bull who always wanted long market exposure even in bear markets would I add the 'short-sell the downgrade' technique at that time. Thus, my long picks in bear markets would be hedged with downgraded short-sell positions. But for now, buying downgraded stocks may simply mean slower price appreciation on high momentum picks like Netflix (NASDAQ:NFLX) that still have large future expected growth.

What is your take on upgraded stock picks when analysts usually come fairly close to their targets?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.