How To Avoid Getting Steamrollered Buying Beaten-Up Stocks

by: Alan Brochstein, CFA

Over the last few weeks I have explored severely depressed stocks, taking a look first at potential bargain S&P 500 stocks trading 50% or more below their 52-week highs, and then following up with "Mid-Caps Sliced In Half." As I suggested, often these names are beaten up for a reason, making investment somewhat of a long shot. While I have encouraged readers to resist the temptation to bottom-feed, I can appreciate the idea of buying a stock that has fallen "too much." Intuitively, a lower price seems to imply less risk, but this isn't necessarily the case.

So, if you are the type of investor who likes to snap up stocks with negative price momentum, how can you raise the odds in your favor? While there are still no guarantees, I believe that the chances of successful entry can be improved by applying certain technical and fundamental criteria.

On the technical side, we want to find signs that a stock is "bent, not broken." Many of the stocks that are really beaten up will suffer from overhead supply, or sellers trading cost, if the stock can actually rally. It's important to identify the primary trend of a stock, as it's a much safer bet to buy a bullish stock correcting rather than one in a clear bear trend. In this vein, one can do things like look at the price trends and moving averages. This can be somewhat subjective, perhaps more of an art than a science.

On the fundamental side, we can look at things like sales and earnings estimates. Is the company growing sales? What about earnings? What are the trends? Are things slowing but still strong? Are analysts reducing or increasing estimates? Again, this can be more of an art than a science, as no one knows the future. We can't count on the analysts to get the numbers right. Sometimes the numbers are going up, but not in a sustainable way (big debt-funded share repurchases, an "accretive" acquisition that is based on flawed strategy, etc.).

With the caveat that there is no holy grail, I designed a screen with the simple goal of identifying stocks with reasonably good fundamentals that are correcting within bullish LT trends. Using Baseline, here are the parameters I employed:

  • Russell 3000 Member
  • QTD Price Return < 15% (S&P 500 = -8%)
  • One-year Price Return > 3% (S&P 500 = -4%)
  • Five-year Price Return > 0% (S&P 500 = -16%)
  • 50dma > 200dma (sign of bullish trend)
  • Price vs. 200dma < 110%
  • 2012, 2013 Three-Month EPS Estimate Revisions > 0
  • 2012, 2013 Sales Growth > 0

The screen is a bit heavier on the technical side, looking for stocks outperforming one-year and five-years but pulling back sharply since March. The requirement that the 50dma exceed the 200dma reinforces the longer-term bullish trend requirement. We also kept the stock close to the 200dma to hopefully minimize downside risk. On the fundamental side, the requirements were mainly that the analysts aren't cutting estimates. Here are the stocks that met the criteria:

Click to enlarge image.

Keep in mind that screening is a starting point; these aren't recommendations. The idea is to dig deeper to see if the story is changing or if the pullback is solely profit-taking.

I don't follow any of these stocks closely, but I will share some brief preliminary thoughts. I have sorted the list by economic sector and then in ascending QTD price returns. I like that several different economic sectors are represented. Before I go on, I included a few extra columns: Net Debt to Capital (companies with higher levels of debt can become riskier in downside scenarios), the earnings growth estimates for 2012 and 2013, and the forward P/E level and comparison to the 10-year median. Like most stocks, current valuations on this list are generally lower than the past. For those who really like to buy stocks "down," I highlighted in red the two stocks that are down YTD. Those, along with another two, are highlighted as trading below the 200dma as well.

In the consumer discretionary sector, I believe that Select Comfort (SCSS) is down in sympathy with Tempur-Pedic (NYSE:TPX). SCSS has been buried by the past two recessions only to come back to life both times. It recently posted an all-time high. PVH (NYSE:PVH) was pounded on the Fossil (NASDAQ:FOSL) disaster; lots of concern over European exposure. Like SCSS, it looked to have been very extended before this correction. Finally, Pier 1 Imports (NYSE:PIR) is another one that has come back to life. In its fourth quarter, it posted double-digit same-store sales and is opening stores. CEO Alex Smith, a TJX veteran, has done a great job of restoring profitability and now growth.

Nu Skin (NYSE:NUS) has been absolutely hammered since Herbalife (NYSE:HLF) was decimated when Greenlight Capital's David Einhorn asked some questions during its conference call. The stock trades very inexpensively, considering its growth, and has plenty of insider ownership (12.7%) as well as a big "smart" investor in Royce & Associates (11%).

Mitcham Industries (NASDAQ:MIND) is the smallest on the list by far. The company leases seismic equipment and also manufactures marine seismic equipment. The recent 10-K cites increased oil and gas exploration, geographic expansion, a higher "channel count" on seismic surveys and additions of equipment to its lease pool as drivers of recent growth. There is substantial insider ownership. The other energy company, Continental Resources (NYSE:CLR), has even higher insider ownership, with CEO Hamm owning over two-thirds of the company. This is a play on the Bakken as well as a few other regions (Red River, Oklahoma Woodford). This is the only stock on the list with more than 10% short interest.

The final four companies are all in technology. Faro Technolgies (NASDAQ:FARO) makes 3D measurement and imaging systems that are used in manufacturing, industrial and construction applications. It's a very internationally focused company with 13,000 customers. The company put up very robust growth of 24% in Q1, including an impressive 21% gain in EMEA. F5 Networks (NASDAQ:FFIV), which sells hardware with embedded software that makes the Internet run smoothly, looks to be suffering simply from fears of a slowdown. Trimble Navigation (NASDAQ:TRMB) sells GPS products into the engineering and construction, agricultural and other markets. The company did a relatively large acquisition last year. Finally, TNS (NYSE:TNS), another relatively small company that offers a global data network aimed at retailers, banks, payment processors, financial institutions and telecommunications firms, is trading at a very low valuation. The company does have substantial debt relative to equity, but the $322 million net debt works out to about 2.4 times trailing EBITDA. Not bad for a company that generates relatively stable cash flow. Insiders own over 7% of the company, and TNS has been repurchasing stock. The company modestly reduced its 2012 sales guidance but also raised the lower end of its EPS guidance after Q1.

Buying a falling knife is quite risky. So rather than just trying to find beaten-up stocks, we have set up a screen to identify stocks in uptrends but that are correcting. While the criteria are designed to uncover stocks that may be experiencing just a short-term decline, some of these may prove to be broken nonetheless. If one pursues any of these stocks further, it's important to monitor closely for a break in the primary trend as it would kill a big part of the buy rationale.

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