12 top stocks to buy at the bottom

By Harry Domash

Editor's note: To view the stock screen mentioned in this column, download the free MSN Money Investment Toolbox.

The recent brutal market pullback took no prisoners. Many quality stocks with solid business plans and great long-term prospects got trashed.

But now, with the major indexes well above their recent lows, their price charts are starting to trend higher. Though some see this recovery as a head fake in a bear market, others tell us that the worst is behind us.

For those who agree with the sunny outlook, here's a screen for finding quality companies likely to shine. These are all big-cap, best-in-class, profitable companies with strong growth prospects.

Even better, they don't carry much debt, so they won't be tripped up if the credit markets turn another somersault. And you can still pick them up at today's bargain prices.

No small guys

Given the uncertain economic outlook, it's best to stick with bigger companies. They generally have broader product lines and stronger balance sheets. Also, they've probably been around long enough to have survived just about every type of economic twist. That experience would serve them well if the unexpected happens.

Market capitalization -- recent share price multiplied by number of shares outstanding -- is the best way to gauge a company's size. Market cap is how much you'd have to shell out to buy all of a company's shares.

Market caps below $2 billion usually define small-cap stocks; market caps above $10 billion are large caps; those in between are midcaps. I set my minimum market cap at $10 billion to limit the field to large caps.

Screening parameter: Market capitalization >= 10,000,000,000

Reasonably priced

Considering the pounding that most stocks have endured, there's no reason to buy overpriced stocks. I use two valuation ratios, forward price-earnings and price-sales, to limit the field to reasonably priced stocks with room to run.

Forward P/E is the price-earnings ratio based on analysts' forecasts for earnings in the current fiscal year (the standard P/E is calculated with the past 12 months' actual earnings). I use forward P/E because the forecast earnings numbers exclude one-time charges that artificially reduce earnings and, thus, distort regular P/E ratios.

Forward P/Es typically run as high as 45 or 50 for hot stocks expected to record 30% to 40% annual sales growth. However, the big, well-established players that we're seeking typically only grow sales and earnings around 15% to 20% annually. Thus sky-high valuations are not justified. I rule out stocks with forward P/Es higher than 25.

Screening parameter: Forward year P/E <= 25

The price-sales ratio is similar to P/E, but the recent stock price is divided by sales totals for the past 12 months. Though earnings can vary dramatically from quarter to quarter, reported sales are much less volatile. Thus the price-sales ratio is a steadier valuation gauge than P/E.

Price-sales ratios usually run between 3 and 10 for growth stocks. However, all else being equal, the higher the ratio, the riskier the stock. I set my maximum price-sales ratio at 5 to limit the field to relatively conservatively priced stocks.

Screening parameter: Price/sales ratio <= 5

Avoid dangerous debt

Many large companies borrow money to pay for growth. Usually, that makes sense. There's nothing wrong with borrowing at 6% if you can put that money to work and earn 10%. However, the credit markets are still shaky, to say the least. It's possible that even the best companies will face unexpected problems when it comes time to refinance their debt.

The debt-equity ratio, which compares a company's total of short- and long-term debt with shareholders' equity (the book value of a company), is the most widely watched debt gauge. Zero ratios indicate no debt, and the higher the ratio, the higher the debt.

Typically, analysts regard companies with ratios below 0.5 as low in debt. But considering the current environment, I set my limit at 0.2. Try lowering it to 0.1 if you want be extra-cautious.

Screening parameter: Debt-to-equity ratio <= 0.2

Growth grows share prices

Earnings growth, real or expected, is what drives stock prices higher. Your best bets are the stocks with strongest earnings-growth expectations.

Normally, historical growth offers good clues as to what will happen next. However, considering the recent economic ups and downs, historical growth figures could be misleading. Instead, I use analysts' forecasts. Normally, you'd want to see at least 15% expected annual earnings growth. But analysts are extra-cautious these days and making lowball forecasts. Consequently, I required only 12% expected growth during the next fiscal year.

Screening parameter: EPS growth next year >= 12

As an extra check, to ensure that next year's growth forecast isn't a fluke because of this year's weakness, I require at least 12% forecast average annual earnings growth over the next five years.

Screening parameter: EPS growth next 5 years >= 12

Since I arbitrarily picked the minimums for expected earnings growth, try moving them up or down to adjust the number of stocks turned up by your screen. However, don't go below 10% or above 15%.

Continued: Profitable stocks do best

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