8 'doomed' stocks to bet against

By Harry Domash

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

Some experts tell us the market has bottomed; others say we're heading into a serious recession and that the worst is yet to come.

If the naysayers are right, the sharp downdraft will take almost all stocks down. Even stocks with strong fundamentals would see their growth prospects deteriorate.

Given this uncertain outlook, I can't resist another try at my long-running effort to devise a screen for spotting short-selling candidates. These would be stocks likely to drop no matter which way the market heads.

As I related in a November 2006 column, "Chasing down stocks to sell short," I've yet to succeed in that endeavor. Nevertheless, hope springs eternal. Here's a rundown on my newest strategy for finding short candidates, aka "doomed" stocks.

This time, I'm piggybacking on the work of Joseph Piotroski, an accounting professor at the University of Chicago. Piotroski devised a financial-strength scoring system to evaluate beaten-down, value-priced stocks. He found the highest-scoring stocks outperformed the overall group by a wide margin. Those results have been successfully replicated by many researchers, including MSN Strategy Lab contributor John Reese.

Though I haven't done enough research to prove the point, it strikes me that Piotroski's scoring system could also be used in reverse to spot growth stocks with deteriorating fundamentals that haven't yet caught the attention of the market.

That's the kernel of my doomed-stocks screen. I start by defining widely known stocks that are in favor, which in my view are the best short candidates. Then, I turn Piotroski's formula upside down to identify the lowest-scoring stocks from that universe, and I add a few extra tweaks to help identify the weakest of the bunch. Here's how it works.

Candidates for doom

To isolate in-favor stocks, I require a minimum $15 recent trading price, because stocks trading below that level are already out of favor with many players, especially mutual funds and other institutional buyers.

Screening parameter: Last price >= 15

Analysts who follow particular stocks issue buy or sell ratings that MSN Money's screener tabulates into these categories: strong buy, moderate buy, hold, moderate sell and strong sell. For our purposes, I'll define stocks rated hold or better as "in favor."

Screening parameter: Mean recommendation >= Hold

To meet my "widely known" requirement, I limit the field to actively traded midcap or large-cap stocks. Market capitalization -- shares outstanding multiplied by recent price -- is how much you'd have to cough up to buy all of a firm's shares.

Definitions vary, but stocks with market caps above $10 billion usually are termed large caps. Those with market caps below $1 billion are small caps, and those in between are midcaps. I define actively traded as stocks with at least 100,000 shares traded daily.

Screening parameter: Market capitalization >= 1,000,000,000

Screening parameter: Average daily volume, last quarter >= 100,000

Piotroski's score

Piotroski awarded higher scores to profitable companies. Because money losers probably are already out of favor, we also want to start with profitable firms. However, where Piotroski looked for signs of improving fundamentals, we'll look for clues that a firm is about to trip up.

First, we find profitable companies: Return on assets, which compares net income to total assets, is a widely used profitability gauge. ROA values can range as high as 20% or 25% and sometimes higher. However, 5% or higher signals a reasonably profitable company. I arbitrarily picked that figure, so try reducing it to 3% or 4% if you want to see more candidates.

Screening parameter: Return on assets >= 5

Piotroski gave higher scores to stocks with improving profitability and decreasing debt compared with the previous year.

For profitability, he relied on return on assets and gross profit margin, which is the profit a firm makes on sales excluding administrative, marketing and research-and-development costs, and taxes. However, I substituted net profit margin, which includes those factors and which I've found gives a better reading on overall profit trends.

Continued: Fine-tuning

 1 | 2 | next >