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Editor's note: To view the stock screens mentioned in this column, download the free MSN Money Investment Toolbox.
Every year around this time, I run my Comeback Kids screen, which is intended to identify beaten-down stocks likely to recover in the coming year.
To be honest, my Comeback Kids screen is a work in progress. My first attempt, run in November 2004, averaged a 15% return over the next 12 months, more than doubling the S&P 500's ($INX) 7% gain.
The next year I "improved" the formula, but my changes apparently didn't help. The resulting portfolio averaged a 10% return for the 12 months, respectable but short of the S&P 500's 12% gain.
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Last year I made additional tweaks, and the portfolio has returned 6.6% since Dec. 1, 2006, considerably better than the 1.4% gain registered by the S&P 500. But getting there wasn't pretty. The results were buoyed by big gains recorded by adult-educator Apollo Group (APOL, news, msgs) and medical-products maker Bausch & Lomb, which was acquired during the year. Actually, only three of the eight stocks in the portfolio registered gains.
This year, I'm adding back elements of my 2004 strategy. I'll get into the details in a minute, but first some background.
My Comeback Kids idea was inspired by a simple strategy dubbed "Dogs of the Dow," popularized by Michael B. O'Higgins in his 1991 book, "Beating the Dow." O'Higgins picked the 10 most out-of-favor members of the 30-stock Dow industrials ($INDU), held them for a year and then repeated the process. While the theory has had its ups and downs, over the years, the Dogs have averaged more or less the same return as the entire Dow 30, but with much less volatility. For instance, in 2002 the Dogs averaged a 9% loss compared with 15% loss for the Dow 30 and a 22% drop for the S&P 500.
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I made two major changes to O'Higgins' Dogs strategy when I devised my Comeback Kids screen.
O'Higgins defined out-of-favor stocks as the 10 Dow members with the highest dividend yields (expected next 12 months' dividend payouts divided by current share price). The way the math works, assuming the dividend doesn't change, the yield goes up when the share price drops. O'Higgins figured that the highest-yielding stocks got that way because their share prices were depressed.
However, that's not always the case. Some stocks, such as Altria (MO, news, msgs), simply pay bigger dividends and always trade at relatively high yields. So, instead of relying on dividend yield, I cut to the chase and defined out-of-favor stocks as those that had dropped the most, percentagewise, over the past year.
Secondly, I broadened the field to include the entire S&P 500 instead of the Dow 30. O'Higgins focused on the Dow 30 because they were big, highly regarded companies that were unlikely to fail. Maybe so, but Dow member General Motors (GM, news, msgs) was on the ropes only a year or so ago.
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Standard & Poor's handpicks leading firms in almost every industry for its S&P 500 index. So, limiting the field to members of the S&P 500, plus a few extra restrictions that I've added to reduce risk, meets O'Higgins' intent while substantially increasing the number of available stocks.
For my 2004 screen, I added additional requirements based on fundamentals to rule out riskier candidates. But, thinking that those changes deviated too much from O'Higgins concept, I omitted them in 2005 and 2006. As I mentioned earlier, this year, I'm again mixing in a few fundamental requirements. Here are the details.
Defining the universe
O'Higgins limited his selections to members of the Dow 30 because he knew that they were big, solid firms that would likely to overcome the problems that had sunk their share prices. I'll start by limiting the field to members of the S&P 500 index and then add minimum share price and company-size requirements to better reflect the Dow 30's risk profile.Continued: Screening parameters
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