Find stocks primed for a turnaround

By Harry Domash

The potential rewards for nailing the right turnaround stocks are enormous. Consider Corning (GLW, news, msgs). Anyone who had the foresight to jump onto the optical fiber and glass substrate maker back in July 2002, when it scraped bottom at $1.60, would have enjoyed a 1,400% return as of last week.

It should be a simple investing formula -- buy beaten down, sell high. But it's not always as easy at it looks.

More than two years ago, in this column in October 2003, I described a screen I had devised for finding battered stocks primed for a comeback. I wasn't necessarily looking for stocks considered undervalued by traditional measures. I simply wanted stocks that had been crushed, with share prices down at least 50% from previous highs, and were turnaround candidates.

A few days ago, I dug out the list of stocks my October 2003 screen had turned up to see how they had fared.

The results were underwhelming, to put it charitably. My 10 turnaround stocks had returned 15% on average, from Oct. 17, 2003 through May 15, 2006, compared to 25% for the S&P 500 ($INX).

What went wrong? I spotted two things I would (and will) do differently today.

First, I focused on stocks that, in terms of fundamental measures such as revenue growth and profitability, had already turned the corner. Since then, I've realized that by the time the recovery shows up in those numbers, it's too late. The recovery already is reflected in the share price.

Secondly, while I realized that strategies such as mine require pinpointing which candidates are already outperforming the market, I didn't do enough to nail the stocks with the strongest price charts.

With the expectation that I've learned from those mistakes, here's my new, improved Turnaround Stocks screen.

First, I'll define a pool of beaten-down stocks, and then I'll pick the stocks in that group with the best appreciation prospects.

Beaten-down stocks

As I already mentioned, I define beaten-down stocks as those trading at least 50% off their five-year highs.

Also, a qualifying stock must have a minimum 10,000-share average daily trading volume. Most stocks trade hundreds of thousands, if not millions, of shares daily. In my experience, very low-volume stocks almost always disappoint.

Also, I excluded stocks trading at prices below $5 a share. Similar to low trading-volume stocks, very cheap stocks are much riskier than higher priced stocks.

• Screening parameter: Last Price <= 0.5* 5-Year High Price

• Screening parameter: Average Daily Volume, Last Qtr. >= 10,000

• S&P 500 ($INX). Last Price >= 5

After applying those constraints, a total of 655 stocks comprised my beaten-down stocks universe.

Fundamentals on the mend

In my original screen, I looked for stocks with strong balance sheets and good profitability ratios. However, recent research found that improving fundamental measures are more important than the actual values. So this time, I'm shunning the already strong in favor of stocks with improving balance sheets and improving profitability, as long as they are not basket cases.

I use the debt-equity ratio -- which compares long-term debt to a company's shareholder equity (assets minus liabilities) -- to measure balance-sheet strength. For the debt-equity ratio, a zero value indicates no debt, and the higher the ratio, the higher the debt.

MSN's screener provides a screening parameter for spotting improving debt-equity ratios in a section you may not have noticed before. It's listed in the "Financial Condition" section of the "Advisor FYI" category.

• Screening Parameter: Debt to Equity Ratio Decreased Since <In The Last Year>

That statement instructs the screener to look for stocks where the debt-equity ratio has decreased (improved) over the past year.

An improving debt-equity ratio doesn't necessarily preclude firms with dangerously weak balance sheets. Doing that requires defining a maximum allowable ratio. However, the definition of what's high and what's low varies with industry.

To rule out the balance-sheet basket cases, I require debt-equity ratios no higher than 50% above the industry average. Since, I picked that cutoff arbitrarily, consider increasing it up to 75% above the industry average (1.75 multiplier) if you want to see more stocks.

• Screening parameter: Debt to Equity Ratio <= 1.5* Industry Average

Profits count

Profitability measures how efficiently a company uses its assets to generate earnings. Sticking with high profitability stocks helps to avoid firms that need continuous cash infusions to fund growth.

Return on equity (ROE), the most frequently used profitability gauge, compares net income to shareholders equity (book value).

As was the case with the debt-equity ratios, we're looking for stocks with improving (increasing) ROEs. To find them, we'll use another obscure screening parameter tucked away in the "Advisor FYI" category. This time, we'll look in the "Investment Return" section to find stocks whose ROEs have increased over the past year.

• Screening parameter: Return on Equity Increased Since <In the Last Year>

Of course, we want to limit our candidates to firms that are reporting earnings, not losses. We can accomplish that by requiring positive values for ROE.

• Screening parameter: Return on Equity >= 0

Cash flows

Our positive ROE requirement, in theory, precludes all unprofitable companies. But, in some cases, companies that report positive earnings are losing money when you count the cash.

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