5 promising stocks for the rebound

By Harry Domash

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

Yes, the bad news keeps coming. But instead of cowering, you should be planning your strategy for the stock market recovery. Why?

Eventually, the economy will recover, and the market will probably rebound months before the economy does. Because so many good stocks have been trashed, the rebound, when it finally shows up, could be a doozy.

The trick, of course, is figuring out when to jump back in. You could get your head handed to you on a plate if you jump in too soon. Conversely, you could miss most of the action if you wait until it's obvious that things are on the mend.

Early recovery clues

Nothing good can happen until creditworthy corporations and commercial-property owners are able to tap the credit markets at something resembling reasonable rates. But don't wait until that hits the headlines. Be alert for early clues, such as stories about individual companies securing needed financing.

Also, look for signs that business for particular industries, although bad, is beating expectations. Maybe home sales or home prices level out. Maybe automobile sales are only 20% below year-ago numbers instead of the 30% drop everybody had expected. Watch for clues that people are getting more optimistic.

Finding rebound candidates

Here's a strategy for picking growth stocks likely to outperform in a rebound. By growth stocks, I mean stocks that are expected to grow sales and earnings significantly faster than inflation or the overall economy. Typically, growth investors look for at least 15% annual sales and earnings growth. Personally, in normal markets, I like to see sales growth in the 20%-to-40% range. Usually, smaller companies have the best growth potential.

Moreover, in normal markets, the best growth stock candidates have strong price charts, meaning that they are outperforming the overall market and have strong earnings growth expectations and a recent history of beating analysts' forecasts.

Because we are not in a normal market, I've adapted my growth strategy to current conditions. A screen that I've devised looks for midsize to large profitable companies with no debt. I limit the field to stocks that the smart money is buying and that have at least some support from analysts. I don't try to pick the most beaten-down stocks. In my experience, stocks that have dropped the most usually underperform the market.

Think big

Even if we get a strong rebound, it still pays to minimize risk, and company size is an important risk factor.

Market capitalization, which is how much you'd have to pay to buy all of a company's shares, is the way most investors measure company size. Stocks with market caps below $1 billion are termed small caps, the riskiest category. Those with market caps above $10 billion are large caps, the least risky. Stocks with market caps of $1 billion to $10 billion are midcaps.

I set my minimum acceptable market cap at $5 billion. Try raising your minimum to $10 billion if you want to reduce your risk. Try reducing it to $1 billion, or even $500 million, if you're willing to accept higher risk.

Screening parameter: Market Capitalization >= 5,000,000,000

A bad time to be in debt

Even in an improving economy, the credit markets will probably remain iffy for some time. The last thing you need is for one of your stocks to run into problems raising cash to refinance expiring debt or to fund product development.

To avoid such unhappy events, I use three financial strength measures -- current ratio, quick ratio and debt-to-equity ratio -- to ensure that passing stocks have plenty of cash and virtually no debt.

The current ratio compares current assets with current liabilities. Current assets include cash on hand, accounts receivables and inventories. Current liabilities are moneys due within a year, such as payroll, rent and advertising expenses. The current ratio would be 1 if current assets equaled current liabilities and 2 if current assets were double current liabilities (current assets minus current liabilities is also known as working capital).

I require a minimum 2.5 current ratio to limit the field to companies with plenty of working capital.

Screening parameter: Current Ratio >= 2.5

One problem with current ratio is that the ratio could be ballooned by counting obsolete inventory that will never be converted to cash. The quick ratio, also called the "acid-test ratio," solves that issue by leaving inventories out of the mix. Thus, the quick ratio adds cash and receivables, and divides that total by current liabilities.

Because the quick ratio doesn't count inventories, it will usually be lower than the current ratio. I require a minimum 1.5 quick ratio, which requires that cash plus accounts receivables must be at least 50% higher than current liabilities.

Screening parameter: Quick Ratio >= 1.5

Continued: 5 stocks to consider

 1 | 2 | next >