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Investment Ideas

Recently, my family has developed an interest and aptitude for archery. This could have something to do with our shared fondness for the Elves in Lord of the Rings, but I've found it to be a genuinely compelling sport that involves a fair amount of art and technique. This past weekend, we spent the better part of an afternoon at a Junior Olympic training session, where target archery was at its best. While there, I had some time to ponder the target. I got to thinking: "Obviously, the target is the focus in archery, but are target stock prices set by Wall Street analysts useful in picking stocks?"

For some time now, I've wanted to test the effectiveness of target prices in picking stocks, but I haven't had the historical data available. Well, now I have access to that data and more via the Research Wizard, which contains over 600 corporate and stock data items. Target prices are one of many pieces of information provided by Wall Street analysts. Other examples of analysts' data and how to use them can be found by clicking here.

So what's the deal with target prices? Are they useful in indicating a stock's future direction? How should one use them in analyzing a stock? Let's try to uncover the answers to these questions.

Looking at the period from 2000 to 2011, I began with a universe of the 3000 most liquid stocks, and tested the ratio of the target price divided by the current trading price. Perhaps the stocks with the highest values (target price is much higher than current trading price) still have lots of room to move while those with low values (target price is below current trading price) are probably due for a correction. At least that's the theory.

I divided the target/trading price ratios into five equal buckets (approximately 600 stocks in each bucket) with bucket #1 containing the highest values and #5 containing the lowest values. The tests were done for each bucket to determine the average annual return an investor might expect per bucket. So what do the tests reveal? You should probably be sitting down for this.

The above results show that the bucket that had the highest target/trading price ratios (#1) had the lowest return at -0.1%. Therefore, you should NOT buy the stocks that have a target price significantly higher than the current trading price. You probably also should avoid the stocks that had the lowest ratio of target/trading price (#5). Ideally, you want to buy something in the moderate range (#2 to 4) with a target price about 5-15% above the current trading price.

These results are contrary to our initial belief that it's better to have a much higher target price when compared to the current trading price. But there's often too much optimism and not enough reality built into expectations. So the expectations, or target prices in this case, are too lofty and most are never fully realized. Also, if the target prices are too high, it probably indicates the stock is over-hyped or "glamorous." As you may know by now, it rarely ends well for glamour stocks. Moderate expectations seem to be the best pathway to profitable stock returns.

Because momentum is playing such a big part in the market at the moment, let’s continue building on that theme by adding those stocks within the best range of their target price:

  • First, start with only US common stocks.
  • Next, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade).
  • Select only those stocks with a Zacks Rank less than or equal to 3. (Let's avoid the worst rated stocks.)
  • Add another filter that only selects stocks that are currently trading within 10% of the target price. (Recall we want stocks that have reasonable and reachable targets.)
  • Choose only the top 20 stocks with the best 52-week price change. (We're looking for winning stocks over the last year.)
  • Pick the five with the best price change over the last 12 weeks. (We also want them to be doing well over the last 3 months.)

Here are five stocks using the above methodology (2/17/12):

VVisa Inc.

Visa, a payments technology company, engages in the operation of retail electronic payments network worldwide. The company's target price is at $123.47 and is within a very reachable distance compared to its current price. The earnings reported this week came in above expectations and its strong cash balance has enabled the company to buy-back shares. Furthermore, Visa expects its 2012 earnings to grow over last year's. This company is also rated a "Strong Buy" by brokerage analysts.

PRIMPrimoris Services Corporation

Primoris, a Dallas-based company that's a specialty contractor and infrastructure company, provides a range of construction, fabrication, maintenance, replacement, water and wastewater and product engineering services. This company has an average broker rating of "Buy" and a Zacks #1 Rank (Strong Buy). Its current stock price is below, yet close, to the target price of $17.66. This company continues to announce new contracts (adding another $40 million two weeks ago) and reported record profits in November.

CBS - CBS Corporation

This New York-based company's current stock price is in range of its $32.41 target and is highly rated among Wall Street brokers and on the Zacks Rank. The earnings report this week showed moderate increases in both earnings and sales. Price momentum looks very strong and the stock is up considerably over the last four months. CBS operates as a mass media company in the United States and internationally.

YUMYUM! Brands, Inc.

YUM operates as a quick service restaurant company around the world. The company develops, operates, franchises and licenses a system of restaurants including KFC, Pizza Hut, Taco Bell, Long John Silver's and A&W. This company is rated as a "Buy" by Street analysts and has had a string of earnings surprises and estimate revisions. The stock of this company has seen a recent surge in price, yet is still within striking distance of its $70.05 target. I've never been to China, but I guess they love KFC there because YUM Brands has seen tremendous growth in the Land of the Sleeping Dragon.

WYNWyndham Worldwide Corp.

Wyndham, together with its subsidiaries, provides various hospitality products and services to individual consumers and business customers in the United States and internationally. This company is rated a "Strong Buy" by all eight of the brokers providing coverage and is a Zacks #2 Rank (Buy) as well. The target price of this company is a modest 8% over its current trading price. This is another company that has initiated a share buy-back program and that's usually a sign the company believes its stock is under-valued.

These five stocks are a good start. Now if you remember my previous article "How Many Stocks Should You Own?" I justify at least a ten-stock portfolio. So I encourage you to click here to learn more about the screening and backtesting power of a stock research system built for the individual investor. With this tool, you'll be able to perfect your aim and discover additional stocks to add to your portfolio. You'll also be able to take target practice on non-live portfolios and, once you've honed your technique, you'll be able to trade live with confidence.

So summon your inner William Tell for stock picking and visit this site today!

Click here to learn more about this stock research tool.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.

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