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Do Your Diligence on Stocks

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Label me a pessimist if you wish, but I believe we're all too optimistic about potential outcomes regarding the stock market and many other things in modern life. Let's not blame ourselves; it's in our DNA. Optimism has served us well throughout our evolution. For example, if early Homo sapiens thought they spotted a Woolly Mammoth in the distance, it was worth checking out. If they were right, and succeeded in killing it, their optimism would be greatly rewarded. However, very little would go wrong if they discovered what they thought was dinner was simply a pile of rocks. In other words, there was little at risk in pursuing their hopefulness.

Don't get me wrong, optimism is great. After all, if you're not willing to stick your neck out and go for something, you'll always be faced with "What if?" And you can probably imagine what happened to those early hominids that weren't, for the most part, optimistic. They didn't last long, and therefore didn't pass on those overly pessimistic genes. But I believe that the optimistic traits, which were beneficial when we lived in caves, aren't as well suited to a modern, high-rise society in general and the stock market in particular. The big difference is that one has the potential to lose a lot of money in the market, if they are acting on optimism alone. So I believe you've got to be extremely careful when making an investment, and that you should resist being overly optimistic about a stock.

What initiated my thought about all this is that most stock analysis is peppered with reasons why you should buy a stock, but little, if anything, is ever said about why you shouldn't. Even given the market today, the fact that 25% of analyst ratings are Strong Buys while only about 1% are Strong Sells is a testament to this optimism. Also, I think with most decisions, when the complete picture isn't viewed, we tend to fill in any blanks with positive aspects, if our initial instinct was positive. As a result, an inaccurate picture of potential results could be constructed. Perhaps instead of simply looking only at the positives, maybe it's best to look at all aspects -- positive AND negative.

Leave No Stone Unturned

Too often I think investors only consider a couple things when deciding whether to buy a stock. They might look at the Price-to-Earnings ratio and the Price-to-Sales ratio. Or perhaps they only look at a couple of growth rates. Or maybe they even look at a valuation ratio and a growth rate, and if those look good, they buy. However, I think one needs to use multiple criteria -- somewhere in the range of 10-12 considerations -- at a minimum. You've got to create a checklist of items that indicate market-beating investments and only buy those that pass on all accounts. How else will you discover the negatives if you aren't meticulous about what you're looking for?

One reason why people don't do all their homework is that perhaps it's just too time consuming. Or maybe they don't have access to all the data. Or possibly one just isn't sure what characteristics of a stock or company lead to a profitable investment. But there are fairly simple and useful tools available for removing the illusions from your portfolio or focus list.

Discovering the "Illusions"

The Zacks Research Wizard removes all those hurdles to comprehensive stock investing by allowing you access to hundreds of data items for thousands of companies, the capability to backtest your ideas to determine what really works and what doesn't, and provides extremely fast analysis and screening. It's the perfect tool for the individual investor to evaluate numerous different investment criteria quickly.

As an example, I used the Research Wizard to create a strategy that removes the underperformers or "illusions" by focusing on ten aspects I feel are important. I then tested the individual factors to determine at what respective value for each factor indicates the stock will underperform the market. For example, I determined that a value less than 0.6 for Asset Utilization usually indicates the stock will underperform the market.

I then tested the combination of all of these criteria to see if creating a strategy designed to remove the dogs could outperform the market. A test was conducted using the strategy detailed below from 2002 until the end of 2011. Here are the results of the S&P 500 and that strategy:

The above results show that strategy I created clearly outperforms the S&P 500 over the last ten years. The total return more than doubled that of the market! Looking at the maximum drawdowns, you can see that risks are very similar. So there are two investment opportunities with similar risks, yet very different return outcomes.

Here's the screen that weeds out those companies that tend to underperform the market:

  • First, we're only going to evaluate US 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 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade.)
  • Because a lot of stocks under a certain price are difficult to trade, keep only those stocks trading above $5/share.
  • Add another filter by selecting only those stocks with a Zacks Rank less than or equal to 2. (Any Zacks Rank 3 or greater is either at or under market performance.)
  • From this set, keep only those stocks with a Price/Forecast Sales Ratio less than 1.25. (My research indicates that a P/FS Ratio greater than 1.25 leads to underperformance.)
  • The Enterprise Value/EBITDA Ratio should be greater than zero, but less than 10.3 (We want positive EV/EBITDA ratios, anything over 10.3 tends to underperform the general market.)
  • Additionally, the Price/Cash Flow Ratio should be less than 14. (Any stock with a P/CF over 14 is likely to underperform.)
  • The quarterly EPS change from the most recent quarter to that same quarter last year needs to be better than -200%. (While not ideal, it's OK to have negative earnings growth to a degree, but anything major is a red flag that indicates future underperformance for the stock.)
  • The 2-year annual cash flow growth needs to be better than -50%. (Again while not ideal, it's OK to have negative cash flow growth to a degree, but anything major is a red flag that indicates underperformance.)
  • The Asset Utilization should be greater than 0.6. (I have found that stocks of companies with Asset Utilizations less than 0.6 are likely to underperform the market.)
  • Accruals should be less than -5%. (Recall, we want low accruals and above -5% isn't good.)
  • Over the last 4 weeks, the company should have had at least one increase in the current year's earnings estimate. (If a company hasn't had an increase in its earnings estimates, it tends to be a market performer or worse.)
  • Finally, the 1 week change in trading volume should be increasing. (Increasing volume shows activity that the market is starting to notice the stock.)

Here are five of the stocks that passed this screen this week (6/8/12):

VSH – Vishay Intertechnology Inc.

Vishay designs, manufactures and supplies discrete semiconductors and passive components in the United States and internationally. This company scored well on the entire checklist. The valuation looks great and earnings estimates have been increasing. There's nothing really bad about this company, but some of the cash flow and balance sheet items look kind of average.

UIS – Unisys Corporation

Unisys provides information technology services, software and technology that solve mission-critical problems for clients worldwide. This company passed on all criteria as well. Things that look good include the basic fundamentals (good cash flow & earnings) and improving earnings estimates. Just keep an eye on the short interest on this stock.

SPB – Spectrum Brands Holdings, Inc.

Spectrum Brands, together with its subsidiaries, operates as a consumer products company worldwide. Spectrum doesn't look bad by most criteria. Things that look good are its price momentum, increasing earnings estimates and improving balance sheet. Something to keep an eye on is the valuation.

MENT – Mentor Graphics Corp.

Mentor Graphics provides electronic design automation software and hardware solutions to automate the design, analysis, and testing of complex electro-mechanical systems, electronic hardware and embedded systems software. This company has been experiencing good earnings growth, increasing estimates for this year, and the stock price has been rocketing. As with any stock that just keeps going up, you should be wary of the valuation you're willing to pay.

BWS – Brown Shoe Co.

Brown Shoe, a St. Louis-based company, operates as a footwear retailer and wholesaler in the United States, Canada, China and Guam. This is probably my favorite stock of the bunch simply because I have a hard time finding something I don't like about it. The fundamentals, valuation, price momentum and earnings estimate revisions all look good. The only yellow flag I see is a spotty history of positive earnings surprises.

Gain Access to the Key

I wouldn't call myself pessimistic, but I would call myself cautious. And I think when it comes to investing we should all exhibit a little caution. Accordingly, I encourage you to fully evaluate a company and if you find something that doesn't look good, skip it and move on to something else.

Use the Zacks Research Wizard to unlock the full picture of a company before you buy. Once you learn what works and what doesn't, you can create and save a screen that can be run in just seconds to provide stock ideas.

Starting today, you are invited to use it free of charge. You'll have 14 days to create, tweak and backtest your strategies. At the same time, you can see the latest picks from pre-loaded winning strategies with average gains of up to +67.4% per year.

Learn more about your Research Wizard free trial >>

Let's make some money!


Kip Robbins is a Quantitative Analyst with He analyzes screens and strategies for Zacks customers and for use in Zacks Research Wizard which empowers individual investors to use market-beating screens, build their own and backtest their results.

In-Depth Zacks Research for the Tickers Above

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Vishay Intertechnology, Inc. (VSH) - free report >>

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