Stock-Picking Strategy

At any given time, there are always stocks that are trading at relatively good valuations. This is usually because they are temporarily out of favor in the investment community. 

 

Out-of-favor stocks represent opportunities for investors. The following is how I capitalize on these opportunities.

 

First, I screen for stocks with prices that have dropped substantially and are trading at relatively cheap valuations. Among these potential candidates, I look for stocks of financially-sound companies that have fallen to less than half of what I estimate to be their fair value. 

 

To determine fair value, I apply several methods and choose the most conservative estimate. (To read more about the guidelines, please see below.)

 

A stock is purchased if its price is below half of  its fair value. Half of a stock's fair value is what I call its Buy Price. This means that the stock is cheap enough relative to its fair value that the potential reward fully justifies the downside risk. Because these stocks are trading at less than half of fair value, most of them double over the next 3 to 5 years. Each stock is then sold at fair value, which I also call its Sell Price.

These are the guidelines of each stock at the time it is purchased:

One of 2 primary guidelines are to be met.

1. The stock　is down by more than 50% from what I call its midpoint (the average of the stock's all-time high and its 5-year low). Preference is given to stocks that have several prominent price peaks rather than one large price peak. (One large prominent price peak can be the result of a one-off period of excessive speculation.)
2. The stock is down by more than 50% from its all-time high.
3. The stock is at, or near, its 10-year low.

In addition, 2 of the following secondary guidelines are to be met. (These are mostly value criteria from financial ratios.)

1. The company has recently had a high level of insider purchases.
2. Price/earnings ratio is less than 10.
3. Price/free-cash-flow ratio is less than 8.
4. Dividend yield is more than 5% and is more than twice its own average yield for the last 5 years.
5. Price/book ratio is less than half of the industry average and is less than 1.
6. Price/sales ratio is less than half of the average price/sales ratio of its industry and is less than 1. 
   

After a stock has met these contrarian and value guidelines, I examine its financial statements to ensure that the company is financially viable. At the time of purchase, the stock should have a debt/equity ratio under 40% or significantly less than the industry average. A stock meeting the above requirements, however, does not guarantee that it will be included in Stock Picks.

You can screen your own stocks at Yahoo! Stock Screener.

These are the ratings and how you should use them.

	The stock is trading at 25% of what I estimate to be fair value. Sometimes, a stock that I rate a "Standard Buy" (see below) will face such extremely difficult business and/or market conditions that the price of the stock will continue to drop past 50% of fair value all the way to 25% of fair value. At this point, it's time to buy more because the stock has become an extreme bargain and therefore offers more upside when business and/or market conditions improve.
	The stock is trading at less than half its fair value. You should buy it at a price less than what I have indicated to be the "buy price".
	The price has risen to more than half of fair value but is still less than 2/3 of fair value. It's still a bargain, but offers less upside than a standard buy.
	The price has risen to more than 2/3 of fair value. It's worth holding if you bought it at the buy price, but doesn't offer enough upside to warrant buying it if you don't already have it. A stock that has had negative developments (such as insider selling or a recent financial loss that made its debt/equity ratio more than 1) may also be rated a hold.
	The price has risen to fair value. For the Sell-at-Target-Price Portfolio, it's time to sell and use the proceeds to buy another out-of-favor stock. For the Minimum-Turnover Portfolio, it's time to sell half. The other half should be held until its secondary target price is reached. A stock that has had negative developments (such as insider selling or a recent financial loss that made its debt/equity ratio more than 1.5) may also be rated a Weak Sell.
	Sometimes negative developments can cast doubt on a company's prospects or viability. Heavy insider selling, declining sales and increasing debt are danger signs that investors do not want to ignore.
	The price has risen to reatively high valuations. It's time to sell and use the proceeds to buy another out-of-favor stock. A stock that has had negative developments (such as insider selling or a recent financial loss that made its debt/equity ratio more than 1.5) may also be rated a Strong Sell.