The objective: buy low, sell high. Sounds easy enough.
But old Wall Street pros would say, "not so fast." A stock trading at or near its 52-week low has not necessarily hit bottom -- nor is it necessarily a bargain. What investors might think of as a cheap price could just as easily turn into a "falling knife" scenario in which the price keeps falling sharply. And trying to catch a falling knife is no easy task.
That's why it's important for investors to use every financial tool at their disposal to weed out losing firms and find the proverbial diamond in the rough. A few key characteristics and ratios can help.
Stocks trade near their 52-week lows for a reason. It could be fundamental or technical, but rest assured, there's a reason behind the price. With this in mind, it's important to separate companies that are fundamentally weak from financially healthy companies that may have simply had a bad run. Best case scenario: the stock rebounds and investors who bought near the low pocket a quick gain. Worst case scenario: the company goes belly up and shareholders are wiped out. Luckily, with some simple number crunching, we can increase the odds of avoiding the latter outcome.
A good metric to use is the debt-to-equity ratio (D/E), which can be calculated as follows:
Debt-to-Equity = Total Debt / Shareholder's Equity
The debt-to-equity ratio measures the stakes of equity owners (shareholders) and debt holders. A ratio of more or less than 1.0 tips the balance in favor of either equity or debt holders. Generally speaking, the lower debt relative to shareholder's equity, the less likely a firm will go bankrupt. A good rule of thumb is to look for stocks with D/E ratios under 0.5, but this depends largely on the financing needs of the industry, so it's not a hard-and-fast rule.
Smart investors also want a stock that has stellar growth prospects, despite a beaten-up share price. The easiest way to find companies with promising outlooks is to look at analysts' long-term earnings growth estimates. Companies with weak prospects should be eliminated, while those with projected growth rates of +10% or higher should be considered.
Bang for the Buck
Last of all, smart investors want to know that they're getting a steal-of-a-deal and not getting robbed blind. That's why it's important to remember that valuation and price are two completely different metrics. A $100 stock is not necessarily more expensively valued than a $5 stock.
The most common way to measure valuation is the price-to-earnings ratio (P/E), but P/Es alone aren't enough. (My colleague Nathan Slaughter does a good job of explaining why here.) For our purposes, it's also important to take into account a company's projected earnings growth rate. That's where the P/E-to-growth ratio (PEG) comes in:
PEG =/ Estimated Long-term Growth
The PEG ratio offers a quick, easy way of measuring a company's true valuation. If a company's growth prospects have deteriorated or earnings decline, valuations will be high. Likewise, a solid company with good future prospects, yet a beaten-up share price, will probably have a PEG below 1.0.
With these factors in mind, I recently asked the StreetAuthority research team to look for turnaround candidates with the following criteria:
- Share price within 10% of its 52-week low
- Market cap greater than $100 million
- Projected future earnings growth of at least +10% per year
- PEG ratio of 1.0 or below
- Debt/Equity ratio near 0.5 or below
Here's what our team found:
|Business||Price||52-Week Low||Debt-to-Equity||PEG Ratio||5-Yr. Growth Est.|
|ExxonMobil (NYSE: XOM)||Oil||$67.39||$63.56||0.09||0.81||+14.4%|
|FTI Consulting (NYSE: FCN)||Consulting||$39.52||$36.10||0.50||0.73||+17.7%|
|People Corp. (NYSE: PPL)||Electric||$28.85||$27.40||N/A||0.79||+11.0%|
|Tower Group (Nasdaq: TWGP)||Property/Casualty Insurance||$22.13||$21.05||0.22||0.40||+18.3%|
|Navigant (NYSE: NCI)||Consulting||$12.01||$11.32||0.52||0.95||+16.0%|
|CBIZ (NYSE: CBZ)||Commercial Services||$6.51||$6.09||0.80||0.72||+16.7%|
|Smith & Wesson (Nasdaq: SWHC)||Firearms||$3.95||$3.83||0.52||0.63||+17.5%|
Some might be surprised to find a solid company like ExxonMobil (NYSE: XOM) in the results. But while record-high crude oil prices in the summer of 2008 produced record profits for the company, prices have considerably slipped since then, and so have profits. Long-term, the picture for oil prices is simple: we're running out, and prices will climb. ExxonMobil is currently flirting with value stock territory, but investors might have to sit through a volatile crude price environment to realize the upside.
FTI Consulting (NYSE: FCN) is a countercyclical play. The company is a market leader in bankruptcy, restructuring and litigation consulting services. Simply put, any time a major corporation has a problem, it turns to FTI. The company's reputation is stellar and its customers are loyal: 85% of revenue comes from either existing customers or referrals. With a PEG of 0.73, a five-year growth estimate of nearly +18% and a debt-to-equity ratio near 0.5, it meets all of our criteria and merits further investigation.
I first made the case for Smith & Wesson (Nasdaq: SWHC) in December 2009. The company reported that future sales growth was likely to decline after guns flew off the shelves since President Barack Obama and other Democrats won control of Capitol Hill. The worry was that gun control would become part of the new administration's agenda, but this, so far, has yet to materialize.
Although shares have remained flat, Smith & Wesson is still a good value play: it's a globally recognized name brand, a debt-to-equity ratio of 0.52, an incredibly cheap PEG of 0.63 and a five-year growth estimate of +17.5%. Soon, investors could wake up to the bargain Smith & Wesson's shares present.