Monday, March 19, 2012

Finding Cinderella Stocks

I don't have a stock pick this week. I don't see any low-risk high-reward buy or sell stock picks this week. I'm still waiting for the market to sell off but in the mean time its seems to be still grinding slowly higher.

Have you filled out your NCAA tournament brackets yet? Every year the tournament has its upsets with a #13 seed unexpectedly beating a #4 seed or that team that was on the bubble, but which still got in, going to the Sweet Sixteen.

The problem with filling out the brackets is: how do you know who is going to be the Cinderella team this year? There's always one team that no one really foresaw getting it together just in time for the Big Dance. Trying to guess who it will be is part of the fun of watching.

Stock picking can be a lot like filling out the NCAA bracket. There are plenty of #1 seeds and everyone knows who they are. Those big guns are companies like Apple and Caterpillar. If you invest in one of them, odds are on your side. After all, in the NCAAs, no #16 seed team has ever beaten a #1 seed.

But how do you find the Cinderella stocks that are the #9 seed that goes to the semifinals? These are stocks that are flying under the radar. They may be turning around their business but investors aren't paying attention yet.

All the #9 seeds, and many companies, may look similar on paper, but which ones will have the special magic to break out of the pack and surprise people?

3 Ways to Find Cinderella Stocks

#1: Look for Winners

To be a Cinderella story in the NCAA tournament you have to win. (Obviously!)

For companies, though, the winning begins when its earnings history starts to turn around. Many times, the analysts are slow to recognize that there is a change in the trajectory in the company, so the company starts easily surprising on the estimate every quarter.

Winning, then, is a company putting up big earnings surprises or a streak of them. When this happens, the analysts will then usually start raising their own estimates in expectation of better things still to come. This good news leads to rising estimates and, hopefully, earnings growth.

Choose stocks that have rising estimates.

#2: Buy Growth Stocks

Companies that are turning it around can be found in any sector. They can be big or small. But the best returns come from buying the stocks that have the highest growth rates. That is because once the turnaround takes place the PE will start to rise from abnormally low levels. The higher the growth rate of the company, the more the multiple will expand and the greater your final return.

Focus on growth stocks for the best turnaround profits.

#3: Value Is Still King

Not every cheap stock is a bargain. Fundamentals, such as rising earnings, still matter. A company may trade for a $1 but if it's just days away from bankruptcy then it's likely not going to be a good turnaround possibility.

In the NCAA, the bracket busters almost always come from a Cinderella team. It's not risky to pick all four #1 seeds to make it to the finals. But betting on a #9 seed to make it there? That takes a lot of guts.

It also takes guts to buy a turnaround stock. You can cut down on the risk by buying one that is trading at a discount to its peers. I use low PE, PEG and Price-to-Book ratios as a way to find value.

Where to Find Cinderella Stocks Right Now

Turnarounds can easily be detected when a company's earnings estimates suddenly reverse from downward to upward. So the proof of the turnaround occurs when a stock makes a sudden leapfrog from a lowly Zacks #5 Rank (Strong Sell) or Zacks #4 Rank (Sell) all the way to a Zacks #1 Rank (Strong Buy).

But that one indicator is not enough. It's important to add key measures of earnings growth and reasonable valuation to the mix. That's the basis for my alert service, the Zacks Turnaround Trader. During a 10-year test period, through bulls and bears, the strategy's sudden #1 Rank stocks outperformed the full list of #1s by more than 2.5 times.

Click the link above to learn more about Zacks Investment Research Turnaround Trader.