Rebound time for your investment

Many experts advise that the best investment candidates are stocks that have already outperformed the market. There's plenty of research to back up that "buy high -- sell higher" philosophy, but following that strategy is not as easy as it sounds.

No stock goes straight up. Even the hottest stocks hit cold spots when they might dip 20%, 25% or even more before they resume their climb. For instance, juice and soft-drink maker Hansen Natural (HANS, news, msgs), with a 185% gain, was one of the best performers over the past 12 months. But Hansen hit a rough spot in June 2004, sending its share price tumbling a nerve-shattering 33% in less than one month for no apparent reason.

Unfortunately, I have on occasion jumped on a hot stock just before it hit one of those bumps. I don't know about you, but no matter how great a stock looks on paper, it's hard to stay the course when you're 33% underwater.

The last time that happened, I vowed to figure out how to pick up these stocks after they've dipped, rather than before. The hard part, of course, is discerning the difference between a temporary dip and the start of a death plunge.

Here's a screen I devised for spotting hot stocks that have dipped but are good candidates to recover and continue their winning ways. These may be stocks that reported results below analysts' forecasts, are in a sector that is temporarily out of favor, or have been downgraded by analysts due to valuation.

First I'll identify hot stocks that have recently dipped; then I'll add fundamental factors to isolate the likely winners.
Spotting hot
I start by requiring at least 25% price appreciation over the past 12 months. That doesn't sound like much, but I'm interested in stocks that have room to run, not rockets that have already blasted off. In line with that thought, I exclude stocks that have doubled in price over the past 12 months. Increase that limit if it's too conservative for your tastes.

* Screening parameter: % Price Change Last Year => 25

* Screening parameter: % Price Change Last Year =< 100

When I say I'm looking for a dip, I mean a recent dip. I don't want strong performers from 10 or 12 months ago that have been heading down ever since. So I ditch those losers by stipulating that passing stocks must be trading no lower than they were six months ago. And I preclude stocks that have moved up too fast during the past six months. There's no way to precisely define how much is too much, so I arbitrarily set the maximum six-month price appreciation at 75%. Increase that figure if you feel adventurous.

* Screening parameter: % Price Change Last 6 Months => 0

* Screening parameter: % Price Change Last 6 Months =< 75

Finding the dip
Defining the dip is straightforward. I require that the current stock price must be at least 10% off its recent high.

* Screening parameter: Last Price <= 0.9* 52-Week High

(Due to my previous restrictions, the 52-week high typically occurred during the past two to three months.)

When researching the concept, I've found that the bigger the dip, the greater the chance that the stock won't recover. So I limit the drop to 25% off the recent high.

* Screening parameter: Last Price >= 0.75* 52-Week High

If you think that's too conservative, try increasing the maximum dip to 30% or 35% (0.70* 52-Week High or 0.65* 52-Week High).

Most of the stocks meeting my price-action requirements will likely see their dips turn into long-term downtrends. So, next, I added several fundamental factors to tilt the odds in my favor.
Keep the earnings coming
Changes in earnings forecasts usually move share prices. Downtrending forecasts are often your best clue that a dip could turn into something worse. Conversely, steady or increasing forecasts signal that the problems are likely short term.

Thus, I want to avoid stocks with downtrending earnings forecasts. The screener includes a parameter specifically for detecting changes in the current quarter's earnings forecasts.

* Screening parameter: Earnings Estimate Decreased Not Since (in the last quarter)

In English, that convoluted statement means that Wall Street analyst's consensus earnings forecasts for a company must not have decreased in the past three months.

Strong earnings-growth forecasts and strong price charts usually go hand in hand. Conversely, weak growth forecasts increase the odds that the dip could turn into a disaster. Many investors consider 15% as the minimum annual earnings growth for a growth stock. Consequently, I require at least 15% year-over-year forecast earnings growth for the next fiscal year. Try increasing the 15% minimum if you get too many hits, but I don't advise lowering it.

* Screening parameter: EPS Growth Next Year >= 15

Keep good company
Because of the pull that comes with generating huge trading commissions, institutional money managers -- mutual funds, pension plans and the like -- are more clued into the market buzz than we'll ever be. There is no stock they haven't heard of. If these pros don't own a stock, it's because they don't think they can make money on it. We can improve our chances of picking right by sticking with stocks owned by institutions.

Institutional ownership is the percentage of a company's outstanding shares owned by the big boys. The figure can run as high as 99%. How much is enough? I've had my best results sticking with stocks with at least 35% institutional ownership, and the higher the better.

* Screening parameter: % Institutional Ownership >=35

The profitability gauge
Profitability is a better predictor of a company's ultimate success than reported earnings because it measures how efficiently a company uses its assets to generate income. Return on equity (ROE) -- the most frequently used profitability gauge -- compares net income to shareholder equity, also known as book value.

ROE will be negative for companies reporting losses, but typically ranges between 5% and 20% for profitable companies. Most investors look for ROEs of at least 5%, and some pros require 15%. I set my minimum at 10%, which, in my view, is sufficient for this application.

* Screening parameter: Return on Equity >= 10

Keeping valuations reasonable
The most obvious problem with stocks that have already made a big move up is that buyers got carried away and the share price has outrun the fundamentals. However, in-favor stocks always seem expensive when you compare them to the market. Instead, I compare each stock's current valuation to its own history, and, to be safe, rule out stocks with price/earnings ratios higher than 90% of their historic five-year high.

* Screening parameter: P/E Ratio: Current <= 0/9*P/E Ratio: 5-Year High

This is a fast-changing screen. The first time I ran it last week, eight qualified stocks turned up. The next day, the screen listed nine stocks, but four were new. Three of the first day's stocks had disappeared from the list because they had moved up and no longer met the 10% minimum dip requirement.

Here's the list of the nine stocks from the second day's screen. Interestingly, each of the stocks represents a different industry.

Keep in mind that, given its fast-changing nature, you'll have to run your own screen to see the current list.

The stocks dipped for the same reasons I listed earlier. Some, such as Nabors Industries (NBR, news, msgs), dropped when their industry rotated out of favor with the market. Others, such as Knight Transportation (KNX, news, msgs), dropped when management reduced its sales or earnings forecasts, or reported earnings below analysts' expectations. Some, such as Cognizant Technology Solutions (CTSH, news, msgs), dipped on an analyst downgrade based on valuation.