How can you pick out-of-favor stocks

The age-old way to make money in stocks is “buying low and selling high”. At first glance, it may sound very easy; but do you know how to implement it?. Well, only the smart investors know the answer of this  million dollar question. Investing with emotions is a serious error, but you can benefit from emotional extremes of others to pick out-of-favor gems for your portfolio. The key to identify profitable out-of-favor stock is to apply sentiment analysis and some simple stock picking techniques as explained below.

What is Sentimental Analysis?

Sentimental analysis is the process of measuring investor attitudes toward the securities markets. The goal is to determine if investors, or the crowd, are bullish or bearish toward the market.

History of Stock Market has repeatedly proved that investors are not always rational. Just as they can bid up the price of a growth stock too high because they are so enthusiastic about its prospects, they can also pummel a good stock that has momentarily slipped to unrealistically low prices. That’s where bargain hunters swoop in.

When studying market sentiment, the smart investor often takes a contrarian approach especially during extreme highs or lows in the Stock Market. That is, if others are predominantly bullish, the smart investor will be bearish (sell stocks). If, on the other hand, the crowd is bearish, the smart trader will turn bullish (buy stocks).

When everyone around you is bursting with enthusiasm, as is the case in a profitable bull market, smart investor may take contrarian view and get out to what their heart (and net worth) is saying. Conversely, buying when “blood is running in the street” takes nerves of steel. But it’s this contrarian way of thinking that can help you to avoid buying the tops and selling the bottoms.

How to identify Out-Of-Favor Stocks?

The easiest way to spot neglected stocks is by looking for low PE ratios. A PE ratio of less than 10 signals that investors do not have much hope for the future of the company, which may, in fact, be an incorrect perception of the situation. The moment the company reports better-than-expected results, perceptions can change quickly, and the stock price can shoot up. Do your research first. Don’t be tempted to buy any stock with a low PE ratio, however. Some companies deserve their lowly valuation and, in fact, will not recover. Moreover, in certain industries even a PE of 20 could be considered cheap.

For example, to provide you a good starting point; here is a list of Stocks that are available at less than half of their 3 year highs & less than 20 times PE & are experiencing on the ground recovery as apparent from their sales & profit growth, both on an annual as well as sequential basis.

Company BSE Closing Price (as on 24/01/2011) PE (x) % Fall from 3 Year High 1 Yr Net Profit Growth (%) 1 Yr Sales Growth % Q on Q Net Profit Growth (%) Q on Q Sales Growth (%) Qtry Net Profit Growth (YoY) %
Comp-U-Learn Tech India Ltd 13.00 2.7 -66.32 127.08 165.06 23.13 47.86 178.09
Grabal Alok Impex Ltd 40.45 4.5 -71.52 33.77 76.35 28.66 26.50 58.36
HB Portfolio Ltd 40.70 4.6 -51.49 486.70 22.10 192.50 170.25 64.79
Powersoft Global Solutions Ltd 7.42 4.9 -54.48 44.05 92.84 56.44 26.36 80.85
R R Financial Consultants Ltd 37.10 5.0 -77.01 61.13 29.88 43.09 37.74 74.26
Tulsi Extrusions Ltd 21.20 6.6 -84.34 411.02 38.88 225.00 35.95 225.00
Twinstar Industries Ltd 3.01 9.2 -56.94 44.44 126.46 600.00 24.15 600.00
Lokesh Machines Ltd 47.55 11.0 -52.25 983.78 30.78 23.58 28.85 50.50
Ramkrishna Forgings Ltd 112.50 11.5 -60.04 141.14 26.40 63.32 29.83 105.93
Vijay Shanthi Builders Ltd 26.75 12.6 -70.49 32.37 33.67 33.14 26.54 222.54
Edserv Softsystems Ltd 153.50 13.7 -50.15 388.35 516.80 129.22 144.72 180.60
Ajcon Global Services Ltd 15.40 13.9 -59.47 70.00 54.01 118.75 159.26 150.00
Alok Industries Ltd 26.65 15.8 -64.44 82.80 43.23 71.58 32.08 40.00
Omaxe Ltd 142.15 18.7 -57.80 144.29 25.34 69.20 40.12 63.26

In addition to a low PE ratio, bargain hunters usually look for industries that are currently out of favor. They also seek stocks with low price-book value ratios because such stocks are typically out of favor. Another sign of benign neglect is when few of the shares are held by institutional investors, such as FIIs, DIIs, or mutual funds, because it is not fashionable to own such depressed stocks. Finally, if brokerage analysts do not pay attention to a stock, it is probably out of favor.

What you should look for is a stock with a fair chance at turnaround. You may infer that a recovery is on the way if sales and earnings are no longer deteriorating or if the company has a new product or service that has the potential to restart its growth. Another way to check for signs of life is to determine whether company executives are buying the stock themselves and whether they are increasing capital expenditures. If the people who know the company best are investing in it heavily, that could be a tip-off that recovery is at hand.

However, you need to remember that not every ugly duckling turns into a swan. If your stock remains depressed after a year or more, you probably should turn it in for another one. It takes only one or two dramatic recoveries for this strategy to pay off.

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