How to pick Cinderella stocks

Learn about 3 ways to find turnaround stocks before the bandwagon starts moving in.

By Zacks.com Apr 25, 2013 5:18PM

Dice on newspaper stock pages © Tom Grill, PhotographerBy Tracey Ryniec

 

Did you follow the NCAA tournament this year? Maybe you even participated in one of the fantasy tournaments online, where you pick teams in each bracket. 


Every year the tournament has its upsets -- with a #14 seed beating a #3 seed -- and this year was no different. The problem with filling out the bracket is: how do you know who is going to be the Cinderella team?

 

This year, Florida Gulf Coast became only the seventh #15 seed to beat a #2 seed in tournament history. It was also the first #15 seed to make it to the Sweet Sixteen.


Be honest. You didn't pick Florida Gulf Coast to win its first game in your bracket, did you? 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 (AAPL) and Caterpillar (CAT). If you invest in one of them, odds are on your side.

 

This year, Wichita State stunned the tournament by being the first #9 seed to make it to the Final Four. But how do you find the Cinderella stocks that are the #9 seed but play like the #1s? These are stocks that are flying under the radar. They may be turning around their business but investors aren't paying attention yet.


These stocks, like the #9 seeds, may look similar on paper but some will have the special magic to break out of the pack.


3 Ways to Find Stocks That Are About to Be Cinderellas


#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 a change in the trajectory of 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 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.


Tracey is Zacks' Value Stock Strategist and is also Editor in Charge of our Zacks Turnaround Trader and Value Investor stock recommendation portfolios.

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