Run With the Current, Don't Fight It

Here are 10 indicators of stocks that have a winning edge in today's market.
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It was good advice when I was 9, and it's good advice for investors now: Don't sail against the wind.

Making a profit from your stock picks is hard enough without bucking the basic currents in the stock market and industry sectors. Sure, it is possible to find an individual stock that goes up even when its group is out of favor and investors hate its "style." But it's sure easier to make money in the stock market if your pick has the overall market wind at its back.

In other words, I want an edge that would work in my favor even if I don't manage to pick the one superstock that will outperform its dud peers.

So how do you identify this edge and which stocks have it right now?

Finding the Edge

I favor a checklist approach, and I'll give you the 10 items that I think define this market and sector edge right now. Stocks that have the bulk of these 10 factors on their side deserve your attention as potential buys -- if they check out after you've done your due diligence on the details of the individual pick. Just because a stock has the wind at its back doesn't mean you should invest in a turkey.

Stocks that don't measure up well against this checklist should get a pass from investors, all else being equal. Sometimes an out-of-favor stock in a distressed sector has such great individual prospects that it does deserve a place in your portfolio. That's seldom, however, though I'd never say never.

The checklist isn't engraved in stone. It defines the current market, and stocks that fit the list are likely to be favored by investors this year. I'd change this list tomorrow if the flavor of the market had changed. So this list is based on my judgment of what styles will work this year and what characteristics investors will value most. As usual, feel free to disagree -- but even if you do, studying my checklist should make it easier to come up with the factors that are optimal for this market.

I'll end with the name of a stock that I think matches up well against my checklist.

1. An earnings and revenue growth story that fits the economic recovery scenario:

This market is bidding up stock prices because of a belief the recession will end sometime in 2002 -- most likely by midyear -- and it will continue to value stocks on that belief until events prove it wrong. Everyone who believes this scenario wants to buy stocks that are poised to participate in this turnaround.

2. An identifiable sector growth catalyst:

Wall Street and professional money managers are putting their money behind broad sector themes that have worked out in the past. A few examples of these themes: Brokerage stocks outperform six months before the economic turn; travel stocks will climb as airline and hotel bookings come back to normal; cyclical sectors such as paper, energy and metals benefit from the return to economic growth.

3. Maximum positive operating leverage:

Companies with high fixed costs get killed going into a recession. As demand drops, they have to eat the costs of factories, sales networks and store chains; shutting down or selling these assets is either extremely time consuming or simply impossible during depressed business conditions. In a recovery, however, as these assets return to productive use, companies with high fixed costs show a tremendous swing in operating profits and big growth in profit margins. That's one of the reasons investors are so eager right now to buy shares of technology companies, which have high fixed costs.

4. Minimal blowup risk from negative financial leverage:

Wall Street knows that more companies are going to blow up before any recovery reaches full speed -- too many companies overborrowed based on overly optimistic projections for revenue and earnings growth. But nobody's sure which companies will face reorganization or bankruptcy.

Will

Kmart

(KM)

go into bankruptcy? Is

Gap

(GPS) - Get Report

about to violate the covenants on its loans? Could

Ford

(F) - Get Report

really run through all its cash? Do labor and management at

UAL

(UAL) - Get Report

hate each other so much that they're willing to let the airline bleed to death?

After

Enron

(ENE)

, everybody knows that the unimaginable can happen, and nobody wants to buy into another ride from $83 to 66 cents a share.

5. Low valuation by historical measures:

This is a tricky one because there is so little agreement about which valuation measures are the right ones to apply to stocks as the economy comes out of a recession. Should stocks be measured by trailing 12-month earnings? By projected 2002 earnings? By projected 2003 earnings? Should the

price-to-earnings ratio (using whichever set of earnings numbers) be adjusted to account for the current extraordinarily low interest rates?

What's important in the current market is less what particular measure is used but the degree of conviction that can be brought to that story. This market is interested in growth, yes, but after 2000-01, it wants to get that growth at a decent price. And investors are still nervous enough that any rally in a sector raises immediate fears that stock prices are getting ahead of fundamentals.

6. Understood, quantifiable and discounted risk:

This market is willing to look past risk, and bid up the price of a stock as long as it thinks it has a handle on the dimensions of that risk. Buying into the brokerage sector seems like a reasonable idea to many Wall Street analysts right now. That's because the risks -- that trading volumes won't come back, that the stock indices will show a third-consecutive down year for the first time since 1939-41, that cost-cutting won't work -- are relatively easy to identify, pop into financial models and then discount to see if they are adequately reflected in the price of the stocks.

The big money-center banks represent a thornier problem because no one is sure what their exact exposure is to bad loans and potential corporate bankruptcies. The need of

J.P. Morgan Chase

(JPM) - Get Report

to raise estimates of its exposure to the collapse of Enron has left everyone on Wall Street jumpy about the sector. It's hard to model risk when you don't know what the facts are.

7. Technical measures indicate the stock has turned:

This remains a nervous market, and many investors aren't convinced that a move up in any stock is real and not just another head fake. Technical indicators that flash a "buy" sign -- such as the traditional "buy" signal when the 50-day moving average crosses above the 200-day average -- are immensely reassuring in this environment and will bring in another group of investors who have been sitting on the sidelines in cash.

8. Favorable sector seasonality:

2002 is likely to bring a market of sector rotation, with money moving from one part of the market to another in search of growth (or growth stories). Investors looking for early clues about which sectors to abandon and which to jump into are likely to use historical track records of seasonal under- and overperformance by individual sectors. For example, many of the late-December and early-January calls to buy retail stocks cited the sector's historical November-March outperformance. Similar calls to sell airlines in recent days have often noted the traditional winter selloff that sets up the March and April rally in these stocks.

9. No, or limited, insider selling:

Investors who were burned in the sucker rallies of 2000-01 will be watching closely for the first signs that the folks who know these companies best are selling their shares. At the least, I'd expect insider selling to be a rally-killer in individual stocks in 2002.

10. A workable business model:

Remember in 1999 when it seemed as if no one cared whether a company's business plan made sense? Contrast that to today, when a sizable number of the analysts who follow

Amazon.com

(AMZN) - Get Report

have already gotten out in front of the company's Jan. 22 earnings announcement by saying, in essence, "The question isn't what Amazon reports this quarter, but whether or not this company has a viable long-term business model."

I don't think we're yet at the point at which Peter Lynch-style investors won't buy stocks in companies they don't understand. But it is important to realize that business-model questions hang over entire sectors and many companies, keeping a damper on any positive reaction to a particular quarterly earnings report.

Finding the Edge

Now here's a name that fits this market checklist closely enough to give the stock a style and sector edge:

American Express

(AXP) - Get Report

.

American Express has suffered a double whammy for the past year. First, with the stock market in bear market mode, the company has seen assets under management drop at its core financial advisory business. And the decline in travel after the Sept. 11 terrorist attacks did nothing to help the company's core travel business either. The final straw for investors came when the company disclosed huge losses in its portfolio of junk bonds.

But these problems also create opportunity for investors because the financial and travel sectors are on the mend. At just 20 times projected 2002 earnings per share, the stock is reasonably valued and has shown good momentum in recent weeks with a climbing relative strength and a push in the past few days that finally took the stock over its 200-day moving average. The quantifiable risk here is represented by rising default rates in the company's credit card business -- again, nothing that an economic recovery won't fix. I'm adding the stock to Jubak's Picks with a target price of $52 a share by December 2002.

Some items on this checklist may strike you as common sense. That's especially likely if you're a disciplined growth-at-a-reasonable-price investor because that pretty much sums up my view of which style will work best in 2002.

Jim Jubak appears Wednesdays on CNBCs "Business Center" at 6 p.m. EST. At the time of publication, he owned or controlled shares in the following equities mentioned in this column: Dell Computer