This column was originally published in two parts on RealMoney: part one on Feb. 21, 2008, at 3:44 p.m. EDT and part two on Feb. 22, 2008, at 2:44 p.m. EDT. Both parts are being republished in one column as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Two Ways to Check Your Stocks' Credit Scores

If you watch any television at all, you probably can't escape those unbelievably obnoxious commercials for credit reports. I mean, I feel for the guy in the ad, working in a tourist-trap fish joint, living in his wife's parents' basement and driving a beater, all because he failed to keep track of his credit score, but enough already!

Obnoxious as they are, the commercials do make a good point. Keeping track of the changes in your credit score is a good idea, and everyone should do it. Tracking the changes can help you see what you are doing right, as well as wrong, with your financial habits. Now, if it makes sense for your personal finances, doesn't it make sense to do the same with your stock portfolio?

It makes even more sense when dealing with value and distressed stock situations. Legendary value investor Chares Brandes did a study a few years ago that tracked the results of what he called the "falling knife" stocks. The study (along with a lot of other great financial market research papers) can be found by going to the Brandes Web site and clicking on the "Institute" pages.

The study has two very important findings. Brandes defines a falling knife as a stock that has fallen 60% or more over the past 12 months. Flying in the face of the old Wall Street adage, the study concludes that for a long-term investor, buying these stocks is actually a very good idea. In fact, for long-term investors who are willing to hold them three years, they more than doubled the performance of the market as a whole.

The other important finding was not really a surprise. The biggest drag on performance for the falling knives, as a group, was bankruptcy. Over the 20-year time period encompassed by the study, almost 10% of the companies ended up filing bankruptcy. Imagine what would happen if we could eliminate that dangerous 10% and concentrate on the survivors? Performance would increase dramatically!

The simple truth is that we can. By applying simple credit-scoring systems to our collection of battered beauties, we can cull the wounded and concentrate on the likely survivors. To accomplish this, I use two credit-scoring methods that assess the health of a company's balance sheet and likelihood that the company will survive and even prosper going forward.

The first of these is the Altman Z Score. The Z Score was developed back in the 1960s by NYU Stern Business School professor and distressed- securities guru Edward Altman. The score uses five common financial ratios to rate each company. A score above 3 indicates that the company is healthy and in no danger of bankruptcy. A score below 1.8 is a prediction of imminent collapse.

In real world practice, this score has been very accurate, predicting as much as 72% of corporate bankruptcies on the basis of the Z Score. There are numerous Web sites where inputting a few simple numbers from a company's balance sheet and income statement will automatically generate this measure.

The other score I use was developed by Professor Joseph Piortroski of the University of Chicago. He noticed that although distressed stocks that sold below book value did outperform the market over time, most of the outperformance came from a handful of stocks. He did a study to see if the factors relating to outperformance could be isolated and identified. He found that, indeed, he could measure not only the health of the balance sheet but the prospects for improvement, using nine financial inputs. A description of the model is available here.

The results were published in his research paper "Value Investing, Using Historical Financial Statement Information to Separate Winners from Losers." He found that the companies scoring highest on the model substantially outperformed the lower-ranking stocks and the market as a whole.

Tracking your credit score makes sense. Tracking the credit score for the stocks in your portfolio makes even more sense to me. Investors who are interested in long-term-value and distressed-stock investing will find these tools invaluable in selecting and managing a portfolio of stocks that are likely to rebound and outperform.

Now I will take a look at some stocks that pass the tests and offer opportunity in this confusing market.

Use Your Tools to Find Good Value

I have found that the Altman Z-Score and Piotroski scale help me avoid the distressed stocks that are truly distressed and unlikely to recover. I sat down with my laptop and calculator this morning and started searching for some stocks that passed muster on both scales and sold for less than book value. The idea is to find value stocks with rock solid balance sheets as well as decent prospects for recovery.

I looked for stocks that had at least 5 out of 9 on the Piotroski scale and a Z-Score of 3. The stocks mentioned here are far from a complete list, but they're an example of the types of bargains that can be found by screening for cheap stocks and then checking their credit scores.

My first stock uncovered is Integrated Device Technologies ( IDTI). IDTI has a healthy Z-Score of 5.7 and a Piotroski score of 5. The company is in the semiconductor business and has sold off sharply over the past year. It is off about 50% from its highs and at less than 90% of book value. The balance sheet is strong, with about 20% of the share price in cash and no debt.

The company's core business lines -- server memory and PC clocks -- have been weak lately, and the stock sells near a five-year low. In its last earnings report, the company lowered its expectation for the next quarter. The company is well positioned to survive the downturn and should do extremely well when the semiconductor business bottoms and begins to turn up, hopefully later this year.

The company is buying back stock in the open market and still has $130 million of stock to buy under its current authorized buyback plan. I like this stock for an economic recovery and have added it to my list of stocks to watch. The options are way too cheap to sell puts, but if you think the semiconductor stocks will rally this year, the 2009 January calls are a good bet.

The next stock is an old favorite, one I have owned off and on several times over the years. Helen of Troy ( HELE) has a solid Z-Score of 4.6 and a P-Scale rating of 6 out of 9. The company makes personal care items such as hair dryers and curlers as well as kitchen items.

The stock sells at 75% of book value and just 7 times earnings. The company has a good balance sheet with over $100 million in cash. Management is cutting lower- margin product lines; making drastic reductions in selling, general and administrative (SG&A) costs; and paying down debt. The retail environment will continue to be difficult, but the company is optimistic that it can grow sales modestly and boost margins going forward and continue to generate cash in 2008.

I like this stock and I respect management. I wish I had run these screens on Monday Feb. 18, as the stock is up today Feb. 22. The May options are thinly traded, but if you can split the wide bid-ask spread, selling the May 15 puts should be rewarding; if the stock slips back toward $15, I would be an outright buyer of the shares.

It's no surprise that a retail clothing company made the list given the steep selloff in the sector. Jones Apparel ( JNY) made the cut with a Z-Score of 3.34 and a P-Scale reading of 7. The company sells brand-name clothing through its own stores as well as department stores and other retail outlets. The company has some of the premier women's clothing brands, including Anne Klein, Nine West and its own Jones of New York.

The stock is down about 60% from the highs and sells at 60% of book value. The company is restructuring to get rid of some lines -- it recently divested the unprofitable Barney New York stores -- and is buying back stock. The balance sheet is solid, with over $300 million in cash at the end of the quarter. I do not think retail apparel business will get better soon -- apparently company insiders agree, as there has been some selling of late -- but this is one to keep an eye on when the economy turns up and the consumer starts shopping again.

More aggressive investors with a better outlook for retail might want to look at the January 2009 combination trade. You can buy the stock here and sell the 17.50 calls and 12.50 puts for a combined premium of 3.10, a healthy 20%. Of course, should things get worse, you will have to buy stock below $12.50.

There are several more beaten and battered stocks that make the cut, but space doesn't really allow me to go through them all. I used these to give you an idea of the type of bargain stocks you can find and how I might trade them in this market. Although it is a little more work than buying the new-high list and praying for momentum, academic research and real-world experience show that this method pays off for patient investors with returns that solidly beat the market.

This was originally published in two parts on RealMoney. For more information about subscribing to RealMoney, please click here.

To learn more about balance sheets, check out " Balance Sheets: The Good, the Bad and the In-Between."

At the time of publication, Melvin no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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