Three Stocks With High Recovery Potential

Editor's note: This was originally published in two parts on RealMoney. It is being republished as one article as a bonus for readers.

On several different occasions I have written about using the Piotroski score to help identify value stocks with significant recovery potential. The score is simply a measurement of nine key balance-sheet and income-statement items to determine not just the financial health of a company but its recovery potential.

It was developed by Joseph Piotroski and tested in his 2000 paper "Value Investing: Using Historical Financial Information to Separate Winners From Losers." Stocks that score in the highest ranges of the system significantly outperform those that have lower scores when combined with the basic value approach of low price to book value.

I have found that the method works very well in practice as well as in theory. I sat down this weekend and ran some screens to find stocks that have high scores on the Piotroski scale and trade below book value. Being me, I also screened for those with solid balance sheets in addition to being cheap. I believe these companies will be among the market leaders when the stock market finally recovers next year.

Tecumseh Products ( TECUA) is a stock I owned several years ago and am going to revisit now that it shows up on my screens. The company makes compressors, primarily for the refrigeration and air conditioning industries.

Given the current weak environment for manufacturing of durable goods, it comes as no surprise that business has been weak in 2008. Sales and earnings are both down compared with 2007 as a result of the economy. However, the company does have a solid balance sheet, with over $7 a share in cash and very little debt. Tecumseh was involved in a shareholder rights battle with a large shareholder, the Herrick Foundation, but it successfully beat back a proposal from Herrick at a recent special shareholders' meeting. Tecumseh will be recapitalizing the company to eliminate the dual share class and equalize voting rights.

At the current level, the stock is simply cheap. The shares trade for less than one-third of tangible book value and have an enterprise-value-to-EBITDA of just 3. The company is extremely sensitive to economic conditions, but I believe this is priced into the stock. When the economy does recover, this stock should be a market leader.

Integrated Device Technology ( IDTI) is still on the list as well. The semiconductor company has also had a tough year and recently reduced its forward guidance. As a result of what the company described as deteriorating order conditions, revenue forecasts for the quarter were dropped by a range of 15% to 18%, and earnings estimates were cut as well.

Integrated Devices is well positioned to withstand the downturn. It has over $300 million in cash and no debt on the balance sheet. Although profits may be slipping, the company is still profitable, unlike many other technology companies this year. The company has a strong global presence, with over 70% of revenue coming from outside the U.S. Integrated Devices will be able to put its cash to work in the current weak stock market in the form of either acquisitions or stock buybacks. The flexibility of a strong balance sheet should allow the company to be a leader in the eventual recovery.

Medical device manufacturer Boston Scientific ( BSX) made the list as well. This one comes with two huge caveats. First, it is near the upper range of my debt limitations for an individual corporation. The second is that because of acquisitions over the years, tangible book value is actually negative.

So why include it? First, the company has $1.7 billion of cash on hand and is still profitable. It has also announced the sale of non-strategic assets to pay down debt over the next year. The other reason to look at the stock is that one of the most successful investors of the current bear market, John Paulson, is a large shareholder. So is value investing legend Charles Brandes. That, combined with the high Piotroski score, makes the stock worth a look.

Although the cardiac stent market is becoming more competitive with the entry of new products from Abbott Labs ( ABT) and Medtronic ( MDT), Boston Scientific remains the market share leader. It is also seeing strong results for cardiac rhythm management products, with sales rising more than 10% year over year in the third quarter. As the economy recovers and continues to pay down debt, I look for this stock to be a top performer in the medical devices sector next year.

As usual, I am going to run out of room before I run out of stocks to talk about, but I want to mention some other companies with high scores that you should look into. Electro Scientific ( ESIO) just settled with activist investor David Nierenberg of D3 Partners about the voting rights of his 15% interest in the company. D3 is pushing the company to use its $150 million cash stockpile to buy back stock. The fund has a record of winning these battles and increasing shareholder value.

Sunstone Hotel Investors ( SNO) also made the list of companies with high scores on the scale. I believe it is the very best of the lodging REITS, with great brands and a strong balance sheet. At these levels, even if I am early, the dividend makes it worth the wait.

The Piotroski score has been tested in the classroom and in the market as a way to find companies with strong recovery potential. It belongs in every value investor's toolbox.

This was originally published on RealMoney on Dec. 22, 2008. For more information about subscribing to RealMoney, please click here.

At the time of publication, Melvin had no positions in 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.