Your Homework: Prep for the Market Turnaround Now

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers. To subscribe to RealMoney, click here

One question I am frequently asked is why I spend any time looking for long ideas and discussing cheap stocks when I think the market is going lower. The answer is very simple: At times I am going to find stocks so cheap I want to own a little regardless of market outlook.

When I find a stock selling for less than net cash or way below tangible asset values, I want to own a little. History and experience have taught me that stocks such as Electro Scientific ( ESIO) should just be purchased regardless of what the market may do. Here you have a stock at half of book value, near cash levels, and with David Nierenberg as a substantial shareholder. I will take my chances relative to the market. My margin of safety is so large that I am comfortable owning it.

The other reason is that although I was politely asked to leave the local Cub Scout troop as a boy for various offenses involving firecrackers, pumpkins and a pack leader with no sense of humor, I do admire the motto -- "Be Prepared." I do think this market is going lower. The economic and financial conditions justify lower prices in my mind. I also have no idea how long it will take to work down to levels that would make me a buyer. It could just continue as we have so far in 2009 -- ticking down day by day. We may have a cataclysmic event that causes a steep one- or two-day sell off. The time to shop for a fire extinguisher is not right after you spill grease into an open flame. I want to be ready with a list of stocks with solid asset values and recovery potential.

In spite of my views on the market, I run my screens every week. I look for stocks that meet the Schloss criteria -- those selling below book value with little debt and insider ownership. This helps me find the small, cheap stocks like Sycamore Networks ( SCMR) trading for less than cash that I want to own now. It also helps me find companies like Darling International ( DAR) -- profitable, solid companies I will want to buy in a selloff.

I also run my Ben Graham screen every week. This produces a list of profitable companies trading at P/E ratios below 8 that own at least twice as much as they owe. I may not buy shares of Forest Labs ( FRX) today, but it is on my list to buy when the market reaches my downside targets. Garmin ( GRMN) probably has more weakness ahead of it due to very weak consumer spending, but given its strong financial condition and dominant market share, it is on my list of recovery stocks to buy at lower prices. Running the screens and finding promising stocks now gives me time to do the homework. When the stock market gets to my levels, I will not have the time to read 10-Qs and 10-Ks. No one will ring a bell a week in advance so I can go through the institutional shareholder lists or read the latest proxy filing.

I also take advantage of what I consider my personal research department. I search at least once a week for 13-D filings of interest. When I see that an activist firm with a long-term track record of success is buying shares of Jackson Hewitt Tax Services ( JTX), I want to take a deeper look at the company. If Bill Gates' investment firm Cascade buys shares of Otter Tail Power ( OTTR) and wants to meet with company management, I want to look at the stock.

I don't just blindly follow the activists into a situation. When I was a broker, I never just blindly followed the research department, either. That being said, there are some very smart activists who have been very successful in unlocking shareholder value. Following their SEC filings is an important part of my regular ongoing search for ideas.

There are several value-oriented hedge funds that I pay attention to on a regular basis as well. If Charles Brandes and John Paulson both own a lot of Boston Scientific ( BSX), I want to understand why. I might want to piggyback the position or at least make plans to buy it in a selloff. I pay attention to what investors like Tweedy Brown, Bob Rodriguez and others are doing. I may not like any of their latest purchases; then again, I have found an occasional long-term multi-bagger by staying on top of their positions.

The time to build your list is now. You want to have your ammunition ready long before the bugle blows. To succeed at long-term value investing, you must constantly be searching for ideas. Even when market conditions and the outlook are horrible -- as they obviously are now -- you have to run the screens and read the filings. There will be no bell before the bottom. As we get closer, you have to know what stocks you like and what price you want to pay. You have to do the homework.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Jackson Hewitt Tax Services and Darling International to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

This was originally published on RealMoney on Feb. 3, 2009. For more information about subscribing to RealMoney, please click here.

At the time of publication, Melvin was long DAR, 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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