The Market Is Ignoring These 5 Stocks (For Now...)

In a recent article, I wrote about a discovery I learned from Dr. Len Zacks, founder of Zacks Investment Research.

He is the one who taught me that positive changes in earnings estimates are the single most influential factor affecting stock prices over the near term. Earnings estimates are changed in one of two ways: The company itself comes out prior to or at their earnings announcement and says, "You know what, it looks like the current quarter is going better than we expected. Sales are so good, were going to have to up our estimates for what we will achieve by the end of it." Or an analyst covering the company, presumably with access to current sales and profit figures, makes the same kind of announcement.

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When this happens, it creates what we can call a "valuation disconnect." According to the Efficient Market Theory (EMT), the current price always reflects all current information regarding the company's forward earning prospects. So when new information arises unexpectedly, the stock price will need to scramble to price in that new information. Positive information like an upside earnings revision is very bullish news, so in general (unless the revision was somehow expected), per EMT, the stock price will rise until it reaches a point of equilibrium with the new level of valuation.

One easy way we can maximize this valuation disconnect is by reducing our list of stocks with recent upside earnings estimate revisions to only those with relatively low valuations. This ensures we have the max disconnect between current valuation and the new projected valuation. The best way to do that is to add a valuation filter to our stock scan, namely the Price to Sales Ratio.

The Price to Sales Ratio is the best way to find companies that are currently undervalued. A low Price to Sales Ratio is considered to be bullish, for it means that the stock has both a high level of sales per share and a relatively low stock price. Let's see what happens when we add a Price to Sales Ratio filter to the scan we used last week.

As you may recall, we applied to all stocks in the S&P 500 the following filter:

% Change in Q1 EPS Estimates over 4 Weeks > 10%

And with that one filter in place, we produced the following excellent return over a five-year lookback period using a four-week rebalance period:

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As you can see from the chart above, by buying only those stocks in the S&P 500 that have raised next quarter's earnings guidance more than 10% in the past four weeks, we've doubled the benchmark return. Our simple scan returned 180% (vs. 90% for the full S&P).

But we can do better. Let's add to this basic scan the following valuation filter:

Price/Sales = Bottom #5 Stocks

This filter takes all the stocks that pass through the first filter and sorts by Price to Sales Ratio, low to high. It then allows only the lowest five stocks to pass. When we use this new scan over the same five-year lookback period, with the same four-week rebalance period, this is what we get:

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As you can see, we've improved our overall five-year return from 180% ROI to a whopping 227.6% ROI, an average compounded gain of 26.8% per year. Not bad...

When we break down the stats of those returns, something else stands out. While our original scan showed a 13.2% maximum peak-to-trough decline, or drawdown, (vs. 9.0% for the S&P) -- very good considering we are trading about 15 stocks every month vs. the 500 stocks of the full S&P -- our revised scan reduced that drawdown by 70 basis points to just 12.5%, on only five stocks. Lower drawdowns and improved returns are exactly what we want to see when we are building a trading scan.

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So here are the stocks that passed my new scan filters this week:

1. United Continental Holdings (Nasdaq: UAL )

2. WellCare Health Plans (NYSE: WCG )

3. Entergy Corporation (NYSE: ETR )

4. The Mosaic Company (NYSE: MOS )

5. Apache Corporation (NYSE: APA )

I've ranked these in order of lowest to highest Price to Sales Ratio. So UAL, with the lowest ratio (shares currently trade at just 0.6x sales), has the highest level of valuation disconnect and so is the mostly likely stock on my list to rally over the near-term.

While these three stocks are certainly worth further investigation, they should not be considered "buys" on their own. But feel free to research these names on your own -- after all, they could turn out to be big winners.

They are also not official picks for my Extreme Tech Profits portfolio (that's reserved for my subscribers, of course). This screen was originally presented to my premium readers as a "bonus" to the picks they already get -- and those are the ones I think have the most potential to deliver incredible gains...

If you'd like to learn more about how we're targeting the areas of artificial intelligence, cybersecurity, the cloud, the internet of things, robotics and more for MAJOR profits in the months to come, then you should check this out right now ...

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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