Stock Screen Picks Winners in Bad Environments

• ByTim Melvin, RealMoney.com Contributor
• On Tuesday November 4, 2008, 7:59 am EST

I am constantly searching for ideas and testing various methods of picking stocks. Over the years I have developed literally hundreds of stock screens to help unearth ideas. Naturally, I have developed several favorites that have worked very well for me over the years. I have also found a few that were pretty on paper, but real dogs in actual trading. At times like this in the market, I like to take a step back and recall what has worked well in the past when the market had drastic selloffs and was showing signs of bottoming.

I wrote about one of these, the Templeton trade, a few weeks ago. That trade is working well, with the package of 53 NYSE stocks trading under $3 bucks already up almost 15%.

There is another set of selection parameters that has worked well under these conditions, the Value Line stocks ranked 1 or 2 that trade under $10 a share. I developed this screen back in the late 1990s. It has always tested out as one of the most successful stock-picking screens I have ever used. The annual returns are almost twice the market rate of return in my quick-and-dirty backtests.

It has also always been one of the most volatile techniques in the arsenal. The annual standard deviation is also about twice the market. The annual returns are actually pretty consistent, but the month-to-month drawdowns could make Popeye seasick.

The premise of the screen is pretty basic. These tend to be stocks that have been beaten down, hence, the low share price. The Value Line system is weighted heavily toward revenue and earnings momentum. There are also weightings for momentum and relative strength, as I understand the system. This tells me two things. The turnaround is under way, and investors are recognizing this fact. Stocks are held until they go over 10 or fall in ranking. It is simple, but it is effective. In past bear markets, it has recorded returns that have been breathtaking.

I ran that screen this morning and saw that it had grown to over 30 names. This is well above average, and has, in the past, been a pretty good indication the market is oversold. I also noticed that it was tech and retail heavy in nature. There were also several names on the list that had been there back in 2003 when the list almost doubled.

Being me, I cannot simply accept screen results without adding additional, more traditional value criteria. As in the past with this list, I used insider buying to filter the list. To my surprise, over half the list had some level of insider buying in the last few months, the most since I started using this method 10 years ago.

One old favorite that makes the cut this year is ION Geophysical . The company develops seismic data products used in both land and marine surveying for oil and gas.ION just completed the acquisition of Aram Systems, a Canadian seismic data company that is expected to increase land-based revenues by 40%. The acquisition is expected to be earnings neutral this year, and add to earnings in 2009. The company also has exposure to the continuing search for energy in the Middle East, as well as Russia and China, that is expected to drive future earnings growth as well. The stock trades at about a third of its 52-week highs.

One of the top-rated selections by Value Line, with a one ranking, is eResearch Technologies . This company provides technology that allows drug and medical device companies to collect and analyze information.

Like the rest of the market, the stock is down for the year, but earnings are not. Second-quarter earnings were up better than 60%. It got even better in the third quarter with fully diluted EPS leaping 85% on a sales gain of 41%. In spite of this, the stock is till cheap, trading at 10 times earnings and an EV/EBITDA ratio of 5.

Leapfrog Enterprises makes the list as well. The company has been a consistent disappointment, posting losses for the last four years, and the stock has suffered a result. There are some signs that management is finally getting its act together. The quarterly loss has been shrinking, and cost controls are starting to work. They have recued inventories, improved the supply chain and reduced expenses. They have also taken steps to improve the product mix toward more profitable products, such as educational games and electronic reading systems.

The whole list of stocks comprises 33 companies. Seventeen of them have insider buying. Space does not allow me to address them all here, and I want to stress that although one stock I already own , 3Com , made the list, I have not bought any of them yet.

This approach has worked so well in the past, however, it will be hard not to add them to my portfolio if the market declines further. It is a trading approach, not a long-term strategy, but historically it has been profitable when the market sells off.