Finding Diamonds in the Rough

 | Jul 26, 2012 | 1:48 PM EDT
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One way to invest is to find a diamond in the rough. Sometimes an industry with many mediocre or otherwise undesirable investment opportunities can have one or two diamonds -- stocks worth buying. If the industry lacks many stars, investors may overlook the entire industry, and as a result, the one or two strong performers can be had at a good price.

To find stocks worth buying, I use automated strategies I created by following the precepts of some of Wall Street's greatest thinkers. These are genuine gurus, and they have written about how they invest. I have taken their descriptions and automated them so I can use these strategies to analyze any stock on the New York Stock Exchange or Nasdaq.

One industry not currently in much favor with my guru strategies is waste management services. Almost the entire industry lacks guru approval, but an exception is Clean Harbors (CLH). This company disposes of hazardous waste, and it is the dominant player in its sector. It also provides environmental cleanup services. Clean Harbors has more than 60,000 customers, including most of the Fortune 500.

Peter Lynch was among Wall Street's greatest mutual fund managers, and his investment strategy gives a high rating to Clean Harbors. This strategy's most important variable is the P/E/G ratio, which is price-to-earnings relative to growth and is a measure of how much the investor is paying for growth. The maximum P/E/G allowed is 1.0. Clean Harbor has a P/E of 23.16 and a growth rate of 26.3%, based on the average of the three-, four- and five-year historical earnings-per-share growth rates, giving it a favorable P/E/G of 0.88.

Hollywood has many stars, but among the companies in the motion picture industry, DreamWorks Animation (DWA) is the sole standout. Originally part of DreamWorks LLC (it was spun off in 2004), this is the company that brought us the Shrek, Kung Fu Panda and Madagascar franchises, and others. DreamWorks Animation is another favorite of my Lynch-based strategy. Its P/E/G is a very desirable 0.57. Another favorable aspect of the company is that it has no debt.

One more diamond-in-the-rough worth noting is Rent-A-Center (RCII), the only company in the rental and leasing industry to get guru approval. The company operates more than 3,000 rent-to-own stores that offer home electronics, appliances, furniture and other items.

James P. O'Shaughnessy is a revered investment strategist and mutual fund manager, and the strategy I base on his writings says that Rent-A-Center is worth investing in. The strategy takes a positive view of the company's market cap of $2.1 billion, earnings per share that have increased in each of the past five years, and a price-to-sales ratio of 0.69, less than half the 1.5 maximum allowed. Among companies that pass these three tests, the strategy then picks the top 50 on the basis of their relative strength, which is a measure of how well a stock has done in the past year relative to the overall market. With a relative strength of 89, Rent-A-Center makes it onto the top-50 list.

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