The Brandes Institute once did a study on what it called falling-knife stocks that has some interesting conclusions. It found that catching a falling knife did in fact work out better than the old Wall Street adage would have you believe. The study defined a falling knife as a stock that had dropped at least 60% in one year and found that those stocks outperformed the market over one-, two- and three-year periods by a wide margin. It also found that the risk of bankruptcy for falling knives was quite high. And so it makes sense that if you can eliminate the companies with a high risk of bankruptcy, you can improve returns over just buying a basket of falling knives. Although this is not a pure value approach, it is an interesting contrarian angle on stock selection.
To avoid potential financial disaster, I broke out two of my favorite financial indicators. The Altman Z-score helps define and measure the amount of bankruptcy risk for a particular company. Many other fancier credit models have been developed since the Altman Z-score was introduced, but I find it still works well. Since I'm not a fancy guy, I have stuck with the old reliable credit-score model developed years ago by Edward Altman, a finance professor at New York University's business school.
I also am a fan of the Piotroski F-score developed by Joseph Piotroski, a professor at Stanford University's business school. That measure uses nine points of data in the financial statements to determine a company's financial condition and predict its future performance. I have found the F-score to be useful and highly predictive over the years.
I ran a simple screen to search for stocks that are down 60% over the last 12 months and have F-scores of 5 or higher, which indicates an ability to outperform the market, and Z-scores over 3, which indicates adequate financial strength. I came up with a list of stocks that might interest contrarian investors and traders alike.
One stock, which is right out of today's headlines, is eHealth (EHTH). It was up 16% this morning after reporting a smaller quarterly loss than expected. The stock is still down 70% over the last year, even after today's move up. The online-insurance broker was one of the stocks to sell that I wrote about as the new year started, and my skepticism had been well rewarded. The stock is not cheap, but there could be a contrarian snapback as the worst may be behind the company. EHealth has an F-score of 6 and Z-score of 5.45, which means it's financially healthy and its conditions are improving somewhat.
Weight Watchers (WTW) has gone from being on the top of everyone's "What Would Warren Buy" list of stock picks to the scrap heap in a relatively short period of time. People are just not willing to pay top dollar for prepackaged diet food anymore it seems. The future for Weight Watchers may be in programs such as the one it has started with Humana (HUM) to run weight-loss programs for its members. People might be more willing to order meals and count points if someone else foots the bill. The Humana deal won't do too much for Weight Watchers until the second half of the year, and so expect more weakness for a couple of more quarters. Still, the upside is intriguing. The stock is down 61% during the past year, and it has an F-score of 5 and Z-score of 3.46. Regaining just half of the lost ground would provide a better-than-60% gain to those willing to make a contrarian speculation of the Humana deal paying off in 2016.
Geospace (GEOS) acquires and processes seismic data for the oil and gas industry, and with oil prices where they are, no one is spending much in new exploration at the moment. We have a plentiful supply of black gold, and until that is worked off, business is going to be slow, to say the least. I expect to see a good deal of consolidation in the seismic-data industry as everyone is in the same back hole until oil prices move up and stay at higher levels. A larger oil-services company making an offer for the company wouldn't be even mildly shocking. Even if that never happens, Geospace has a Z-score of 9.89 and F-score of 6, and so it appears to be financially strong enough to survive until higher oil and gas prices allow it to thrive again.
Finding the financially strong falling knives and avoiding those in distress should help contrarian investors and traders to avoid stocks that would slice up their portfolio and to earn higher returns.