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A Simple Trading Strategy for Magic Formula Stocks?

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May 04, 2010 – Comments (0) | RELATED TICKERS: DECK , UIS , APOL

MagicDiligence is a fundamental analysis site. All of the site's stock reviews and recommendations are based on fundamental analysis of the company's financial statements, competitive position, growth potential, management, and so forth. Considering all of this, I try to determine a fair value and give the Magic Formula stock a thumbs up or thumbs down (or neutral) depending on the relationship of the current stock price to that fair value.

However, in 2 and a half years of staring at the price movements of Magic Formula stocks, there have been several times when I've seen an already undervalued stock plummet 20% or more in a short amount of time, and thought "that stock is way oversold". Usually within a few weeks the price is back up to at least where the original drop took place. The phenomenon is especially prevalent in MFI because the screen produces so many small cap listings, which can be quite volatile in price.

This, of course, gets the brain gears turning. If we could successfully play some of these oversold conditions, there is a serious opportunity to make some money in short time periods. With this in mind, I set off to try and find a simple technical strategy to support this goal of finding short-term oversold MFI stocks.

The first criteria was that the company should be fundamentally sound and trading at least 30% below a fair value estimate. Under no circumstances do we want to buy a stock just because its price is exhibiting a certain kind of behavior. We need solid fundamental underpinnings first. For example, a stock like Santarus (SNTS) may show a technical oversold pattern, but we know from research that this massive sell-off is probably justified due to adverse patent rulings.

The technical part was next. Wanting to avoid getting too deep into technicals, I found an interesting and simple strategy using Bollinger bands that captures potentially short-term oversold conditions.

Bollinger bands are simple to understand. They were invented by John Bollinger in the 1980's. The bands consist of three parts - three lines that are plotted on a price chart. The middle line is the simple moving average of the stock price over the past 20 days. The upper line (band) is this moving average plus two standard deviations, and the lower band is the moving average minus two standard deviations. Statistically, this range is supposed to cover most normal distributions.

 

Pretty much all the finance sites offer Bollinger band overlays on their price charts. A chart with the Bollinger bands (from Google Finance) is shown below for MFI stock Deckers Outdoor (DECK):

(link)

The green band is the upper range, red the lower, and the blue line the moving average.

There is no "by-the-book" way to play Bollinger bands, but the strategy linked to above is simple. A stock should be bought when the price crosses the lower band, and can then be sold when the price returns to the moving average (or higher). The thinking here is that a stock has been oversold due to knee-jerk reactions following some adverse event, and will return closer to average over a short period of time.

We can see that this strategy would have worked well for DECK since the beginning of the year. At two points in early February we would have purchased and sold a few weeks later, booking about 7% gains. That may not sound impressive, but on an annualized basis it is over 220%! In April the strategy would have worked even better. It crossed the lower line on 4/19 at $133, then jumped to $143.65 just 3 days later for a sweet 10.7% gain. Annualized, that one is a 1,000% gainer!

So, with this in mind, how does the current Magic Formula list fall within their respective Bollinger bands? Here are the stocks that are trading below the lower band, which would be "buys" according to this simple strategy (any MagicDiligence fundamental analysis is linked, some are premium, some not):

America Online (AOL)

Apollo Group (APOL)

China Education Alliance (CEU)

NeuStar (NSR)

Unisys (UIS)

Only one MFI stock, China Biologic Products (CBPO), currently trades above the upper Bollinger band, meaning the stock has had a recent strong upwards price movement. The others trade within the range.

While there is no evidence that using this strategy with MFI stocks will be effective, it could help produce very good price levels to buy into already undervalued stocks.

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