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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):

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.

Disclosure: Steve owns APOL, CEU, NSR

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Comments

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Posted by zafh on 2010-05-04 05:08:09

I really like the blog but this is very bad advice.
This is the same as tell someone who wants to learn about value investing to just buy the company with the lowest PE.

If you wanted to enhance magic formula stocks with TA but keep it simple I would say Support and Resistance would be best along with trendlines

http://www.investopedia.com/articles/technical/061801.asp

Zaf

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Posted by Steve on 2010-05-04 06:15:57

Buying only low P/E stocks is actually an excellent investment strategy!

Can you tell why it is bad advice? Support and Resistance are not generally supplied at most finance sites. Trend lines can be determined from Bollinger graphs, but we are not really concerned about trends, more about short-term overselling. I looked at 6 month charts for almost all of the current MFI stocks, and this simple strategy would have worked to short-term gains for almost all of them (there were a few exceptions). The strategy listed here is referenced in many places on the web.

Also, I again emphasize that we are limiting the strategy to MFI stocks, which are by definition cheap to start with. And then, I want readers to do (or read my) fundamental analysis (Bollinger's "rational analysis"). Only then should this strategy be applied.

Thanks for the feedback.

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Posted by sjoag on 2010-05-04 17:55:14

I've had the same experience - buying a MFI stock and seeing it go lower and have unsystematically tried to find a good entry points based on 50d moving avg. Bollinger bands could be another approach. Great idea - let us see if it works in practice.

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Posted by zafh on 2010-05-04 18:08:06

Sorry when I said "...buy the company with the lowest PE." I meant in the context of this site.

a) Buy lowest PE
b) Buy Magic formula stocks
c) Do fundamental analysis on MF stocks to pick the best ones.

c)is best but a) is better than nothing.

I have attached a image of DELL over the last 8 months showing a downward trend line (red). Each of the 4 times price gets close to the trend-line the stock is sold off

http://rt4.t.prorealtime.com/ProRealTimeNew/tmp/img_12730200226914.gif

When Price finally breaks above the trend-line it rallys for 22% in about 5 weeks.

Using these lines could help you decide at what price to consider buying. You wouldn't consider buy under but close to the trend-line, but you would buy above the trend line.

Generally if you were interested in short term trading then the MFI stocks would probably be a bad choice. Buy there very nature they would have to be low in price.

While value investing you are interested in "Stocks on sale", but when speculating you want to buy high and sell higher.

I once read "If a stock is at a 52 week high price, that means nobody has lost money on that stock in the last year, which means few will sell it and more want to buy it. So price goes up"

Zaf

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Posted by dansam on 2010-05-08 19:20:50

Steve,

Although I generally think technical analysis is BS, I'm trying to keep an open mind. The first thing that comes to mind is that if a stock's price is not normally distributed then using standard deviation is not "technically" (sorry) correct. Bur regardless of these details, the simple question remains: Does it work?

Do you have the resources to back-test MANY magic formula stocks to see?

Dan

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Posted by ztripp on 2010-06-03 18:58:33

Great website and thanks for the information. I am not sure if a stock touching off on the lower band is a good buy signal. I would rather see it touch the bottom band, then cross the moving average, then touch the upper band before buying. The problem is with low price stocks, you could "lose" some short term gain. For long term investments, I prefer to look at the 50 or 100-day moving average and ensure the price is above the moving average. I am following TCK: SOLR currently and waiting to see some upward movement in the 50-day moving average before buying.

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