Floyd Brown says it’s important to keep a portion of your portfolio in contrarian plays, even in a bear market. But it can be tough to distinguish between undervalued firms and garbage.

Floyd says any investor can use a simple stock screener to help identify potential bargains. Reviewing cheap stocks for companies with profits, cash flow, and the ability to make debt payments is an excellent way to find the next portfolio superstar.

Using this strategy, Floyd says Qwest Communications (NYSE: Q), American Shared Hospital Services (AMEX: AMS), 3COM Corp (Nasdaq: COMS) are good contrarian profit plays…

Protecting investment principal and your profits should be a concern in any market, much less a bear market. Contrarian investors looking for deep discounted value can find themselves walking a tightrope between “buying on the cheap,” and “buying garbage.” And in the down markets like we’ve been in, it can be hard to distinguish between the two.

Nevertheless, keeping a portion of your portfolio in deep value and contrarian plays can be hugely profitable. The possible rewards of double-digit plus returns from these “portfolio superstars” are the stuff cocktail-party stories are made of.

The last year has been painful for the market. Record numbers of stocks are in the gutter, and cheap stocks seem to be everywhere. Many of these shares are selling at a discount not because of poor performance, but simply because of negative investor psychology. Here’s a strategy for finding these bargains, and separating them from the companies on their deathbed.

Screen for Stocks… Like a Professional

I like to use an ordinary stock screener, but if you have one you like, use whatever you’re comfortable with. If you don’t use one on a regular basis, try Yahoo’s stock screener. These are great tools to start off a potential investment search that many professionals wouldn’t be caught without.

Open up your screener, and let’s find some deep value stocks…

We want stocks on the major indexes that are trading like penny stocks (stocks trading below $5 a share). At Investment U we generally don’t advise investors to purchase penny stocks, because there are a lot of good reasons these companies are priced so low. However, the market is not a rational system. It behaves irrationally and over-reacts. This has created some exceptions for the contrarian investor…

Set your first criteria on the screener under “Share Performance” for “Current Price” with a condition of “<=” and a value of “$5.” (Companies trading less than or equal to $5.00 a share.)

Next, we will look at valuation. There are a number of metrics we could use like price-to-earnings (PE), price-to-cash flow or price-to-book value. However, today I want to look at price to sales (P/S) ratio. By screening for these super cheap firms trading at less than one times sales you are paying less than $1.00 for a $1.00 in sales.

Set your second Criteria under “Valuation” to “P/S” with a condition of “<=” and a value of “1.” (Companies with a P/S ratio of less than 1.)

Hmm, what do we find?

We find a mix of beaten-down companies including financials, media firms, tech firms, auto related firms, a couple of airlines and even some consumer names. The screener returned over 200 stocks from this simple two-factor screening. I find that by looking at the largest companies you can find the ones best suited to weather economic downturns.

In reviewing the list, I am looking to identify companies with profits, cash flow and the ability to continue to make debt payments.

Here are three of the firms that caught my attention.

Qwest Communications (NYSE: Q) is trading at $3.85. This telecom firm gets no respect. It is the product of the ill-fated merger of long distance provider Qwest and the old regional Bell firm US West. As the firm loaded up on debt for the merger, the business swiftly changed. It has been plagued by the cancellation of landlines. In addition, its core business is shrinking. If its customer base stabilizes, and if it’s able to leverage its network, its debt will go down. Without a mountain of debt to dig out from, shareholders should see profits hitting the bottom line, and their wallets.

3COM Corp (Nasdaq: COMS) is trading at $2.20. Last year, the Chinese and Bain Capital tried to take this computer-networking firm private. The Pentagon blocked the sale because of national security concerns. Why? The technology this firm controls is vital to national security in everything from handheld devices to networking applications. Security personnel are currently watching over the Olympic Games via IP-based surveillance cameras, thanks to networking provided by 3Com. Quarterly earnings at 3Com are improving, and the share price action is more the result of the broken leveraged buyout than the state of the company.

American Shared Hospital Services (AMEX: AMS) is trading at $2.17. This firm helps hospitals acquire the Gamma Knife equipment used in advanced radio surgical and radiation therapy services. This company was known for paying a healthy dividend. But late last year management decided to cut the dividend to reinvest the cash in growing the company. Shares were punished as income investors fled. The AMS Chairman, Ernest Bates MD, is bullish on the future saying in the last company conference call that earnings results “show how our strategy to use AMS’ creative financing solutions to make proton beam radiation therapy (PBRT) systems, Leksell Gamma Knife PerfexionTM systems, IGRT systems and other next-generation devices for radiation oncology delivery available and affordable to our clinical partners and their patients has put us on the path for long-term growth.”

With a little research you can find that this current market correction is just the opportunity that deep value and contrarian investors like myself love to see. So fire up the stock screener and find your portfolio’s next “superstar.”

Source: Finding Deep Value Plays… and Your Portfolio’s Next Superstar