Zacks.com Featured Expert Kevin Matras highlights: Walter Industries, Aeropostale and Oriental Financial Group

Screen of the Week written by Kevin Matras of Zacks Investment Research:

When it comes right down to it, a company's fortunes will rise and fall on its ability to grow business and earn profits.

In down markets, there seems to be fewer stocks with strong growth rates. And even fewer still with prices responding to these growth rates.

The reason why I think these kinds of stocks do so well in down markets is that there are fewer of them. There are fewer stocks competing for investors' attention. As more investors search out the best performing companies, you've got more money going into fewer top stocks. I believe that pushes the price up even more.

So does one just look for the companies with the largest growth rates? You'd think that would make sense. But it doesn't.

Stocks with growth rates that are too low just aren't growth stocks at all and don't perform that well. But stocks with crazy high growth rates don't test that well either.

One of the easiest ways to find the right balance is to search for companies that are projecting growth rates greater than the average for its industry.

Every industry's average growth rate is different, so trying to find the top companies in those industries - the best of breed if you will in terms of growth projections - is a sure way to avoid companies with growth rates that are too low.

What's interesting though, is that in my testing I've found that very high growth rates perform almost as bad as poor growth rates.

And all growth rates are not equal. A growth rate of 20% in an industry with an average growth rate of 40%, for example, isn't that great. But a growth rate of 20% in an industry with an average growth rate of 10% is excellent. Moreover, if a stock is growing at 100% in a 20% industry, is this 100% growth rate really sustainable? The answer is probably not.

And that's why comparing the growth rates to their industries and sticking with the stocks above their industry's average (or their peers) works so well.

As for how to make sure their growth rates aren't 'too high'; I like to look at their valuations.

Two ratios I look at are Price to Sales and the PEG ratio. The PEG ratio is particularly interesting when used with growth stocks because it takes into account the growth rate. Basically, it shows you how much you're paying for each unit of growth.

The PEG ratio is simply the P/E ratio divided by the Future Growth Rate. A lower PEG ratio is considered better than a higher PEG ratio. For example: if the P/E or multiple is lower than the growth rate, that's considered a good value. The higher the P/E ratio is vs. the Growth Rate, the higher the PEG ratio will be and the more 'overvalued' it might be considered.

So by concentrating on lower valuations, you're able to keep these big growth rate stocks in check, meaning they haven't been too bid up already. And you're getting in on the ones with the most potential to go higher.

So you have a strong growth component and good valuations.

It's true that some valuation plays get overlooked sometimes. But I believe that's because there may not be a compelling enough growth story behind it. But by demanding good growth, you avoid the problem.

I've also found that by making sure the stocks have been robust price movers over the last 12 weeks shows they're in demand and investors are pouring in their money.

Of course, making sure these companies also have a Zacks #1 Rank is a sure way to get people's attention.

As you know, the Zacks Rank is one of the best rating systems out there, showing an average annual return of over 30% per year over the last 20 years.

And statistics have proven that companies receiving upward earnings estimate revisions outperform the market. And of course, that's one of the things that the Zacks Rank looks for.

I put a lot of the above ideas together into several screens and tested them. And the results were pretty impressive.

I tested this strategy from the beginning of 2000 through the first quarter of 2008 using a 4-week rebalancing period and running it over multiple start dates to verify its robustness.

The average Compounded Annual Growth Rate was 57.2% per year. That's over a 4,000% total compounded return over a little more than an 8-year period.

Even during the bearish years of 2000, 2001 and 2002, while the S&P 500 was down more than -37%, the strategy significantly outperformed the market.

What's really impressive is that it continues to find some of the top performers over many different industries regardless of what the market is doing.

In fact, when I first started creating this strategy, I set out to find stocks that would do great in both up and down markets. And I knew that one of the keys was going to be the projected growth rate.

Of course the Zacks Rank, the different valuations, the price responsiveness and etc., are all very important too. And together, they form a very powerful combination.

In fact, this strategy is so impressive, it became the stock picking model for our new Growth Trader service.

Some recent winners include Walter Industries (WLT), Aeropostale, Inc. (ARO) and Oriental Financial Group, Inc. (OFG).

Click here to learn more about the Growth trader: http://at.zacks.com/?id=111

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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