While it's always a good time to cast about for unfairly punished stocks, the market seems to be presenting us with more than a fair share these days. But how do you identify the good ones -- separating the true gems from the shiny rocks? Today we'll talk about a few things to look for, and I'll give you a list of stocks that may qualify as turnaround plays.

Tom Gardner, Motley Fool co-founder and pilot of the Hidden Gems small-cap investing service, recently told his members that investing in a successful turnaround is one of the most satisfying experiences in investing. While others are unloading shares of a quality company, you're right there to buy from them at fire-sale prices.

It's not easy, of course. Sometimes stocks keep going down and never recover. Perhaps the company has lost a competitive advantage, or is suffering from poor leadership, or its entire business has been undermined by a disruptive technology. So when a company is down in the dumps, well off its recent highs, you have to decide whether it's a temporary condition or long-term trouble.

Tom says that in order to separate the legitimate companies from the has-beens, he looks for six things: a stock that's fallen 40% or more, a strong balance sheet, conservative accounting, skilled leadership, a large market opportunity, and fixable mistakes. If you find a company with these characteristics, take a good hard look, because you may be on to something. After all, nearly every great company has, at one time or another, been beaten down hard. Dell (NASDAQ:DELL), for instance, fell 70% in 2000, and Apple (NASDAQ:AAPL) was down even more that year.

Finding the contenders
To see if there were any companies out there fitting that profile, I set up my Capital IQ screening tool with the quantitative elements of Tom's list. First, I limited it to companies trading on major U.S. exchanges with a market cap of at least $200 million (I didn't feel like venturing into risky micro-cap land for turnaround plays) and a stock price at least 40% off its 52-week high.

I figured return on assets of 15% or better for at least the past two years would help us find good management that was skilled in deploying capital ... thus representing the "skilled leadership" category. Finally, I found it tough to come up with a single metric that would separate strong balance sheets from all the rest. Things are simply different from industry to industry. So I settled on an interest coverage ratio of at least 4.0, meaning the company earned at least enough before interest and taxes to meet its interest payments four times over. Such companies, at least, should have more than enough to meet their debt obligations.

Here are the passing companies:


Decline From 52-Week High

Apollo Group (NASDAQ:APOL)


MEMC Electronic Materials (NYSE:WFR)




Tuesday Morning (NASDAQ:TUES)


Multi-Fineline Electronix (NASDAQ:MFLX)


Universal Technical Institute (UTI)


Tiens Biotech Group (TBV)


Last, but not least ...
As for Tom's other criteria -- conservative accounting, large market opportunity, and fixable mistakes -- they're difficult to screen for, and thus are items to be checked for manually. If you think one of these companies meets all three conditions, please drop me a note and let me know why.

Tom believes his July Hidden Gems recommendation has all these qualities, and he has used the technique to great success for other stocks: He and his analysts have averaged 25% total returns for their recommendations, compared with 10% for equal amounts invested in the S&P 500. You can try the service free for 30 days, allowing you access to every issue and every one of their picks.

Rex Moore has been beaten down hard, but he's ready to rebound. He owns no companies mentioned in this article. Dell is an Inside Value and Stock Advisor selection. Universal Technical Institute is a Hidden Gems recommendation. The Fool'sdisclosure policyis brought to you by the letter "F."