Reuters Select Screens
©2008Author: Marc Gerstein
It's good to find companies whose EPS are growing at a healthy pace. It's even better to find
companies whose growth rates are accelerating. This screen focuses on firms whose results
are growing at an increasingly rapid clip.
Rationale for this screen
Everybody likes to invest in companies whose EPS are growing quickly. But finding good
growth situations is often easier said than done. We know that we really want to invest in
companies whose EPS show the greatest potential for future growth. But we can't really know
what the future will bring. All we can do is estimate the future, usually based on what we saw in
the past and what we know of the present.
Suppose we assume companies that have grown briskly in the past will continue to do so in the
years ahead. That's a tricky assumption, since we can't be sure that the same factors that
caused rapid growth in the past will prove sustainable indefinitely. But even if we are willing to
accept the assumption just as a starting point (in order to compile a manageable-sized list of
companies whose future prospects that we will then qualitatively assess one-at-a-time), we still
have some decisions to make. What past period(s) will we look at? The latest quarter? The
latest twelve-month period? The latest three years? The latest five years?
Good arguments can be made for all of these time periods. Looking at growth rates that
compare the last reported quarter with the comparable quarter one year ago will produce a list
of companies that are growing briskly right now. This is important information for momentum-
oriented investors. But such lists will often uncover companies whose latest-quarter rapid
growth rates were aberrations.
To learn which companies have proven themselves capable of posting strong growth rates
consistently, you may be better off examining a longer period, such as three or five years. But
this approach isn't foolproof either. Factors that led to strong five-year growth rates may not be
sustainable over the next five years either.
Therefore, this screen looks at several periods in order to uncover a pattern of accelerating EPS
growth. Companies that make the cut have demonstrated strong growth rates over a period
long enough to refute the idea that the good performance was a fluke. The screen also
searches for clues regarding the sustainability of the factors that caused strong growth we've
seen until now.
Specific Screening Criteria
Here's how the screen was created:
- Three-year EPS Growth
We start with a requirement that the EPS must have grown at an average annual rate of at
least 15 percent over the past three years. Obviously the hurdle could have been set higher,
but business follows a natural cycle in which newer companies grow at extremely rapid rates
and then decelerate as they become increasingly established, and eventually, mature. The
higher the growth rate over the past three years, the harder it will be for the company to
maintain it in the future.
- Acceleration
We look for a pattern of acceleration (an increasingly rapid rate of growth) over two separate
intervals. We require that rate of growth over the Trailing Twelve Month (TTM) period be
greater than the rate for the preceding three years. We also require that the rate in the latest
quarter (compared to the equivalent quarter one year ago) be greater than the rate for the TTM.
- Inferences About The Future
Screening for future expectations can be challenging. One could simply look at projected
growth rates in the same way one looks at rates achieved in the past. But different analysts
may base their forecasts on different expectations about the overall economy. Fortunately,
there are other approaches. Having already narrowed the list from more than 9,400
companies to less than 200 on most runs, we can now afford to make this part of the screen
more behavioral than statistical. Rather than looking at specific growth rate projections, we
search for indications that analysts and investors who examined these companies, based
not just on numbers but qualitative factors as well, came away from the process feeling
encouraged about the future. Two such factors are used here. One is a requirement that the
estimate of current year EPS be greater than it was eight weeks ago. The other is that the
stock have outperformed its industry average over the past four weeks.
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Relative Growth run it
Growth is a popular investment theme. But how much growth should an investor seek? Should
one consider only those companies that are growing 20 percent or more? Or is a 15 percent
rate of growth sufficient? Perhaps 25 percent would be a more attractive target.
Rationale for this screen
When screening for growth stocks, it's tempting to seek the highest rate that will produce a list
containing a reasonable number of stocks. But that's not always a good idea. Such lists are
often tilted toward "hot" industries. That's fine if you want to use a top-down approach to stock
selection that focuses primarily on sectors or industries and secondarily on individual
companies.
Bottom-up investors look mainly at individual companies and are more willing to invest in firms
whose industries aren't in vogue. The idea here is that shares of such companies are likely to
fare well over longer periods of time despite the ebb and flow of market fads.
Growth rates can be used to locate companies like this. Instead of targeting specific growth
numbers, seek growth rates that look good measured against some other test(s). The
Accelerating EPS Growth screen seeks companies whose recent growth rates have exceeded
the rates tallied over past periods. This screen however, considers acceleration, but also
introduces other comparisons. It compares EPS growth to Sales growth, and it looks for growth
that exceeds industry averages.
Specific Screening Criteria
Here's how the screen was created:
- Earnings Quality
We start by requiring that the company's tax rate be at or above 25 percent. Unusually low
tax rates are often unsustainable over time. One example of this would be a company
whose tax rate is being depressed by loss carry-forwards from prior years. When those
carry-forwards expire, the tax rate will jump significantly, leading to a lower level of earnings
per share, even if the basic business (i.e. its capacity to generate pretax income) continues
to grow.
- Sales Growth
A company can boost its EPS by cutting costs, and occasionally by divesting money-losing
operations (the latter would cause Sales to fall and EPS to rise). But such strategies can go
just so far. Over prolonged periods of time, strong rates of EPS growth start with strong
rates of Sales growth. This screen requires that each company's Trailing Twelve Month
(TTM) Sales growth be greater than the three-year cumulative average rate of Sales growth
(the acceleration factor) and greater than the average rate of TTM Sales growth for its
industry.
EPS vs. Sales
The screen requires that EPS growth exceed Sales growth over the past three yeas, and in
the TTM period.
- EPS Growth
As suggested above, this screen is designed to find companies that may be of interest to
long-term investors. But all else being equal, most investors would prefer to take new
positions in stocks that seem likely to behave well sooner rather than later. So we analyze
EPS by focusing on recent results, these being more likely to influence near-term share
price performance. The screen requires that EPS growth in the latest quarter (compared
with the equivalent year-earlier period) be greater than the industry average growth rate,
and that it be better than the growth rate that prevailed over the TTM period. I'm willing to
shorten the time horizon for the EPS analysis in this manner because the previous tests
probably eliminated most, if not all, flash-in-the-pan companies.
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Relative Momentum run it
At times, momentum investing gets hot. This screen searches for stocks that have been beating
their industry peers by wide margins in terms of price performance and sales growth.
Rationale for this screen
Simply put, momentum investing means buying winners. Different investors have different ways
of deciding whether or not a particular stock is a winner. But more important than these
distinctions is what's not usually considered: price.
If you're a momentum investor and you found what you believe is a "winner," you buy it. You don't
worry about the stock price, its relation to EPS, sales, asset values, growth rates, or any other
such metric. You just buy the stock. You might overpay for the shares, but you figure you can
always find a "greater fool" later on who'll buy your stock at an even more inflated price.
That's pretty much what momentum investing is all about. From a purely theoretical viewpoint,
there's no way to justify this. Indeed, when this "greater fool theory" is described at seminars, the
audience tends to chuckle. But for a generation now, greater fools have been laughing all the way
to the bank. So if you are going to be a momentum investor, what should you look at?
In the past, stocks were priced in relation to the cash that could be expected to actually reach a
shareholder's hands; dividends and proceeds of an anticipated future sale. Later, dividends were
de-emphasized in favor of EPS, and then cash flows, as proxies for a company's dividend-paying
capability. Now, we've gone a step further, and look to sales as a proxy for a company's eventual
ability to generate EPS, cash flows, and then dividends.
Actually, a focus on sales can be quite sensible. For "new economy" companies that lack
earnings, sales probably is the only legitimate measure of business performance. It won't always
be that way. Eventually, these companies will need to produce profits. But for now, the market is
willing to make allowances for the inevitable financial burdens of building new businesses from
scratch.
Even those who use sales as a measure must still decide if they are momentum or value
investors. A new-era value investor would still refuse to buy a stock if the price is too high in
relation to sales per share. On the other hand, a new-era momentum investor may be quite willing
to buy if the company is posting excellent rates of sales growth (as opposed to EPS growth).
Assuming you are a momentum investor and that you want to focus on sales growth, you still
need to make some of the same kinds of decisions made by those who invested based on EPS
growth.
So the question is: how much growth should you expect? As we often do for EPS-based screens,
we set the growth hurdle based on comparisons between a company and its industry average.
In some respects, this test is more lenient than would be the case if we simply set a specific
growth target; say 30 percent. By comparing companies to industries, we avoid systematic
elimination of companies that happen to operate in mundane business sectors. On the other
hand, we also eliminate companies whose strong growth is based on being in a hot industry ("a
rising tide lifts all boats").
This momentum-based screen has something of a bottom-up flavor in that we don't simply pick
the highest growth rates or share price gains we can find. The industry comparisons shift our
attention to companies that are doing better than might be expected simply based on their
presence in a particular business.
This tilt toward "good" companies can be worthwhile because of the typically non-existent
relationship between momentum investing and financial theory. This lack of connection can be
good because you need not be distracted by any theory that tells you a stock can't go higher. The
other side of the coin is that financial theory isn't giving you any clues about when the music
might stop, resulting in a reversal for the stock.
It's never pleasant for a momentum investor to be caught with a long position when the party
ends. But if that happens, the pain will likely be less if, at least, you're holding good companies.
That can make it easier to hang on until the momentum tide returns. Perhaps the only thing worse
than staring at a paper loss is realizing those losses by selling and then missing the next rally.
Few people can truly time market ups and downs as well as they like to imagine.
Specific Screening Criteria
Here's how the screen was created:
- Relative Sales Growth
We start by requiring that a company's year-to-year sales growth be more than 50 percent
above the industry average in the latest reported quarter, and over the Trailing Twelve
Month (TTM) period. It's tempting to add a similar test for a longer span (i.e. three years),
but that would systematically eliminate many new-economy companies that haven't been
around that long. And for a momentum screen offered at this juncture, that would be an
undesirable outcome. We aren't going to be perfect, since some interesting companies are
less than 52 weeks old, but we should still try to capture as many companies as we
plausibly can.
- Relative Share Price Performance
We require that a company's percentage change in share price be greater than zero over
the past four weeks and the past 52 weeks. We also require that each company's share
price be more than 50 percent above its industry average over the four- and 52-week
periods. Reference to a four-week interval is designed to locate stocks that are hot right
now. By also looking at the 52-week span, we reduce the likelihood that the current strength
is a fluke.
- PEG (Price/Earnings-to-Growth) Ratio
The P/E ratio used here is the one we get when we divide the share price by the consensus
estimate of EPS in the next fiscal year. The growth rate is the consensus EPS annual rate
for the coming three to five years. The screen requires a PEG ratio above 1.00. Value
investors want stocks whose PEG ratios are below 1.00. A ratio above 1.00 is indicative of
an issue that appeals to momentum investors.
- EPS Estimate Revisions
The screen requires that the consensus estimate now in place for the current fiscal year be
no lower than it was eight weeks ago. Downward revisions--which is what we're
eliminating--tend to dampen momentum-based appeal.
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Rising Expectations run it
There are many things you could look at when evaluating a stock. And chances are that the
company scored well on all, or at least a sufficient number, of these considerations if brokerage
house analysts are raising estimates to try to catch up to companies that habitually outperform
consensus expectations.
Rationale for this screen
Nowadays, companies and analysts communicate very closely and analysts are routinely
expected to present earnings-per-share estimates that prove accurate down to the penny. In this
climate, any earnings report that tops consensus expectations has the potential to be a market-
moving event. (Conversely, unfavorable surprises can put quick and powerful downward pressure
on stock prices).
To understand the dynamics underlying earnings surprise and share prices, it's necessary to
review the development of corporate "investor relations." Strictly speaking, companies aren't
required to have investor relations (i.e. company/analyst communications). Any NYSE, AMEX or
NASDQ company would be well within its rights to do nothing more than file required documents
such as the proxy statement, the annual 10-K report, quarterly 10-Q reports, and hold annual
(and, where warranted by events, special) shareholder meetings. And a generation ago, many
companies, including some that were large and well known, did little more than that. So among
the older generation of investors, earnings tallies that fell within 10 to 15 percent of analyst
estimates were considered to be within a reasonable range of "estimate error."
As the bull markets of the Eighties and Nineties progressed, institutional investors became more
prominent in the equity markets and Wall Street research organizations grew in order to serve
this increasingly powerful customer group. As increasingly sophisticated analysts spent more and
more time communicating with increasingly talented IR professionals, it became harder and
harder for companies to avoid discussing earnings estimates. And as companies participated
more closely in the process of creating estimates, analysts became increasingly demanding
about the information they desired and confident in the conclusions they drew. Estimates that
were once "rounded" to the nearest nickel or dime are now set to the exact penny. Hence an
analyst who, twenty years ago, would have been satisfied to estimate quarterly EPS within a 15
percent margin of error now expects to forecast the number to the penny.
In light of the historical development of IR, consider the changed meaning of an earnings report
that falls shy of expectations. What might you think if you were the disappointed analyst who
expected EPS of $0.50 only to be confronted with an actual number of $0.46? Twenty years ago,
you might have thought: "I missed by only eight percent. That's pretty good considering the lack
of help I received from management." Nowadays, you may think: "I spent an hour with the CEO
and CFO, and then two more hours with the IR Vice President. I started out looking for $0.48, but
they kept talking about a $0.50-$0.53 consensus range, saying they were comfortable with it. So
what went wrong? Do they have a proper handle on their markets? Are their internal controls
functioning properly? If they were wrong about this quarter, what does that say about the next
period... and the full year estimate... and next year's estimate?"
Consider what this implies. Years ago, when companies didn't do much to guide analysts,
earnings surprises meant that the analyst was wrong. But nowadays, earnings surprises have
increasingly come to mean that corporate management is wrong. And in the financial markets,
few things are as bearish as a belief, among investors, that top management does not have a firm
grasp on its own business.
In theory, the same set of reactions should occur when surprises are favorable. If one questions
management's grasp of its own business when it reports $0.46 a share instead of the expected
$0.50, couldn't one be equally concerned if the company reports $0.54? Reasoning further,
shouldn't the stock likewise fall in response to the favorable earnings surprise? But in fact, this
doesn't happen. That's because the issue of company error exists along side with a long-standing
tendency on the part of Wall Street to "extrapolate" the latest trend; to assume that the most
recently reported trend will persist indefinitely.
When corporations report negative earnings surprises, the tendency to extrapolate the weakness
into the future aggravates the perception of company error and sparks a sell-off in the stock.
When the surprise is favorable, euphoric reaction to the traditional perception that good news will
persist indefinitely wins out over concerns about company error. This is not a logical balance.
Nevertheless, it is the modern stock market culture.
In fact, one can argue that little of this is truly rational. But for better or worse, these dynamics do
move stocks. Accordingly, study of earnings surprises and estimate revisions can be very helpful
to investors.
Specific Screening Criteria
Here's how the screen was created:
- Earnings Surprise
We begin looking for stocks by choosing companies that reported favorable earnings
surprises in the most recent quarter, and in each of the three prior quarters.
- Supporting Tests
Data screening contains elements of art as well as science. We can start, for example, with
an assumption that positive earnings surprises portend good things for a stock. But suppose
an announcement of surprisingly strong corporate earnings is accompanied by a warning
that prospects for the next few quarters seem dim. That's likely to hurt the stock. Hence, we
must support our basic earnings surprise data with additional tests that aim at investor
behavior. In other words, if an earnings surprise in the latest quarter is truly a harbinger of
good things to come, there are some things we would expect to see happen within the
investment community.
- The current-year consensus estimate must be above where it stood four weeks ago,
and the four-week-ago estimate must be above the eight-week-ago estimate. Analysts
wouldn't be raising their estimates if the trend of recent EPS strength is about to end.
- Institutions must be buying more shares than they are selling and this level of net buying
must be above where it was a quarter ago. This suggests that portfolio managers also
expect the company to continue performing well in the future.
- Over the past four weeks, the stock must have outperformed those of other companies
in the same industry. Analysts usually focus on a particular industry and when they turn
bullish, they are often doing so based on industry trends. Even so, analysts and money
managers tend to have lists of favorite stocks within particular industries. This price
performance test is designed to help tune into those lists.
- The current-year consensus estimate must be above where it stood four weeks ago,
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Sales Growth Leaders run it
Whatever our individual investment philosophies, we all know that ultimately, stock prices are tied
to company bottom line performances. And the most fundamental way for a company to generate
a healthy bottom line is to flourish on the top line.
Rationale for this screen
Everybody likes to invest in companies whose EPS are growing quickly. But in seeking growth,
investors sometimes get so caught up in looking at EPS trends that they don't always dig deeper
to see where the strong profits are coming from.
Essentially, there are two ways to generate earnings growth. A company can boost sales. Or, a
company can do things that lead to wider margins.
Margins are certainly important, and our Operating Margin screen addresses this theme in great
detail. But this isn't necessarily the best way to generate growth over the long term. Companies
can cut costs for a while. But they can't do it forever.
Sooner or later, even the best managed companies run out of opportunities to improve margins.
Hence long-term growth will depend on a company's ability to generate more sales.
Specific Screening Criteria
Here's how the screen was created:
- Year-to-year comparisons
We start with the comparison examined most frequently by investors: the year-to-year
comparison in the latest quarter. We look at the latest quarter and require that the Sales
change be greater than zero, and that each company's sales growth be greater than its
industry average. We then extend the industry comparison to the Trailing Twelve Month
(TTM) interval.
- Longer-term Comparison
Usually, sales growth is based on healthy demand for the company's goods or services
and/or sufficient market power to raise prices. But sometimes, the top line can get a boost
from factors that are less impressive, such as acquisitions. Therefore, we seek some
indication that a company's sales prowess amounts to something more than a one-shot
boost. We require that sales growth be above the industry average over the latest three
years.
- Supporting Tests
Having already narrowed the database down quite a bit using basic sales-related tests, we
go the final distance by shifting to other indicators consistent with investment merit. We
require a showing that at least some of the top-line strength translate to EPS, through a test
requiring that company EPS growth exceed the industry average in the TTM period, the last
three years or the last five years. We also require that the consensus estimate for the
current fiscal quarter be higher than where it was thirteen weeks ago. Finally, we add a test
requiring that recent insider stock purchase transactions (net of sales) be greater than zero.
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Contrarian Opportunities run it
Many investors like to buy stocks that are going up. And momentum players have made a lot of
money doing this. But they've also lost a lot at times, and missed other opportunities. Sometimes,
you simply have to focus on good companies and not worry if the stock has, in the short term,
been moving the wrong way.
Rationale for this screen
From an emotional standpoint, it's scary to buy a stock whose price recently plunged or may still
be in the process of falling. After all, we buy stocks because we want them to go up.
From a gut perspective, momentum investing--buying stocks because a stock's EPS and/or
share price is rising--makes the most sense. And there's more here than good feelings. Over the
years, plenty of investors have made a lot of money through momentum investing, in spite of the
fact that theoretically, it's always been questionable and can be referred to as the greater fool
theory (it's OK to overpay for a stock today if you can find a bigger fool to overpay even more in
the future).
But stock market activity in late 2000 and early 2001 reminds us that momentum investing is,
indeed, dangerous. It also reminds us that there's virtue to the opposite end of the spectrum,
contrarian investing. The latter is based on the idea that you want to buy low and sell high and
that in order to do this, you have to be willing to buy (or at least hold) when the stock is out of
favor (which causes the price to be low).
The major objection to contrarian investing is the "dead money" argument. This approach
acknowledges that downtrodden companies often have excellent long-term prospects, but
suggests that there's no point in being early. Instead of leaving dead money in depressed longer-
term plays, you're better off focusing on stocks that are performing better and leaving the long-
term plays on a watch list; go into these companies later on, when it's clearer that improvement is
nigh.
The dead money theory sounds pretty compelling on paper. And like momentum, it also worked
in the real world for a long time. But times are changing. We've seen that stocks make
increasingly large and rapid moves, up or down, in response to news. Today, we can see, what
was once regarded as an entire market cycle's worth of share price movement in a matter of
minutes.
This requires us to view contrarian investing in a new light. The momentum and dead money
theories assume that the market presents investors with a reasonable number of entry and exit
points for an individual stock. But that's happening less and less. If I see a company now, and I
like its long-term prospects and hate the short-term scenario, I have only two practical choices. I
can get in now and wait. Or I can cross the stock off my list because any development that would
cause me to reassess the situation will instantaneously drive the stock high enough to wipe out
the benefits of the long-term potential I see now.
Today, contrarian investors are those who are willing to be patient. This is different from an
automatic pursuit of bad news. The idea behind the contrarian approach presented here is to
invest in good companies whose shares have been hit by short-term adversity. That's why most
of this screen's tests are geared toward ferreting out companies with demonstrated track records
of long-term strength in a variety of areas. When you examine this screen's companies on a
case-by-case basis (as should be done with any screen), identify the problem that caused the
stock to fall. Ask yourself if it is indicative of structural problems that will be long-lasting, or if it
reflects the kind of bumps in the road that hit even the best of companies from time to time.
Specific Screening Criteria
Here's how the screen was created:
- The Stock Price
Consistent with the overall theme of this screen, we start by seeking poorly-performing
stocks. The screen requires the share price, over the past four weeks, to have suffered a
decline of more than 15 percent and to have performed worse than the industry average
share price percent change. Often, stocks will meet these tests because of an unfavorable
earnings surprise, but we do not explicitly build surprise into this screen. That means that for
these companies, the weak share price performance could also have been caused by an
earnings-related pre-announcement that is not sufficiently detailed to show up in the
database as a surprise, an analyst rating downgrade in anticipation of unfavorable
developments, market pessimism due to bad news at another similar company, etc.
- Good-Company Tests
These are designed to find firms that can justifiably lay claim to the label "good company."
We address this by insisting that companies outperform industry peers on a variety of
measures over prolonged time periods. Notice that we don't focus on the latest quarter or
Trailing Twelve Month (TTM) period. This screen prefers to look at the big picture, and
tolerates recent mishaps. We don't assume that good things always happen to good
companies and bad things only happen to bad companies. The screen is built upon the
notion that over short time periods, bad things can happen to even the best of companies,
and that investment opportunities come from the market's frequent failure to differentiate
between good and bad companies and thereby excessively punish shares of better
concerns.
- EPS Growth:
EPS must be above the industry average over the past five- and three- year periods.
- Operating Margin:
The five-year average operating margin must be above the industry average.
- Return On Investment:
The five-year average return on investment must be above the industry average. This is
our preferred measure of management effectiveness in that it measures the ability of a
company to effectively utilize its capital without addressing how that capital is allocated
between long-term debt and equity.
- Return On Equity:
Debt capital is generally riskier than equity. Companies willing to work with borrowed
money, other people's money, can boost the amount they earn on whatever the
shareholders have put into the business. This screen is willing to tolerate this sort of
"leveraging up" so long as companies execute the strategy well. Hence there's a
requirement that in addition to the return on investment test, five-year average return on
equity must be above the industry average.
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Favored Value Plays run it
Many investors believe that the only good values out there are to be found among stocks Wall
Street rejects or ignores. That's not so. This screen helps you find reasonable value plays that
are well regarded by the investment community.
Rationale for this screen
From an ivory tower standpoint, "value" is the only legitimate investing style. After all, how could
any rational person buy a stock that is priced above its objective worth?
In the real world, though, life isn't nearly so simple. The factors that we need in order to calculate
intrinsic value are so inherently uncertain as to seem doomed to futility. As a result, Wall Street
culture evolved in a variety of directions. One is a focus on growth, especially short-term growth
prospects. This approach figures very heavily in the recommendations analysts make. The other
involves seeing value as a quest for dogs; very low stock valuation metrics for shares of troubled
companies.
It doesn't have to be this way. Despite the practical difficulties inherent in assessing intrinsic
value, there's plenty of room for proper consideration of valuation metrics for shares of good
companies, stocks that analysts favor. This screen seeks these kinds of stocks.
Specific Screening Criteria
Here's how the screen was created:
- Basic Metrics
We establish the presence of reasonable valuation by requiring that each stock's Trailing
Twelve Month (TTM) P/E ratio to be less than the industry average, and each Price/Sales
ratio to be less than or equal to the industry average. We then require that the forward
looking PEG ratio (the P/E calculated with reference to the consensus EPS estimate for the
next fiscal divided by the consensus long-term projected EPS growth rate) to be no higher
than 2.00. Many investors believe that PEG ratios should be no higher than 1.00. Such
levels would, indeed, constitute very attractive valuation, and another one of our screens
(Growth At A Reasonable Price) is based upon that theme. But in truth, the 1.00 PEG ratio
owes more to folklore than the mathematics of stock valuation (which computes theoretical
P/Es not just on the basis of growth rates but also with reference to interest rates, stock
price volatility and dividend payout ratios).
- In Favor
To measure analyst sentiment, we use the average recommendation score. The average
rating is calculated as follows: A Buy gets a score of 1.00. Outperform ratings get 2.00
points. Hold, Underperform, and Sell get 3.00, 4.00 and 5.00 points respectively. Then, we
compute a weighted average of all the scores. Suppose a stock has three Outperform and
three Buy ratings. It gets three points for the Buys (1.00 times three) and six points for the
Outperforms (2.00 times three). The total of nine is divided by the total number of ratings
(six consisting of three Buys plus three Outperforms) to produce an Average Rating of 1.50.
If we add four Hold recommendations to the mix, that adds another 12 points, bringing the
overall total to 21. The Average Rating would be 2.10 (21 divided by 10 ratings). The screen
requires that this score be less than 2.00 and that it be less than or equal to where it stood
four weeks ago. We also require an increase, within the past four weeks, in the consensus
EPS estimate for the current quarter.
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Growth At A Reasonable Price (GARP) run it
Investors who want to buy shares of rapidly growing companies often find it necessary to accept
steep P/E multiples. Other investors who are determined to purchase only reasonably-priced
stocks often find themselves looking at relatively unexciting companies. Growth at a Reasonable
Price (GARP) is an approach that reconciles both dilemmas.
Rationale for this screen
The "value" and "growth" approaches to investing are sometimes seen as being at the opposite
ends of a spectrum. At one end, we find the stereotypical value investor, who will buy any shares
that are priced inexpensively, even if the company's growth prospects are poor. At the other
extreme, we see growth investors who will buy shares of companies that are growing rapidly
without regard to how high a P/E multiple the shares might already command.
Growth At a Reasonable Price (GARP) reconciles the two approaches. It provides a framework
for value investors who don't want to miss out on today's most promising growth opportunities.
And it affords the growth-oriented investor a tool to help determine when a high P/E becomes too
high. GARP is based on the principle that any P/E ratio is reasonable if it is equal to or less than
the company's annual rate of earnings growth. In other words, one should be willing to accept a
P/E multiple of up to 25 if the company's earnings are growing at an annual rate of at least 25
percent.
Specific Screening Criteria
Here's how the screen was created:
- Growth
We require that consensus projections of five-year EPS growth be at least 20 percent. Also,
earnings growth in recent years must have been stronger than the average for the industry.
We also require that the growth trend show some degree of acceleration by requiring that
EPS over the past three years grew more rapidly than was the case over the past five years.
- Quality of Growth
Since companies can boost growth rates by taking on more risk, we check profitability ratios
to see if management is taking on too much risk by unduly "leveraging up." The test we use
is a requirement that the five-year average return on equity be no more than 20 percent
above the five-year return on investment. To accommodate the fact that some businesses
typically call for more debt than others, we allow a company to exceed that 20 percent
threshold if the ratio of its five-year return on equity to five-year return on investment is no
greater than the comparable ratio for the industry in which it operates. We also seek
companies whose tax rates are at least 25 percent.
- Stock Valuation
We check to see that P/E is no higher than the rate of earnings growth. We do this two
ways. First, we refer to the company's existing track record by comparing a P/E calculation
based on EPS over the Trailing Twelve Months (TTM) with EPS growth achieved over the
past three years. Next, we compare a P/E calculation based on consensus estimates of next
year's EPS with the projected five-year rate of EPS growth.
- Depressed Equities
Value investors often find many troubled companies coming to their attention because the
low multiples they seek are often low for good reason: poor company prospects. This screen
checks to see that each stock has demonstrated at least a respectable degree of market
performance in the recent past. We do this by requiring that the share price be above where
it was four weeks ago, or at least that the stock has performed better than its industry
average over the past four weeks. The idea is to either find companies that are performing
well, or turnaround situations that are actually starting to unfold and be reflected in stock
prices.
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Income Stocks run it
Dividends, the mainstay of stock valuation, were out of fashion for a long time, but they are
coming back into favor now. But that doesn't mean all income stocks are created equally. This
screen targets some of the better opportunities in this group.
Rationale for this screen
Dividends came back into vogue in a big way in late 2002 and early 2003. To some extent, this
reflected a quest for perceived safe havens during the darkest days of a multi-year bear market,
the idea being that as stocks fell, yields would rise so high as to attract new buyers, therefore
cushioning against future declines. Another catalyst is talk of eliminating or scaling back
unfavorable tax treatment accorded to dividends. (The same money is taxed twice; once as
income to the corporation, and a second time as income to the individual shareholder.)
Both of the factors referred to above are valid reasons why income stocks merit attention
(although the first argument would lose steam if company fundamentals are deteriorating to the
point where the directors may find it necessary to reduce or eliminate the dividend). But there's
more to the story than that.
Decisions to pay dividends and retain profits for reinvestment are crucial capital allocation
decisions made by the corporation. And when push comes to shove, wise capital allocation may
well be the premier yardstick for measuring management effectiveness.
During the 1980s and 1990s, we were in what one might refer to as an era of "financial
machismo," when it seemed that just about every company out there saw itself as a super-growth
vehicle. That led to low dividend payout ratios, as firms retained the lion's share of profits to
reinvest in growth ventures. (The double-taxation issue was often cited as justification for high
profit retention, but you could easily argue that this was a rationalization for a decision that would
have been the same regardless of tax considerations.)
In truth, many companies are mature, and don't have nearly the growth opportunities they and the
investment community at large thought they did. There's nothing wrong with this. Humans cease
to grow vigorously when they reach adulthood, yet that period is the main portion of their lifecycle.
Companies can be productive and valuable even if they don't grow as rapidly as they did in their
formative years. But the financial machismo era blinded many investors to such considerations.
Then, after the tech bubble burst starting in 2000, the investment community took notice of the
spate of write-offs. Much of the rhetoric centered on efforts to distract investors from those
charges by focusing them on pro forma earnings and the like. But another, perhaps bigger,
aspect of the story is the extent to which the write-offs reveal the shortcomings of financial
machismo. One cannot help but think about the corporate events leading to the write-offs (failed
ventures, misguided acquisitions) and wonder how much stronger many companies, and the
economy itself, would be had that capital been returned to shareholders as dividends instead of
being squandered on futile efforts to show more growth than was really feasible.
In screening for income stocks, we obviously seek yield. But we also seek companies that are
less tied to the financial machismo culture. In other words, we're looking for companies that have
realistic notions of how much they can grow, how much capital they can productively reinvest in
the business, and how much capital they should pay to shareholders. A 2002 study by Reuters of
such companies demonstrates that over the long haul, their shares have fared better than many
realized at the time.
Specific Screening Criteria
Here's how the screen was created:
- Minimum Yield
We start with a requirement that the stocks have current yields of at least two percent.
- Dividend Growth
Dividend growth (a different sort of growth from the financial machismo growth culture
discussed above) is a key element of an income investment. The fact that dividends grow
over time is why investors are usually willing to accept current yields below prevailing rates
on fixed income securities. This screen requires that over the past three years, the dividend
growth rate was above zero and at least ten percent higher than the industry average
dividend growth rate.
- Payout Ratio
Addressing payout ratio (the percent of net income paid to shareholders as dividends)
requires a balancing act. On the one hand, we want the ratio to be high; we want capital
allocation decisions that have, at the very least, a healthy respect for the benefits of
distributing income to shareholders. On the other hand, we don't want payout ratios to be so
high as to threaten the ability of the company to properly run the business. This screen
addresses the balance by requiring Trailing Twelve Month (TTM) company payout ratios to
be no greater than 25 percent above the industry average ratio.
- Dividend Safety
Unlike payments on bonds, maintenance of the dividend is not legally required. So we need
to consider tests that reduce the odds we'll wind up with companies that find it necessary or
desirable to reduce or eliminate their dividends.
- We require that over the past five years, the rate of capital spending growth was greater
than zero and no less than 90 percent of the industry average. Companies that have
spent in the past are less likely to have pent-up needs that might, in the future, reduce
the company's dividend-paying capacity.
- Perhaps the ultimate warning about the future of dividends comes in the form of a yield
that's too high. The market may not be as efficient as academicians often claim, but it's
not stupid either. Often, a yield climbs too far when investors fear that the payout will be
reduced or eliminated. We screen out such situations with a test requiring that today's
relative yield (company yield divided by industry yield) be no more than ten percent
above the five-year average relative yield.
- We require that over the past five years, the rate of capital spending growth was greater
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Relative Value run it
Traditionally, value investors want to buy stocks with valuation ratios, such as P/E or Price-to-
Sales, below a certain level. One way to select appropriate thresholds is to compare individual
stocks to relevant benchmarks.
Rationale for this screen
At first glance, value investing seems easy. All you need do is select stocks with low P/E ratios
(or Price-to-Sales ratios, Price-to-Book Value ratios, etc.). But in fact, value investing presents
some serious challenges.
The first issue a value investor confronts is how to establish an appropriate threshold for P/E or
any other ratio he might want to use. At one time, it was assumed that it was a good idea to look
for stocks with P/E ratios of 8.00 or less. Try following that approach today!
In theory, you could simply raise the target from 8.00, to 15.00, or 20.00, or whatever number
seems reasonable in light of current market conditions. But the more you think about it, the less
comfortable you're likely to be. After all, regardless of market environment, you don't want to
simply pull numbers out of a hat. To feel confident about investment decisions, you need to
understand why your criteria are reasonable.
GARP (Growth At A Reasonable Price) investors solve this dilemma by using P/E thresholds that
are based on rates of EPS growth. A P/E that's higher than the growth rate signifies a richly
valued stock. A P/E that's less than the growth rate means the stock is undervalued. This is a
very reasonable method, but it's not the only option for value investors.
Like most stock-selection criteria, GARP is a general guide that serves to spotlight issues, rather
than give hard-and-fast answers. In other words, there may be reasons why a value investor
might accept a P/E of 30.00 for a company whose EPS are projected to grow at a 25 percent
annual rate. One justification might be an expectation that the 25 percent growth forecast is too
low. Another might be that shares of similar companies have P/E multiples ranging from, say,
35.00 to 45.00. The latter situation is the focus of this screen.
Relative value assumes the marketplace sets prices in such a way that similar assets have
similar valuations. It assumes that anomalies will eventually be corrected by a decline in the price
of an excessively valued asset, or a rise in the price of an undervalued asset.
Intellectually, you could throw some darts here and, perhaps, say that the 30.00 P/E is the only
correct one and that the shares of all other companies will move lower. But day-to-day experience
teaches that the tail doesn't usually wag the dog. What often happens is that isolated cases move
toward the crowd. So if you see a P/E of 30.00 and a peer group average P/E of 45.00, you can
reasonably assume the 30.00 P/E will move toward the peer group average.
This leads us to the other major issue value investors must face. A generation or so ago, one
might have said that a stock has a low P/E ratio because many people don't realize how good the
company is. But we're now living in an information revolution. Today, you can still find stocks that
are undervalued because of neglect, but you have to search much harder than in the past. With
so many investors knowing so much about so many companies, many stocks have low valuations
because their prospects are poor.
Analytically, your task is to look at a seemingly undervalued company to see if you can identify
some fundamental reason to explain why those other companies whose shares command higher
P/Es aren't really as similar as you first assumed. If your company is better than the group, you
can be bullish on its stock. If your company has some particular problem not shared by the
others, you may want to avoid the stock. This is the way you should look at stocks appearing on a
relative value screen.
Specific Screening Criteria
Here's how the screen was created:
- Valuation Ratios
We start by examining some basic valuation ratios and comparing companies with their
respective industry averages. A rigid approach would simply require that the ratios be equal
to or less than the industry averages. But we're going to be a bit flexible, since we want to
be sensitive to the fact that superior companies tend to command higher valuations.
- We examine Trailing Twelve Month (TTM) ratios for Price-to-Earnings, Price-to-Sales,
and Price-to-Free Cash Flow, and in each case, we require that the stock's ratios be no
more than 10 percent above the industry average.
- We also require that the P/E-to-Growth (PEG) ratio be at or below 2.00. That's higher
than would be allowed under the Growth At A Reasonable Price method, but this screen
will allow a PEG ratio to reach 2.00 if it's a favored industry normally characterized by
high multiples.
- We examine Trailing Twelve Month (TTM) ratios for Price-to-Earnings, Price-to-Sales,
- Strong Companies
The following tests are designed to filter out situations in which low stock valuation reflects
lackluster company prospects. In fact, it leans a bit in the other direction by actively seeking
strong companies.
- The screen requires that EPS growth rates for the latest twelve month period and for the
past three years be at least 25 percent better than the industry average growth rates
over those same periods.
- The above tests go a long way toward favoring good companies, but they aren't perfect.
We must remain sensitive to the possibility that a company with strong historical
performance may soon take a turn for the worse. We examine this by comparing
company share price performance (over the past four weeks) to the average
performance of other shares in the same industry. It's unlikely that companies will meet
this test if investors see trouble looming on the horizon. Note that we don't require the
stock to have appreciated in the past four weeks; we only require performance that's
above the industry average. Hence this test will tell us what we want to know, in the
context of this screen, even during periods of market weakness.
- The screen requires that EPS growth rates for the latest twelve month period and for the
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Fastest Turnover run it
All else being equal, the higher the margins, the better the company. But all else is rarely equal.
Turnover can help you uncover attractive companies others might brush aside because of low
margins.
Rationale for this screen
It seems as if everybody nowadays looks closely at profit margins. There's nothing wrong with
this. Margins tell you how many cents out of each sales dollar are left as profit after subtracting all
expenses. Higher is better. It's an easy concept to understand and it's an easy concept to like.
But there's more to life than margins. There are big-ticket products that sell infrequently, but when
these sales occur, they often fetch big profit margins. At the other end of the spectrum, there are
low-ticket items, such as groceries, that net the seller only a few pennies per dollar as profit but
are sold so frequently as to make for a very lucrative business. Turnover is a method of
measuring the frequency of transactions.
As an investor, you want to consider turnover because it's a useful gauge of fundamental
strength. But better still, turnover can help you spot good companies that are being neglected by
other investors. Nowadays, many investors fully understand the importance of healthy margins.
But turnover gets far less attention. And in the investment world, undue neglect creates
interesting opportunities.
There are several different kinds of turnover:
- Receivable Turnover
Accounts Receivables represent money customers owe you for goods already sold or
services already rendered. Assuming your customers or clients pay their bills when due, you
will eventually collect all of these Receivables. Receivables turnover measures how quickly
you receive that money. We calculate the ratio as Trailing Twelve Month (TTM) revenues
divided by average receivables.
- Suppose you sold $100 million worth of goods or services in the past 12 months.
Suppose too, that on average, your Accounts Receivables over that span stood at $20
million. Your Receivables Turnover ratio would be 5.00.
- Now suppose you hire an efficiency dynamo to lean on your customers and get them to
pay more quickly. You may find yourself with fewer outstanding Accounts Receivable,
say $10 million on average. Now, your Receivables Turnover ratio would jump to 10.00
($100 million in revenues divided by an average Receivables balance of $10 million.)
You're better off because money that is owed to you spends more time in your hands
than in the hands of your customers. So all else being equal, higher turnover is better
than lower turnover.
- Suppose you sold $100 million worth of goods or services in the past 12 months.
- Inventory Turnover
This tells you how fast you sell the products you hold in inventory. (It is calculated as TTM
Cost Of Revenues divided by average inventory). You spend money to build/buy inventory.
This may involve purchasing raw materials for your factories to use in order to create
finished products. Or you may buy merchandise from a wholesale distributor that you'll
eventually sell through your retailing operation. Either way, you're out the money you spent
while you're holding onto the goods. So you want to move your inventory as quickly as
possible to get the products into the hands of paying customers. So, as with Receivables, all
things being equal, higher levels of Inventory Turnover are better than lower levels of
Inventory Turnover. At the very least, holding inventory can cost you money (you may have
to pay interest on money you might have borrowed to tide you over until you can receive
proceeds from the sale of your inventory). Analysts often view deterioration in inventory
turnover as a sign that the company's future looks dim. For a struggling company, one that
has trouble getting trade credit, excess inventory can threaten corporate viability.
- Asset Turnover
This can be a difficult concept to grasp. It is calculated as Revenues divided by Average
Assets. But the definition of assets is somewhat "conceptual." Assets are the sum total of
what you paid for everything you own, minus depreciation charges. We could nit-pick the
definitions. But it will be easier for you to grasp asset turnover if you think of it this way: You
have a certain amount of your money, say $25 million, tied up in a business (let's assume
you have no long-term debt and your plant and equipment are all new). If your annual
revenues amount to $100 million, your investment has been returned, in the form of revenue
from customers, four times over the course of the year ($100 million divided by $25 million).
Your asset turnover would, then, be 4.00. Again, higher turnover is better than lower
turnover, all else being equal.
quickly. High Receivables Turnover means your customers are paying their bills more quickly.
High Inventory means your customers are buying goods more quickly. High Asset Turnover
means you're getting money from your business investment more quickly.
If you have a choice of two business opportunities, is there ever a reason why you'd want to go
into a business that pays you more slowly? Of course! You may accept lower turnover if the
business compensates by offering higher margins. The reverse is also true. Higher turnover can
make it worthwhile for you to accept lower margins.
Specific Screening Criteria
Here's how the screen was created:
- Turnover Data
We require that companies exceed their respective industry averages by more than 25
percent in terms of Trailing Twelve Months (TTM) Receivables Turnover, TTM Inventory
Turnover, and TTM Asset Turnover. When looking at turnover, it's very important to
compare an individual company to its industry average. Otherwise, the screen would
systematically exclude companies in industries that are normally characterized by high
margins and low turnover. By using industry comparisons, we see turnover as an indicator
of superior corporate efficiency within an industry, as opposed to a judgment on the financial
profile inherent to a given industry.
- Supporting Criteria
We've often said that screening is not just a science, but also an art. There are countless
ways in which atypical events can produce numbers that don't truly depict a company's
underlying fundamentals. So we use what we refer to as supporting criteria (screening tests
that relate indirectly, if at all, to the main focus of the screen) that help point us toward
companies that met the main test(s) because of legitimate fundamental strength, as
opposed to statistical aberrations. This screen uses two supporting criteria:
- Return On Investment:
All else being equal, companies with above-average turnover tend to have above-
average returns on investment. This screen requires that each company's five-year
average Return on Investment be above the five-year average Return on Investment for
its industry.
- Earnings Expectations:
Whatever fundamental themes we pursue, it's always useful to remember that EPS
trends are important determinants of share price performance. The second supporting
criterion for this screen is a requirement that the present day consensus EPS estimate
for the current fiscal year be equal to or above where that estimate stood eight weeks
ago. We could arguably have used a more rigid EPS test, one that measures growth as
opposed to revision. But our decision to look instead toward revision is based on a
desire to stay within the broad fundamental theme of the screen. A focus on turnover is
not really aimed at momentum investors (we have other screens based on that
approach) but instead at those who are more willing to be patient with "good
companies," even if the stocks aren't presently hot. So rather than tilt the screen toward
hot stocks, we decided to use the last supporting test to tilt the screen away from
companies most likely to be cold (those that have been hit by negative estimate
revisions).
- Return On Investment:
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Industry Leaders run it
What's a good profit margin? How much debt is too much? How high a growth rate should you
expect? Often, the best way to answer such questions is to compare an individual company to
others in the same industry.
Rationale for this screen
Working with data can become easy, fun, and powerful if you understand the following: (1) Data
items are most powerful when compared to other data items. (2) Data items are rarely useful
when viewed in isolation. (3) The key to sound fundamental analysis involves deciding what
comparisons to examine.
Consider net profit margin (the percentage of each sales dollar left as profit after subtracting all
expenses). Suppose you see that ABC Corp. had a net profit margin of 8.00 percent in the
Trailing Twelve Month (TTM) period. Is that good?
Let's go further. Suppose you also learn the average net margin of companies in the same
industry as ABC Corp. was 6 percent. Now a picture of ABC is starting to emerge.
We still don't know if an 8.00 percent profit margin is good. But we're losing interest in the
question. It can be much more productive to ask how ABC's net margin stacks up against its
industry average. It would also be interesting to ask how ABC's TTM margin compared with its
five-year average margin.
The bottom line is that we learn nothing about ABC when we are told its net margin is 8.00
percent. To make the data useful, we need to compare it to one or more other data items. We've
already seen that we can learn useful things if we compare the number to an industry average
and/or ABC's own five-year average.
This is not, by any means, a scientific process. Often, you'll see companies that exceed some
benchmarks but fall shy of others. Some companies will barely exceed benchmarks while others
will outperform them by wide margins. So there's lots of room for debate as to which benchmarks
will be used and how strict the comparisons should be. But when you analyze companies, you
can't get the right answer unless you're asking the right questions. And comparative analysis will
often steer you toward some of the most important questions you can ask.
When you do comparative analysis, break the task into two components. One is a cross
comparison that measures data items against external benchmarks. The ratios report found in our
Stocks section presents three important benchmarks you can use here: the industry average, the
sector average, and the S&P 500. The other component is a time series comparison that
measures current data items against past performance. The most common time series
comparison matches the TTM data item with a five-year average. For growth rates, it's also useful
to compare data items for the Most Recent Quarter (MRQ) with the TTM figures.
This screen is a cross comparison focusing on company-to-industry match-ups.
Specific Screening Criteria
Here's how the screen was created:
- The Stock
Over the past four weeks, the company's share price must have performed at least 10
percent better than the average achieved by other stocks in its industry. Also, the TTM P/E
multiple must come in no higher than 10 percent above the industry average. When creating
a screen like this, it's tempting to search for P/Es that are below the benchmark. But if we
want companies that exceed benchmarks in a variety of ways, we are probably best off
accepting the fact that shares of good companies will probably command premium P/E
ratios.
- Growth
We require that Sales and EPS growth over the past five years each exceed industry
average figures by at least 10 percent. In one departure from the screen's cross-comparison
structure, we also seek companies whose EPS growth over the past five years exceeded its
five-year rate of Sales growth.
- Profitability
The net profit margin over the past 12 months must be at least 10 percent greater than the
industry average net profit margin.
- Debt
Comparative analysis is especially important when looking at balance sheets. Some
industries are normally more debt-oriented than others (try to find a bank that has no debt).
If you automatically eliminate all companies with "high" debt, you may wind up missing some
very attractive investment opportunities. This screen requires the total debt to equity ratio in
the latest quarter to be below the industry average ratio.
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Return On Investment run it
Momentum, which means buying what's hot, plays a big role in today's stock market. But we've
all heard the virtues of investing for the long-term. Even so, it's hard to invest when you suspect
your new stock may not blast off overnight. You can use Return on Investment as an important
indicator to determine whether or not a particular company merits patience.
Rationale for this screen
Imagine you're looking at what you believe to be a very interesting company, say a micro-cap in a
seemingly mundane business. Perhaps there's intriguing growth, such as a series of acquisitions
within what is now a highly fragmented market. The PEG ratio is extremely low. But you see
some baggage. Perhaps the company has some exposure to higher interest rates and/or a
slowdown in the pace of economic activity. In sum, perhaps it's a case of a nice company with
questionable timing.
What should you do about such firms? If you're an active trader, the answer is easy: pass them
by and come back when the timing is right, assuming you can confidently determine when that
will occur. But while the media shines its spotlight on day-trading, the fact remains that there are
still many fundamental investors out there who are willing to invest in companies they deem
attractive and hold the securities for a number of months or years.
It's unlikely that anyone would ever buy shares if they actually expect the price to decline, even if
for only a short time. But predicting things like this isn't so easy. Are interest rates really going to
trend upward over a long period, or will they stay in a more-or-less horizontal trading range? Are
we really going to have a recession in the foreseeable future, or will occasional periods of slower
growth continue to prove sufficient in preventing excesses from building in the economy. In other
words, might the interesting new stock you found settle into a better opportunity to buy later at a
lower price? More importantly, can you really predict such things?
If you are a long-term fundamental investor, and you believe you found a good company but are
uncertain about the timing, you may be best off ignoring the question. In other words, buy the
stock and don't worry if it falls in price. You would have good company if you were to do that. In
"The Warren Buffett Way" by Robert G. Hagstrom, Jr., on page 54, the author described Mr.
Buffett's view of this dilemma as follows:
When Buffett purchased Wells Fargo, the stock price had declined 50 percent from its high.
Even though Buffett had purchased some shares of Wells Fargo at higher prices, Buffett
welcomed the decline in price as a means of purchasing the shares at cheaper prices.
According to Buffett, if you expect to continue to purchase stocks throughout your life, you
should welcome price declines as a way to add stocks more cheaply to your portfolio.
It's not easy to view equity investing this way. Warren Buffett is able to do it because he's
confident that his methods of assessing opportunities help him allocate capital to what he
regards as good companies. Mr. Buffett has a variety of criteria he uses to analyze firms. One
important consideration for him is Return on Equity, or profits as a percentage of shareholder
money that has been invested into the business. A high return indicates that management is
doing a good job using capital that has been invested in the business. And companies with high
returns have the wherewithal to generate good rates of growth without taking drastic steps,
such as making acquisitions.
When you read about returns on investment, you are more often than not reading about returns
on "equity," the capital contributed by the owners of the business (the stockholders). But that's
not the only way to measure management effectiveness. A company can sharply boost returns
on equity by skillfully putting borrowed money to work alongside the capital contributed by
owners.
"Return on Investment" is a more pure measure of management's success in operating the
business. "Investment" is defined as equity plus all long-term liabilities (mainly, long-term debt).
In other words, Return on Investment measures management's operating skill, while Return on
Equity measures a combination of operations and financial skills.
High Returns on Investment indicate that management is good at running the business. That's
an important factor in any decision you may have to make about whether or not you're willing to
hold a stock, even if it falls in price after you buy it. The idea is that you're willing to forego any
effort to time the market and instead identify and stick with winning management teams and
business models.
By the way, don't assume that shares of high-return companies will always take forever to shift
into high gear. If other favorable factors are at work (earnings growth, for example), shares of
high-return companies can take off as quickly as any other issue. The key here isn't so much
that you'll need to be patient with these stocks. Instead, think of high-return companies as
situations in which you can feel more comfortable being patient, should that become necessary.
Specific Screening Criteria
Here's how the screen was created:
- The company's Return on Investment over the Trailing Twelve Months (TTM) must have
been more than 20 percent above the average TTM Return on Investment for its industry.
- The company's average Return on Investment over the past five years must have been
more than 20 percent above the industry average five-year average Return on Investment.
- The degree of superiority we see in a company's TTM return compared with its industry
average (company return divided by industry average return) must be more than 20 percent
better than the degree of superiority we see when we look at the five-year average.
- The company's TTM return on investment must be more than 20 percent above its own five-
year average return.
compared with the past and with industry peers. By now, we've filtered out most of the Reuters
database. Even so, the list remains too big to justify case-by-case analysis. To get a more
manageable list, we add two more tests designed to tap into recent investment community
sentiment.
- The consensus EPS estimate for the current (or soon to be reported) fiscal year must not
have been reduced over the past eight weeks.
- The number of shares purchased by institutional investors over the latest quarter
reported by each institution must be greater than the number of shares sold.
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Strong Operating Margin run it
Margins tell you how many cents out of each sales dollar are left, after expenses, as profit. That's
the easy part. The hard part is deciding which margins you should look at. Gross margins? Pretax
margins? Net margins? EBITD margins? This screen is based on strength in Operating margins.
Rationale for this screen
The operating margin measures how much profit is left after deducting the basic expenses of
running a business. The best way to understand this definition is to compare operating margin
with the alternatives.
- Gross Margin
This tells us how much profit is left after subtracting costs that are necessary to actually
produce the goods or services the company sells. For a manufacturing company, this would
include the costs of raw materials, salaries of factory workers, etc. For an airline, gross
expenses include fuel, salaries of the flight crew, etc.
- Operating Margin
We know that fuel expenses are deducted when we calculate an airline's Gross Margin.
What about the salary of the corporation's Chief Executive Officer? Fuel expense is a
"direct" cost of running an airline; this expenditure is clearly and specifically tied to the
activity that produces revenue. The CEO's salary, although an essential part of maintaining
the business, is not specifically tied to the process of getting passenger-filled planes up into
the air. This is an "indirect" cost, or put another way, overhead. Operating Margin tells us
how much profit is left after subtracting direct costs and overhead.
- Other Margins
The EBITD Margin is similar to the Operating Margin except that the EBITD does not
subtract non-cash depreciation charges. The Pretax Margin accounts for all expenses
except taxes. And the Net Margin tells us what's left over after deducting ALL expenses.
effective gauge of the performance of a company's BUSINESS activities. This is not the same
as measuring the performance of the COMPANY itself.
Suppose two firms in the same business incur the exact same expenses for direct and
overhead costs, but Company A has a lot of long-term debt while Company B has none.
Operating margins for A and B will be identical, but A's pretax and Net margins will be lower
because of interest expense. Considering another example, two companies can have the same
Pretax Margins, but different Net Margins due to variations in tax rates (one company may
operate in lower-tax states or countries). So if you want to assess the overall cost-efficiency of
the entire corporate enterprise, pretax and net margins are useful.
The EBITD margin is one that periodically becomes very popular in the investment community.
It helps you see how much cash a business generates year in and year out. But be careful
about relying too heavily on this. If you want to look at the "economic performance" of the
business, you should not rush to dismiss depreciation, which represents an allocation for plant
costs. We can debate the wisdom of accounting rules that dictate how depreciation is
calculated, but one cannot deny that some sort of plant cost ought to be recognized as part of
an overall evaluation of business performance, since these costs are necessary to get the
enterprise off the ground and stay in peak operating condition.
Comparing Operating and Gross Margins raises more delicate issues. On the one hand, it can
be argued that Gross Margin is a more perfect measure of business performance and that
overhead ought to be seen as affecting the caliber of the overall company, not the business
itself. There is much merit to this. But it's important to realize that Gross Margin comparisons
among different companies, even within the same industry, may not always be apples-to-
apples. That's because there are occasions when it becomes a matter of accounting judgment
as to whether a particular cost should be considered direct or overhead.
In sum, operating margin is a good way to assess the overall economic success of a company's
day-to-day business activities, and it is a measurement that will often provide meaningful
comparisons when you compare more than one company.
Specific Screening Criteria
Here's how the screen was created:
- First, we required that each of the companies have operating margins that are above the
averages for their respective industries. This above-average performance is measured for
the Trailing Twelve Month (TTM) period, and again based on an average of the five most
recently completed years.
- Next, we require that each company's margins improve over time. The screen picked up
only those firms whose operating margins in the TTM period were at least 25 percent above
their five-year average operating margins.
- By this point, we've eliminated many companies. But the list is still too big for company-by-
company review. So we use the following tests to narrow it further.
- The company must exceed the industry average in terms of five-year return on equity,
five-year return on investment, or five-year return on assets.
- EPS growth for the TTM period must exceed the industry average.
- Analysts must have raised their estimates of current-quarter EPS during the past four
weeks, or the average analyst rating must have become more bullish (i.e. a lower
numeric score) during the past four weeks.
- The company must exceed the industry average in terms of five-year return on equity,
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Consensus Choices run it
You can follow analyst recommendations or chart your own course. But it's hard to deny that the
recommendations influence stock price performance, at least over the near term. Here's what the
brokerage house analysts like now.
Rationale for this screen
It's hard to ignore what Wall Street analysts have to say about a stock. For better or worse, most
of them deal with institutional portfolio managers who buy and sell stock in large quantities. When
these money managers react to an analyst's recommendation (and they typically do this, if not
simultaneously, then within a fairly small window), the basic law of supply and demand pretty
much dictates that the stock will move the way the analyst thinks it will.
Suppose you roll up your sleeves and do your homework on XYZ Corp. and decide the stock is a
screaming buy because you expect profits to soar in the fourth quarter of the year. Let's also
suppose all of your assumptions are accurate. But what will happen if the analysts that follow the
stock are disappointed by what they hear about the near term and lower their ratings? Their
clients will sell, or at least reduce their positions in the stock.
Do the math. You are a single decision maker. However much money you have in your
portfolio(s), you are still just one investor. But the analyst has many clients. If you are the only
one not following the analyst's advice, your bullishness will be overwhelmed, at least in the short
term, by the large number of Sell orders. The impact is magnified if other analysts adopt the same
stance and influence their institutional clients as well.
This shouldn't cause you to blindly follow analyst recommendations. As we move through the
year and analysts start focusing on the same good things you saw earlier on and start raising
their ratings, the stock will return to favor. But if you don't at least know how the analysts rate
stocks, you may churn your portfolio needlessly.
Going back to our example, if you know that shares of XYZ are plunging because analysts
lowered ratings due to their pessimism about the next quarter, you can nevertheless make a
knowledgeable choice to stay the course based on your assumptions about subsequent periods.
But if you ignore the analysts, you may simply misinterpret bearish signals in every technical
indicator you can think of and wind up shelving your assumptions and selling your shares at a
price that is at or near a major bottom.
The strength-in-numbers argument, by itself, underscores the importance of knowing how
analysts rate stocks even if you believe those who say analysts are all biased and that their
conclusions are flawed. But in truth, most analysts are hard working, highly skilled professionals
who make great efforts to develop and communicate accurate assessments of the companies
they cover.
As confirmed by the news flow in recent years, analysts have had conflicting agendas.
Nowadays, most investors know how reluctant analysts have been to issue bearish
recommendations about a stock if their firm is doing investment banking work for the same
company. Regulators are working aggressively to address that situation.
But it's not that simple. Less well-known are the considerable competitive pressures on analysts
(from their institutional clients) to get it right. There are a variety of organizations that monitor and
assess analyst performance. Some use quantitative measurements. Others rely on surveys
conducted among institutional portfolio managers. Scoring highly can have a major impact on the
earning power of individual analysts. And the way to score highly is to get it right more often than
your competitors.
But even in the best of circumstances, analysts are human, so they won't always make correct
predictions about the future. And often they do overestimate the extent to which they can
accurately forecast certain issues. But you can generally count on them for accurate
assessments of the present and the relevant past.
There has been much discussion of the traditional reluctance of analysts to issue a "Sell." That is
a concession that even the best of them make to the politics of their business. That, too, is being
addressed by reform efforts. But aside from that, if you learn to read between the lines, it's really
quite easy to discern their true sentiment about a stock.
First, ignore target price ranges, which are published mainly for cosmetic reasons. To give you an
idea of how tenuous these are, consider that the analysts never explain how much of the
supposedly projected price change is due to market factors and how much is due to company-
specific considerations. What you really want is a sense of whether they believe the company is
likely to outperform, more or less match, or underperform the market as a whole.
Traditionally, Wall Street rates stocks on a five-part scale. Each firm has its own terminology.
What's most important is whether the stock has the top ranking (whatever the firm calls it), the
next-highest ranking, or lower. For the sake of convenience, Reuters uses a common set of
labels for each rank, starting with (1) Buy, (2) Outperform, (3) Hold, (4) Underperform, and finally
(5) Sell.
As noted, Underperform and Sell ratings have been rare sightings. But analysts have always
been uninhibited about shifting ratings among the top three categories. As a result, I found it
useful to view the top Buy rating as the functional equivalent of a sincerely bullish stance, the
Outperform rating (the middle of the threesome typically sued by analysts) as the functional
equivalent of neutrality, and the third rating, formally labeled Hold, as the functional equivalent of
a bearish stance. This approach allowed me to examine the distribution of ratings for an individual
stock to get a pretty good picture of what the analysts truly think.
As of early 2003, it appears that the five-part scale is giving way to a three-part scale simplified to
Buy, Hold, and Sell. And firms are working harder to generate a reasonable percentage of Sell
recommendations. It's too early to tell how this will map into the old five-part scale.
The 2/26/03 revision to this screen addresses this by shifting attention from the ratings
themselves to a score we compute based on a weighted average of all the ratings. The score
indicating maximum bullishness is 1.00; the score indicating maximum bearishness is 5.00. (The
computational method is described below.)
Regardless of how firms map new three-part rating scales to the old five-part system, we know
two things that are important for screening purposes: (1) Scores below 2.00 are bullish. (2) A
decrease in the numeric score over time (i.e., a shift from 2.35 to 2.15) indicates an increase in
bullish sentiment.
Specific Screening Criteria
Here's how the screen was created:
- Bullish Sentiment
The stock must have an average rating less than or equal to 1.75. The average rating is
calculated as follows: A Buy gets a score of 1.00. Outperform ratings get 2.00 points. Hold,
Underperform, and Sell get 3.00, 4.00 and 5.00 points respectively. Then, we compute a
weighted average of all the scores. Suppose a stock has three Outperform and three Buy
ratings. It gets three points for the Buys (1.00 times three) and six points for the Outperforms
(2.00 times three). The total of nine is divided by the total number of ratings (six consisting
of three Buys plus three Outperforms) to produce an Average Rating of 1.50. If we add four
Hold recommendations to the mix, that adds another 12 points, bringing the overall total to
21. The Average Rating would be 2.10 (21 divided by 10 ratings).
- A Bullish Trend
The present average rating must be less than where it stood four weeks ago, and the four-
week-ago rating must be equal to or less than the thirteen-week-ago rating.
- Homework
To guard against stocks that "benefit" from so-called "throwaway" ratings by just one
analyst, we require that at least one analyst go beyond the near term and publish a
projection for long-term EPS growth.
- Supporting Criteria
We double-check analyst sentiment by requiring that short interest be no more than three
percent of the float, or that it be a lesser percent of float than was the case a month ago. We
also put a ceiling on valuation by requiring the PEG (P/E-to-growth) ratio to be no greater
than 2.00. (In computing PEG, we use a P/E calculated with reference to the consensus
estimate of EPS for the next fiscal year, and the long-term growth projection.)
back to top
High P/E Multiples run it
This is not a typographical error. This P/E-oriented "Best In Class" screen really is designed to
seek stocks selling at high multiples, not low ones.
Rationale for this screen
Conventional wisdom tells us to avoid stocks that carry high P/E multiples. Nowadays, that maxim
has been tempered a bit by the PEG ratio, which is an analytical tool that justifies buying high-
multiple stocks if the P/E ratio is less than the rate at which earnings per share are growing. But
even users of PEG are still staying more or less within the standard approach to stock selection.
They try to get the lowest valuations feasible under the circumstances. Low valuations easily
appeal to the most basic common sense idea of buying low and selling high.
So why are we presenting a stock screen designed to find stocks that command high P/Es? The
answer is quite straightforward. In this day and age, with financial information so accessible to all
members of the investment community, you cannot assume that someone who purchases a stock
sporting a high P/E multiple does so out of ignorance. Assume that buyers know what the P/E is,
and assume they know the P/Es are high relative to industry or market benchmarks. Someone
who buys any stock under conditions like that typically does so because they believe that the
multiple is justified by the company's prospects.
If you assume that high P/E multiples reflect optimistic growth expectations, you might think it's a
good idea to simply invest in those stocks that have the highest P/E ratios. But data screening
isn't just a science; it's also an art. When drawing from a list of investment candidates as large as
the Reuters active database (more than 9,000 stocks) there are many variations on any theme
and we need to adapt our screen in such a way as to enhance the probability that each individual
high-multiple equity will, in fact, be consistent with our starting assumption.
We also know that a simple list of high P/E stocks with the highest P/E ratios will likely be
concentrated within a few hyper-growth sectors (e.g., technology, internet). There's nothing
necessarily wrong with this. But many investors may wish to choose from a broader range of
industries. This screen is designed to draw stocks from a variety of groups using high P/E
multiples as an indicator of favorable expectations.
Specific Screening Criteria
Here's how the screen was created:
- High P/E multiples
We start by requiring that each stock's Trailing Twelve Month (TTM) P/E multiple be at or
above its respective industry average and that the multiple be above that which prevailed for
the prior twelve month period. By measuring the P/E against the industry average, we
assure that no company is automatically excluded because it is in an industry that normally
commands low P/E multiples. This screen can draw from any industry, so long as investors
expect more from the company than they do from its peers.
- P/E no more than 200
This test is designed to eliminate companies whose multiples may reflect some sort of
aberrant condition, as opposed to investment community expectations of strong growth. For
instance, a slow growing firm whose TTM earnings per share are temporarily depressed, to
say a few pennies per share, may be eliminated by the screen (some companies like that
will slip through, but they will ultimately be eliminated by the next screening criterion). Other
eliminations will include early-stage growth companies for which P/E may not be the best
stock valuation metric.
- Year-to-year growth in share earnings positive and in excess of the industry average,
and a three-year EPS growth rate above the industry average
This is a very important test since it will weed out companies that have high multiples
because of share prices that failed to fall in tandem with depressed earnings. The latter part
of this test, involving the three-year growth rate, weeds out generally sluggish companies
with stock prices that may be elevated in anticipation of an unprecedented growth spurt.
There are better screens we can create to pursue investment opportunities of this sort.
- Analytical Coverage
We require that each stock be covered by at least three analysts. This enhances the
probability that favorable expectations will have come about as a result of careful,
professional analysis. This isn't a sure thing. Note, though, that analyst ratings on some of
these stocks may be lackluster. But stock valuation can be a very personal thing. Often,
investors will appreciate and utilize an analyst's assessment of a company but disagree with
the analyst's opinion on the stock. Clues about such situations can be found by looking for
modest ratings under the Professional Analysis section of the Reuters stocks area.
- Declining Short Interest
This adds some active support to the notion of favorable expectations in that it limits us to
stocks for which short sellers (hard-core bears) are reducing their positions. A stock whose
P/E is unjustifiably elevated would seem more likely to show a short interest that is rising,
rather than falling.
back to top
Insider Buying run it
Corporate insiders presumably have good information on company prospects. So when they buy
shares of their own companies, the investment community would do well to take notice.
Rationale for this screen
Who better to look to for a sense of a company's merits than those who work there; i.e. corporate
insiders. In theory, we'd like to simply ask them for the scoop on what's happening, but such
direct pipelines are likely to run afoul of modern securities laws. Even official communications are
tightly regulated such that no single investor can get information that isn't available to all. These
restrictions are not necessarily troubling. We can easily tap into them by using screens that reflect
positive analyst sentiment (since analysts keep track of all such disclosures).
But we can also indirectly monitor sentiment on insider opinions that are not officially
disseminated. We cannot look to what they say, but we can look at what they do; specifically their
purchase transactions.
This isn't a silver bullet. Some insiders may be buying to exercise stock options with the intent of
immediately cashing them out. But there are enough insider buy transactions based on favorable
opinion (purchases made with the intent to hold) that it's worth screening on this basis and
subjecting companies that make this screen to individual case-by-case assessments of
underlying merit.
You might think we could say the same about insider selling, but that's a more tenuous point.
Basic financial planning principles call for diversification. As such, it is imprudent for people to rely
on one company for salary and their entire investment portfolio. Hence it is usually wise for
insiders to convert stock options they receive as part of their compensation, or shares they may
have otherwise come to own, to cash (possibly for reinvestment elsewhere). And insiders may
often have occasion to sell shares for personal reasons.
Some maintain that this latter line of argument is just a rationalization for buying shares while
insiders are selling. It is true that insider selling may, indeed, reflect bearish sentiment, but the
alternative selling reasons are highly legitimate. If you doubt it, try to imagine your entire income
and wealth concentrated in any single business entity, and how uncomfortable you'd feel with a
lack of proper diversification.
So we're left with an uneven situation. We understand that insider selling might signify bona fide
bearishness, but we can't count on that. We have to look to other factors to build a negative case.
Insider buying, on the other hand, might reflect something other than bona fide bullishness, but is
so often based on true sentiment that we can productively use buying data as a starting point in a
search for investment ideas.
Specific Screening Criteria
Here's how the screen was created:
- Insider Transactions
The screen's primary insider buying theme is articulated through two tests: one requires at
least three insider purchase transactions, net of sales, and the other requires more than
three insider buys (regardless of how many sell transactions there are).
- Insider Ownership
We require that the percentage of insider share ownership be no lower than 25 and no
higher than 75.
- Trading liquidity
We want to assure that the shares are reasonably tradable notwithstanding conspicuous
insider ownership. We do this by omitting shares that trade over the counter (as opposed to
on an exchange). We also require that the stock's float contain at least two million shares
and constitute at least 25 percent of the total number of outstanding shares.
- Supporting tests
There are usually many insider purchases. So it will usually be impossible to get a
manageable sized list with insider tests alone. This screen therefore includes tests designed
to confirm the wisdom of the insider purchases.
- We search for some good measure of business performance by requiring that sales
growth rates exceed industry averages over the Trailing Twelve Month (TTM) or three-
year periods. In the alternative, a stock can satisfy this screen if TTM sales growth
exceeds the three-year rate of sales growth.
- We seek market confirmation of insider purchase decisions by requiring that the stocks'
four-week price performance be above the industry average four-week share price
performance, or in the alternative, that short interest as a percent of float be less than
where it stood a month ago.
- We search for some good measure of business performance by requiring that sales
back to top
Institutional Ownership run it
Institutional investors tend to be diligent and sophisticated, so their interest in the stocks you are
considering is a nice confirmation that you've done your homework properly. But high levels of
institutional ownership would mean that you are late getting to the party. This screen uncovers
stocks that strike a balance between these considerations.
Rationale for this screen
Imagine you've found a great company. Sales and earnings are growing briskly. The balance
sheet is strong. Returns on capital are excellent. The stock seems reasonably valued. Insiders
have been buying. But suddenly, the balloon pops. You notice that institutions already own 95
percent of the common, compared to an industry average ownership level of, say, 55 percent.
You wonder where the stock can go if the big money has already arrived.
It can be very comforting to follow the institutions. You can argue with their investment
philosophies. But it's hard to deny that they are diligent and that they do know what's going on at
the companies they examine. If too many institutions own the stock, it's hard for it to rise given a
shortage of prospective new buyers.
This screen attempts to strike a good balance between institutional ownership as evidence of
endorsement by those who've thoroughly studied the facts and as a source of pent-up demand
from prospective new buyers.
Specific Screening Criteria
Here's how the screen was created:
- Trading Liquidity
We want institutional ownership to be low now, but we also want it to be rising. That can't
happen unless there's enough liquidity to accommodate the needs of these investors. We
address that by limiting ourselves to stocks trading on the NYSE, AMEX or NASDQ, and by
requiring that average daily volume be above 20,000 shares.
- Ownership
The screen requires that institutions own more than 10 percent of common shares. A stake
below that very modest threshold should cause you to wonder why institutions were
avoiding the stock. The other test requires institutional percentage ownership of the stock to
be less than the industry average percent of institutional ownership.
- Trends
We require that net institutional purchases (shares bought minus shares sold) have risen in
each of the last two reported quarters. This test, combined with the one just above, finds
stocks for which institutional ownership is rising, but hasn't yet reached industry average
levels. The screen is also limited to stocks whose prices moved up in the past four weeks.
This doesn't prove that institutional purchasing continued strongly during this period, but it
would at least make it less likely that institutions recently switched to a selling mode.
- Analyst Coverage
The screen requires that each stock be covered by at least two analysts. This would suggest
that increases in institutional ownership is accompanied by access to some fundamental
research.
- Supporting Decisions
No matter how thoughtfully any screen is constructed, numbers alone can't tell the whole
story. So we look for ways to tap into qualitative assessments made by key market
participants. A good way to do that here is to look at whether the behavior of other investors
suggest that also have developed favorable assessments of the stock.
- The screen requires that the shares have been purchased by one or more insiders in
the latest six-month period.
- Short interest must have declined in the latest month for which data is available.
- The screen requires that the shares have been purchased by one or more insiders in
back to top
Lesser Known Stocks run it
With so much information so readily available nowadays, it's getting harder to uncover interesting
investment ideas that haven't already been discovered by the crowd. But it can still be done.
Rationale for this screen
About half the stocks in the Reuters database have no discernable analyst coverage. For
companies trading on the NYSE, the percent is less, but still higher than you might suspect--
approximately 25 percent. These aren't precise numbers, since it's possible that some firms may
be covered by analysts who don't report their estimates and recommendations to the
organizations that collect and report analyst data. But even subject to adjustments like that, we
are still left with a large pool of companies that are ignored by Wall Street research departments.
The number of potential "undiscovered gems" increases if we change our definition from zero
coverage to modest coverage. Among stocks that have coverage, the average number of
analysts per stock is six. But mathematical averages can be distorted by high counts at one
extreme or the other. Only one-third of the covered stocks are monitored by more than six
analysts.
A stock with little or no research coverage can be a great investment opportunity, or a very poor
choice. The latter concern is a serious one. We're living in an age of abundant information. You
can legitimately suspect that stocks with little or no analyst coverage may simply be unworthy of
attention.
On the other hand, there are a lot of stocks out there--Reuters covers more than 9,000 publicly
traded companies, which means that however much effort Wall Street firms put into research,
that's still a lot of ground to cover. So if you want to dig a bit harder, you have lots of opportunities
to discover winning companies and buy their stock before the crowd catches on.
But high potential reward comes with high risk. Even if you don't agree with a particular analyst's
report, you can at least benefit from a factual presentation that can give you a sound basis for
developing your own opinion. And as the quality and quantity of coverage increases, so, too do
the opportunities of potential future problems. The system isn't perfect (for instance, you need to
know that a Hold recommendation may be the functional equivalent of a Sell), but it helps. And
"doing without" can be a challenge.
Specific Screening Criteria
Because lesser coverage might signal unfavorable prospects, we can't look for stocks simply by
sorting based on the number of analysts. We need to add other tests to help point us toward
stocks that don't deserve their neglected status.
We start screening with a definition of uncovered/under-covered stocks.
- Analytical Coverage
The screen requires that the stock be covered by six or fewer analysts, six being the
average level of coverage for all stocks that are monitored by analysts.
- Institutional Ownership
We require that institutions own no more than 50 percent of the outstanding float. We then
add a requirement that institutional percentage ownership be less than 80 percent of the
average level of institutional ownership for stocks in the industry.
uncovered or under-covered because they don't deserve wide following. No screen can ever do
this perfectly, so in the end, we must always make a case-by-case review before actually
investing. What we're really asking the screen to do is help narrow the list to a more
manageable number.
- Corporate Earnings
Year-to-year EPS comparisons in the latest reported quarter are an important consideration to
investors. So we required that that the latest available comparison be positive (in other words,
EPS in the last quarter must have been above the EPS reported for the comparable quarter a year
earlier). We also screened year-to-year growth rates in the latest reporting period to be above the
industry average growth rate.
- Market Performance
Next, we added some measures of stock price action. Since we're trying to find stocks that haven't
yet been fully appreciated by the crowd, we need to tolerate at least some level of lackluster
market performance. But we don't want to accept so much weakness as to suggest that the
investment community took a good look at the company and came away unimpressed. Here's how
we struck the balance.
- Over the past 52 weeks, the stock's percentage price change should be no worse than
zero; in other words, it should not be negative.
- Of late, the market has been erratic, so in looking at recent share price performance, we
need to be flexible. We require only that the percentage price change over the past four
weeks be no worse than -10 percent. (Note that as a result of the prior test, the allowable
correction must still leave the price higher than it was 52 weeks ago.)
- Trading volume over the most recent 10 market days must average at least 20,000 shares.
This keeps the least liquid stocks off the list.
- Finally, we require that net institutional share purchases (shares bought minus shares
sold) in the latest quarter reported by institutions be positive (or zero). On the one hand, a
focus on stocks that are under-owned and under-researched has at least some contrarian
flavor, since it does lead us away from companies getting the most press. But active
selling on the part of institutions may suggest too much contrarianism, because such activity may reflect unfavorable qualitative judgments about the stock's real prospects.
- Over the past 52 weeks, the stock's percentage price change should be no worse than
