Stock Screening – Weed Out The The Losers

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The smaller the company, the lower the quality of the business franchise and the management team, says Neal Bradsher, MD of Campbell Advisors.   When you have a market cap that small, there is probably something wrong with the company, says David Warnock

Big performance from market caps below $50 million.

Poker pros sit only at tables where others are less sober, more emotional. Or less expert than they are. Who is on the other side of the trade?

You need an edge.

Develop expertise in one area.

Figure out why other people are betting against you.

To learn the ways of the market is to learn about human nature.

Study Lebon, Gustave: The Theory of Crowds.

We may have more information, but the percentage of people with good judgment is no higher than n in Lebon’s time.

Become an independent agent, and go your own way. Learn to exercise control over your sources of information. Do your own homework, and act on it and it alone. Stick to areas in which you already have some expertise.

Do the work to be part owner of the company

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening. I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional. I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG with Estimated Growth, PEG With Historical Growth, and two of O’Shaughnessy’s screens - Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street. That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment. There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle. I mentioned how much I like the CXO Advisory blog. One page to visit is the Big Ideas page, if you like academic finance papers. I want to give you my short synopsis of what seems to work:

  • Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
  • Price momentum
  • Low accrual accounting entries as a fraction of earnings or assets
  • Piotroski’s accounting criteria
  • Low net stock issuance
  • Positive earnings surprises
  • Low historical return volatility
  • Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues. Let me summarize them one more time:

  • Look for a cheap valuation.
  • Look for mean reversion, but don’t try to catch a falling knife.
  • Grab positive price momentum and earnings surprises.
  • Look for sound accounting, and management that is loath to dilute shareholders.
  • Avoid volatile stocks
  • Look for neglected stocks

That’s my quick summary for what seems to work in stock selection. I invite commentary on this. I downloaded a lot of the papers cited, and will be reading them over the next few months.

About the author: David Merkel

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and... More

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening. I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional. I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens - Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street. That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment. There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle. I mentioned how much I like the CXO Advisory blog. One page to visit is the Big Ideas page, if you like academic finance papers. I want to give you my short synopsis of what seems to work:

  • Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
  • Price momentum
  • Low accrual accounting entries as a fraction of earnings or assets
  • Piotroski’s accounting criteria
  • Low net stock issuance
  • Positive earnings surprises
  • Low historical return volatility
  • Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues. Let me summarize them one more time:

  • Look for a cheap valuation.
  • Look for mean reversion, but don’t try to catch a falling knife.
  • Grab positive price momentum and earnings surprises.
  • Look for sound accounting, and management that is loath to dilute shareholders.
  • Avoid volatile stocks
  • Look for neglected stocks

That’s my quick summary for what seems to work in stock selection. I invite commentary on this. I downloaded a

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