This article appeared first on The Stock Market Blueprint Blog.
Using a stock screen to create your own investment strategy allows you to systematically invest in the stock market without performing hours of tedious and often meaningless research.
Additionally, systematic investment strategies have been shown to outperform strategies which require careful analysis of individual stocks.
If you want to invest in the stock market, you need to create your own investment strategy which follows a set of simple guidelines.
The investment strategy you choose needs to be one you believe in and can personally implement for several years or even decades.
Using a Stock Screen to Create Your Own Investment Strategy
With literally thousands of stocks to choose from – and financial “advice” being thrown at you everywhere you turn – the only one way to confidently make the best decisions is by using a stock screen to create your own investment strategy and sticking with it.
Any successful investment strategy needs to provide a clear answer to each of the following questions:
- What stocks should you buy?
- How many stocks should you buy?
- When should you buy your stocks?
- How much of each stock should you buy?
- When should you sell a stock?
In this first of a five part series, we address the first question: What stocks should you buy?
By using a stock screen to create your own investment strategy, you can easily determine what stocks should be included in your portfolio.
The remaining four questions will be addressed in upcoming posts.
What Stocks Should You Buy?
The first step to creating your own investment strategy is to choose a stock screen you want to follow.
As an investor in single stocks, you have two choices. You can perform careful analysis on individual companies, or you can invest in a basket of stocks which are likely to provide high returns as a group.
In a 1998 speech to MBA students, Warren Buffett described his method of providing careful analysis when selecting individual stocks:
“I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, ‘If you could only buy stock in one coal company that was not your own, which one would it be and why?’ You piece those things together, you learn about the business after a while.”
So, Warren Buffett chose to perform careful analysis by interviewing everybody about everycompany until he found the right investment.
As the greatest investor of all-time, this clearly worked out well for him.
Highly Simplified Approach
You are more than welcome to try to compete with Buffett and other professional investors by performing this type of rigorous analysis. However, a more realistic approach is to take the path of legendary value investor Benjamin Graham.
Graham was asked in a 1976 interview which investment strategy he liked best:
“Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.”
By using a stock screen to select stocks for you, you can ensure your investment strategy is highly simplified and relies on the group results rather than the performance of each individual investment.
Just a Starting Point?
This method may seem too simple or even too risky. Many investors will scoff at the idea and say things like:
How could any responsible investor buy stocks blindly based on the results of a stock screen?
Stock screens should be a starting point for investment analysis and not the final word.
You should consider the results of any screening process as candidates for further research, not as a buy list.
Screening helps to narrow a search based on pre-defined criteria. It is not a substitute for independent research.
Many of the same investors who make the above arguments are also proponents of index investing. This is an interesting point because an index fund invests in its underlying assets by using the same methods as a stock screen.
For example, an S&P 500 index fund makes investment decisions based on the S&P 500 index. If a stock is removed from the index, the fund will sell it. If a stock is added to the index, the fund will buy it.
The S&P 500 index selects stocks based on one highly simplified criteria: the size of the company’s market capitalization. The index simply ranks the market-cap of every U.S. equity from highest to lowest, and buys the top 500 stocks.
No one can argue against the benefits of indexing. Academic researchers and prominent investors alike agree that an investment strategy which consists of systematically investing in an index fund is a proven way to build long-term wealth.
How could investing in an index fund be a proven way to build wealth, while investing based on a stock screen is considered irresponsible or too simple? There is no difference between the two.
Better Than Indexing
The returns of an S&P 500 index fund, while outstanding over time, can also be improved upon. By using a stock screen to create your own investment strategy, you can achieve better returns than if you simply invested in the S&P 500.
Whether or not you actually achieve higher returns depends on the criteria your stock screens use to select investments.
For example, academic research clearly shows that stocks with low price ratios always outperform stocks with high price ratios over time.
As stated earlier, an S&P 500 index fund only takes a stock’s market cap into consideration when selecting stocks to invest in.
If you create your own investment strategy using a stock screen which takes price ratios into account, you could easily outperform an S&P 500 index fund.
When you create your own investment strategy using a stock screen, you’ll need to choose a stock screen you want to follow. To be successful, the screen you select must be: simple, logical, and proven.
When discussing the ideal strategy, Benjamin Graham recommended a highly simplified one that applies a single criteria or perhaps two. There is no reason to follow a stock screen that is more complicated than this.
If you include too many criteria, you’re investment strategy will be too specific and filter out more investments than it should.
The stock screen you follow must be logical and make intuitive sense. There will be times when your strategy performs poorly and you’ll want to give up.
These are exactly the times you must stick with it and wait for things to turn around. If you understand the logic behind why you’re strategy is a good strategy, it’ll be easier for you to stay the course.
Don’t just pick a stock screen because it seems logical. Find a screen that filters stocks based on proven results.
There are countless numbers of academic studies and financial research reports which highlight the best performing criteria to look for when investing in individual stocks.
Rank the Results
Once you select the stock screen you are going to follow, you need to determine which of the qualifying stocks will be selected as investments.
To make this decision, rank the screen results by one specific criteria and invest in the best ranking stock(s).
For example, the Enterprise Multiple stock screen ranks each stock from lowest Enterprise Multiple to highest.
Because a lower enterprise multiple is considered a better investment, it would make sense to invest in the stock(s) with the lowest enterprise multiple.
How Many Stocks Should You Buy?
Now that it’s been established that using a stock screen to create your own investment strategy is both profitable and realistic, we need to address the remaining four questions.
In next week’s post we’ll discuss the answer to the question: How many stocks should you buy?
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.