As a rule, most investors and analysts spend a lot of wasted time screening for stocks. Don’t get me wrong, I think that screening is an indispensible tool. It’s just that most investors are doing it completely wrong.
- They believe that increasing the number of inputs will improve the result
- They are not selective about the inputs that are chosen, resulting in the selection of meaningless or contradictory inputs.
- They tend to try out different screens until they get the result they want. This is a waste of valuable time and undermines the value of the exercise.
The Importance of Simplicity
“Simplicity is the Ultimate Sophistication” Leonardo da Vinci
Most screening tools offer a choice of Fundamental, Valuation and Technical screens. Many investors try to apply a chaotic combination of all three, believing that they are somehow gaining an “edge” or being more “sophisticated” by doing so.
Starting with technical screens, my view is that you should ignore these entirely. I’m aware of few technical strategies that have worked consistently over a substantial period of time. Adding a technical screen will only muddy the waters and could rule out a number of stocks that are interesting on a fundamental basis.
Some investors, like Mohnish Pabrai will look at stocks that are trading at 52 week lows, or stocks that have underperformed 2 years in a row. While this can be an interesting way to pick out hated stocks, I personally prefer to focus my efforts on Valuation and Fundamentals.
Rather than select for every metric that is offered by your screening tool, it’s better to keep things simple. When it comes to screens, the thing to remember is that the quality of the input is far more important than quantity.
What can you Measure?
A metric is only valuable to screen if you can measure it accurately. For this reason I exclude any screens based on “growth”. Let me explain why:
What exactly are we trying to measure when we talk about growth? The only growth that’s of interest to investors is the future growth of earnings. Some investors will screen for growth in EPS over the past 3 years, or future growth as indicated by consensus estimates. However, experience (and a wealth of research) tells us that neither of these measures are good proxies for future growth. Companies that grew rapidly over the past few years often end up disappointing as the sales force finds it harder to grow off a larger sales number and as competition creeps in. Analyst forecasts are no better, since often they simply extrapolate the growth seen in the past 3 years. Analyst forecasts are almost always too bullish. By screening for “growth” you are often subjecting yourself to the same biases that are held by the consensus view.
So What Should I Screen For?
I prefer to focus on one valuation metric and one or two fundamental ones. For valuation metrics, I use historic multiples of P/E, Earnings Yield or P/BV.
The screening tool at gurufocus also allows you to look at Shiller P/E, which averages out the earnings of the past 10 years. I love this screen because it picks out stocks with the potential for high “earnings power”, but which may have been overlooked due to an unfavorable perception (See the Benjamin Graham lecture at StockViews Campus for a full explanation of earnings power) .
As for fundamentals I tend to stick to measures of “quality” such as ROIC. I will sometimes add to this a balance sheet metric such as Debt/Equity
The screen that has worked best for me in the past is a simple combination of ROIC and Earnings Yield. There is a theoretical underpinning to this combination, which explains why it works so well. For this we turn to the “Value Driver Formula” (which I explain in more detail in this lecture at StockViews Campus).
The Value Driver Formula
Below is the “Value Driver Formula”, which derives the theoretical value for a stock where growth and ROIC are constant.
(where g = growth in earnings)
By introducing price into the equation we get the following formula (upside of course being the difference between price and value)
Simplifying the above equation we get:
Using this simple piece of math, we have an understanding of the metrics we should track in order to identify upside. These are Earnings Yield, ROIC, WACC and growth in earnings.
We have already established that growth in earnings cannot be reliably estimated, while WACC will be more or less consistent across our universe (unless you subscribe to CAPM, but that’s a different blog post)
This leaves us with ROIC and Earnings Yield. Let’s now consider a scenario where WACC is fixed at 8% and growth is fixed at 3% (an artificial exercise I know, but stick with me here) The following chart shows how “upside” theoretically changes with ROIC and Earnings Yield.
Interestingly ROIC and Earnings Yield are the metrics that Joel Greenblatt has used so successfully to identify great stocks at Gotham Capital (coincidence? I think not!)
Magic Formula Investing
Despite the cheesy name (I guess it was the 90s when he coined this), I find Greenblatt’s “Magic Formula” to be a hugely valuable screening tool.
The formula works by ranking 3,500 US stocks by ROIC and by Earnings Yield. The ranks are added together and the stocks with the highest rank are selected. There is a great online tool that does all this work for you at www.magicformulainvesting.com
The clever thing about this tool is that it combines the rank for ROIC and Earnings Yield. So the top ranked stock may not even have a top quartile ROIC or a top quartile Earnings Yield, but it exhibits an excellent combination of the two. A traditional method of screening might actually exclude the top rated stocks selected by Joel Greenblatt’s methodology.
While the “magic formula” is not exactly scientific, it does a great job of capturing the two key metrics that count. For me, this is far preferable to the use of arbitrary thresholds on a number of diverse metrics.
Screening is an essential tool in the armory of any intelligent investor. There is no faster way to narrow down your investment universe and focus your work where it’s most valuable. The best investors I know include screening as an integral part of their investment process.
One of the most powerful attributes of a screen is that it forces you to consider stocks that you might otherwise not have considered because of an unfavorable perception in the market. If you take a look at the top 50 stocks right now at www.magicformulainvesting.com, most of them would make a normal investor want to throw up. But this is precisely why the screen is interesting.
Whether you make use of the “magic formula” or whether you use other screening tools, remember however that it is only ever a starting point for further work. The purpose of screening is to save time by pre-selecting a group of stocks that may be suitable as investments. Only at this point can you start to think about things such as the business model, growth prospects, and sustainability of ROIC. This is when the real work of investment begins!