Consistently picking individual stocks that will generate excess returns is hard, but most investors make it much more difficult than necessary. There are a number of simple, fundamental stock screens that have generated historical returns of 20% to 40% per year. This article will document the results for several of these screens and explain how they could be used in practice. If you buy individual stocks, the screening information described below should help you significantly enhance your investment process and improve your future returns.
Stock screens are objective sets of criteria or rules that are used to create lists of stocks. Only stocks meeting the criteria are included in the lists. To calculate the historical performance of a stock screen, a rebalancing frequency is also required. Most screens are rebalanced weekly or monthly. Higher frequency screens obviously generate additional transaction costs, but are also much more responsive to changing market conditions. A new list of stocks is generated on each rebalancing date. Stocks that no longer meet the screening criteria are removed from the list and sold. When new stocks meet the criteria for the first time, they are added to the list and purchased.
The concept of stock screens is simple, but finding fundamental criteria that generate excess returns is much harder. In addition, there are very few research platforms that offer the capability to calculate historical performance results for user-specified fundamental screening criteria. The few services that do exist often charge subscription fees of several thousand dollars per year, which exceeds the research budget for most individual investors. These services are expensive because they require a vast amount of fundamental data for every company (every major balance sheet and income statement item for every historical period).
Fortunately, you do not need to create your own screens from scratch. I will describe several stock screens below that have all generated compound annual returns of at least 20% over ten or more years.
Zacks Investment Research has been a leading provider of equity research for institutional and individual investors since 1978. They are famous for their proprietary classification system called the Zacks Rank. While Zacks does not disclose the exact formula for their secret sauce, the Zacks Rank is based on changes in earnings estimates. The concept is simple: stocks with increasing earnings estimates outperform stocks with stable or decreasing earnings estimates.
Kevin Matras is a vice president at Zacks Investment Research and is Zacks' leading expert on stock screens. For much of his screening research, he uses the Zacks Research Wizard, which is a powerful tool that allows users to access Zacks' most successful stock-picking strategies and to develop and back-test custom strategies using over 650 different variables.
As I mentioned earlier, these types of services can be expensive for individual investors. Fortunately, Matras recently wrote a book titled Finding #1 Stocks, where he provided detailed descriptions and results for a number of very profitable stock screens. He was kind enough to permit me to explain the rules for several of these screens and to document their historical results in this article.
All of the data for the Zacks screens in this post comes from Matras's book Finding #1 Stocks. All of the Zacks screens discussed in this article can be created with a Zacks Premium Subscription. This service is currently offered for approximately $200 per year and Zacks typically offers discounts for multi-year subscriptions.
A common element in all of the Zacks' screens presented below is the Zacks Rank. Zacks ranks stocks from #1 (Strong Buy) to #5 (Strong Sell). The top 5% of the stocks earn a Zacks #1 ranking and the bottom 5% of stocks receive a Zacks #5 ranking. 60% of the stocks receive a Zacks #3 Rank (Hold). While this classification is called a "hold," it really means that these stocks should perform in line with the market. The remaining stocks are split evenly between Zacks #2 (Buy) and Zacks #4 (Sell).
We can look at each of the five Zacks Ranks as an individual stock screen and calculate the historical returns for each group over time. The following table shows the compound annual returns for each of the Zacks Ranks from 1988 through June 2010 (excluding commissions and transaction costs). The average annual return for the S&P 500 was 8.86% for the same period.
Figure 1: Zacks Rank Study
Zacks #1 Rank stocks returned an astounding 27.27% per year for this 20+ year period, outperforming the S&P 500 by almost 20% per year. The high correlation between the Zacks Rank and the compound annual returns is even more impressive.
Unfortunately, simply buying Zacks #1 Rank stocks is not a practical investment strategy. There are over 200 Zacks #1 Rank stocks at any point in time. However, there are still many ways to use the Zacks Rank in our investment process. If we wanted to create a new strategy, we could start by simply limiting our universe of prospective stocks to Zacks #1 Rank stocks, or possibly Zacks #1 and #2 Rank stocks. We would be choosing from a list of stocks that has historically outperformed the market by 10% to 20% per year. This is not a bad start, but thanks to Kevin Matras's book, we can do even better.
Price to Cash Flow
In addition to the long-term results for the Zacks Rank, Matras also created and tested a number of fundamental stock screens for the period February 2000 to February 2010. He identified several variables that were highly correlated with excess returns. One of these variables was price to cash flow (P/CF).
This variable represents the price per share of the stock divided by the cash flow per share generated by the company. A P/CF value of ten means that we would be paying $10 for every $1 of cash flow. A P/CF value of 50 means that we would be paying $50 for every $1 of cash flow. While a higher growth rate could potentially justify a higher P/CF ratio, the compound annual returns in Figure 2 below clearly demonstrate the benefits of buying stocks with a P/CF ratio of ten or less.
Figure 2: Zacks PCF Study
If we limited our purchases to Zacks #1 Rank stocks with a P/CF ratio of ten or less, we would have earned a return of 34.7% from 2/2000 to 2/2010, which doubled the return of the best P/CF group alone. The 34.7% compound annual return was earned over a period that spanned two recessions, including the market meltdown in 2008, making the results for this stock screen even more impressive.
This would be considered a value screen, which is used to identify undervalued stocks. However, when we add the Zacks #1 Ranking, we would be purchasing undervalued stocks with increasing earnings estimates - a very powerful combination.
If we created a new strategy from a universe of Zacks #1 Rank stocks with a P/CF ratio below ten, our odds of beating the market would increase dramatically. Or, what if we added an additional filter to our existing stock-picking strategies to eliminate all stocks with a P/CF ratio above 30? As you can see in Figure 2 above, that group of stocks actually lost value over the 10-year period. While some of these stocks will do well, the entire group will probably lag the market. There are thousands of stocks to choose from. Why try to choose the few winners out of a group of likely losers?
Price to Earnings
The next explanatory variable that Matras identified is the price to earnings ratio (P/E). The P/E ratio is another value metric. All things being equal, we would prefer to pay less for each dollar of current earnings. However, stocks represent ownership claims on all future earnings, which will eventually be paid out in the form of dividends. Companies with rapidly growing earnings will generate greater future earnings per dollar of current earnings, which can justify higher P/E ratios.
If the growth projections are high enough, P/E ratios can climb to 50 or more. Often, these companies are priced for perfection. When these companies stumble, their stock prices can plummet. The compound annual returns in Figure 3 below clearly demonstrate the benefits of buying stocks with P/E ratios of 20 or less.
Figure 3: Zacks PE Study
If we limited our purchases to Zacks #1 Rank stocks with P/E ratios of 20 or less, we would have earned a return of 26.2% from 2/2000 to 2/2010, which was almost 10% higher than the CAR of the best P/E group by itself.
Price to Book, Price to Sales, and PEG Ratios
Matras provided three additional value screens based on three other value metrics: the price to book ratio (P/B), the price to sales ratio (P/S), and the PEG ratio. The P/B ratio and the P/S ratios are self-explanatory. As was the case with the P/CF and P/E ratios, cheaper stocks have lower P/B and lower P/S ratios.
The PEG ratio is the P/E ratio divided by the earnings growth rate. As I explained above, companies with higher growth rates should have higher P/E ratios. The PEG ratio attempts to adjust for this fact by dividing the P/E ratio by the earnings growth rate. The resulting PEG ratio should be comparable across companies with a wide range of growth rates.
The results for all three screening methods are provided in Figures 4, 5, and 6 below.
Figure 4: Zacks PS Study
If we limited our purchases to Zacks #1 Rank stocks with a P/S ratio of 1.0 or less, we would have earned a return of 33.9% from 2/2000 to 2/2010, which was over 16% higher than the CAR of the best P/S group alone. Stocks with a P/S ratio above 4.0 earned a compound annual return of -7.9% for the period.
Figure 5: Zacks PB Study
If we limited our purchases to Zacks #1 Rank stocks with a P/B ratio of 2.0 or less, we would have earned a return of 31.3% from 2/2000 to 2/2010, which was almost 20% higher than the CAR of the best P/B group alone. Stocks with a P/B ratio above 5.0 earned a compound annual return of -2.7% for the period.
Figure 6: Zacks PEG Study
If we limited our purchases to Zacks #1 Rank stocks with a PEG ratio of 1.0 or less, we would have earned a return of 26.0% from 2/2000 to 2/2010, which was 7.8% higher than the CAR of the best PEG group without the Zacks #1 Rank requirement. Groups of stocks with PEG ratios from 4.0 to 5.0 and above 5.0 both earned negative compound annual returns for the ten-year period.
Combined Screen - Multiple Value Parameters
Using Zacks #1 Rank stocks with each of the value filters above was a very successful screening technique over the ten-year period above. However, could we make some further improvements? What if we required our prospective stocks to meet all of the value criteria above, instead of just one of the criteria? How would the combined value screen have performed? Normally, we would need Zacks' Research Wizard to answer this question, but Matras did this calculation for us as well.
Using weekly rebalancing, if we had invested in Zacks #1 Ranks stocks that satisfied each of the top value criteria above, we would have earned a compound annual return of 45.8% over the same ten-year period (before commissions and transaction costs). This strategy would have only held an average of six to seven stocks at a time.
When using strategies like this with limited diversification, it is important to restrict the amount of capital allocated to these strategies. In addition, transaction costs and commissions would reduce the total return, especially when using one-week holding periods. Nevertheless, 45.8% annually equates to a cumulative return of 4,241% over ten years. Those are pretty amazing returns for a simple value screen.
Here are the actual rules used to create this screen:
- Price >= $1
- Average 20-Day Volume >= 100,000
- Price to Cash Flow <= 10
- P/E using F(1) Estimates <= 20
- Price to Sales <=1
- Price to Book <= 2
- PEG <= 1
- Zacks Rank = 1
- Weekly Rebalancing
Combined Value Screen Results on 11/23/2012
Figure 7: Combined Value Screen Results on 11/23/2012
The screens presented in this article are only a small sample of the screens available through Zacks and other services, such as American Association of Individual Investors (AAII's) Stock Investor Pro (SI Pro). Using a proven systematic approach to stock selection enhances returns and removes emotion from the investment process.
The screens in this article ignored market timing, which could have improved returns even further.