Time to Turn Off Value Screening

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Includes: AFL, ALL, GD, INTC, MSFT, NOC, RTN, XOM
by: John Tobey, CFA

About two months ago, we were discussing the benefits of value stock screening. Since then, the market has moved higher, and most of the stocks we found no longer pass the screens.

This is a common occurrence when investors enter a previously weak market. They first select high quality stocks that offer the best value, and the buying drives up the prices. While these stocks may or may not be good buys now, it is clear that value screening can no longer identify them. We have entered a more normal environment, where successful stock picking requires analysis and forecasting.

Where we started (August 31)

In August, the US stock market sold off based on macro-investing worries that then petered out. This broad-based sell-off took down most stocks, including some high quality ones. Such an environment is good for using value screening.

These two previous write-ups explain the situation and show an example of value screening along with its seven “picks.”

Where we were last month (September 23)

September saw a steady stock market rise that began to chip away at screening’s usefulness. This article explains what was happening and the effect on the list of seven.

Where we are now (October 20)

The stock market is now higher still, with the Dow Jones Industrial Average (DJIA) up 10.9% (from August 31 through October 20). Five of the seven original “picks” have outgrown their obvious value status. Microsoft (NASDAQ:MSFT), a performance laggard, now passes.

First, a look at the stock performance for the period:

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Now, the data for the three current “picks.”

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Such results are typical in a normal stock market. With investors more active and becoming selective, we must now assume that many people are looking at those same names and, for valid reasons, are deciding the stocks are not underpriced. (In other words the three stocks are passing the value screens due to fundamental weaknesses or risks, not because investors have overlooked them.)

So… Value screening has served its purpose once again. Although less than two months have passed, the screening has lost most of its usefulness. Therefore, it’s best to turn it off and return to the normal process of analyzing and forecasting to identify attractive stocks.

Disclosure: Client positions: XOM, INTC