Stock screening has become an integral part of many retail investor strategies. It isn't difficult to understand why - investors are confronted with thousands of options for their hard-earned investing dollar, and picking which of these companies makes the most sense to invest in is daunting. Why not add filtered qualifications to make the list a little more manageable? Further bolstering support for the process, investment researchers often come out with backtested validation of what the next "best measure" is when it comes to outperforming the market as a whole. Generating alpha is the name of the game, and screening seems to be an easy way to unlock alpha. Strategies have run the gambit. First was investing on liquid book value (advocated by Benjamin Graham), then P/E ratios soon became the best method, EV/EBITDA saw a rise in popularity in the mid 2000s, and lately FCF yield has come into vogue as investors shift focus to the statement of cash flows from the income statement.
Typical investor screening methods are an area I explicitly avoid. I firmly believe stock screening has its place, but not for isolating companies on numerical values like earnings ratios or profit margins. In other words, I use screening tools, but only to isolate areas to research, not as a replacement for research. I might screen for mid-cap stocks or for companies in a particular sector, but I do not screen by some popular methods. A typical screen might look like the below:
P/E Ratio: Less Than 18x
Operating Margin: >15%
Profit Margin: >10%
Forward PEG Ratio: <2
At face value, this screen looks healthy. By using this screen, we'd be isolating companies that trade at or below market earnings multiples, are healthily profitable, and have reasonable expectations for future earnings growth according to analyst consensus. However, using this screen can cause investors to gloss over some quality companies while drawing them into others. I've listed a few common events that typical screens miss, along with some historical examples to provide real world examples.
Microsoft (NASDAQ:MSFT) has been a stellar investment over the past nine months, with shares up 17% compared to the S&P 500 which is underwater over the same time frame. Calls for Microsoft's "expensiveness" on P/E have been prevalent, and at first glance, it appears justified. Microsoft's ttm P/E currently stands at over 38x, well above historical averages. What gives?
In the company's fiscal Q4 2015 (calendar quarter Q2 2015), the company announced a $7.6B write-down of its acquisition of Nokia's Devices and Services business. This is a non-cash charge taken to reflect Microsoft's new position that these acquired assets had much less value than anticipated; e.g., goodwill impairment. Nonetheless, in GAAP accounting, this non-cash charge impacts the income statement, which affects both operating income and bottom-line profit. On a backwards looking basis on prior year results, ttm profit and operating margins, and as a result, earnings multiples given that the stock did not fall on this news, look way out of whack compared to historical norms.
Many shareholders who use screens to either make a purchase or to dictate sales within their portfolio would have missed out on Microsoft's excellent stock performance since the announcement.
Was the acquisition of Nokia assets and the subsequent write-down a good thing for the company? No. Steve Ballmer made a terrible call and used billions of dollars that could have been spent on actual accretive acquisitions or shareholder returns. But Microsoft's core business was not structurally impaired by this mistake, so the stock shook off the legacy issue and instead put faith in new CEO Satya Nadella to not repeat the past, and the market has instead focused on the positives coming out of Microsoft. Excluding this item, diluted earnings per share would have come in at $2.33/share, putting ttm P/E excluding this impairment charge closer to 23.5x, relatively in-line with historical averages during the most recent prior period of market strength in 2007.
Companies In Secular Decline
Investors who screen via P/E ratios in particular have an alarming tendency to end up in value traps more so than fund managers in my opinion. This is a result of investors having a backwards looking bias. The logic usually goes: "This stock is trading so much cheaper than it has in the past, I'm getting a deal." Pitney Bowes (NYSE:PBI) is a prime example here:
Shares fell more than 50% from 2010 to 2013, but earnings contracted just as quickly as well. This created a situation where "buy the dip" mentality took over among many retail investors, who quickly got burned. Pitney Bowes always managed to remain marginally profitable, just enough to keep investor hopes alive and keep them invested in the stock. Overall, time took its toll on the company, and the impact for Pitney Bowes was large: net income fell from $617M in 2011 to just $143M in 2014, resulting in the spike in P/E as the business model approached a near lack of profitability.
In this case, analysts underestimated the impact and overall size of declining mail volume and the subsequent effect on the company's future results, resulting in earnings estimates that Pitney Bowes consistently missed. I've always been fascinated by retail investor use of forward PEG and earnings estimates. By and large, most retail investors are heavily critical of the investment banking industry and their earnings estimates - but only when it doesn't reinforce their own opinion. They seem more than happy to use analyst estimates as a backup for their own stock research and as a resource to back up their own picks, resulting in a healthy dose of confirmation bias.
In this case, the market was right that Pitney Bowes' business model was in trouble. When a share price continues to decline for years, along with earnings multiple contraction, there is usually a compelling reason for that market reaction. The contraction in P/E was justified, as the quality and stability of earnings for the company had evaporated. Only once Pitney Bowes had a plan for revitalizing its business (a new high growth business line) did shares mount a small recovery, but that jump has done little for shareholders. Pitney Bowes shares trade at half the value they had in early 2006, and investors who have stuck with the company have stinging regrets.
Cyclical companies are much like companies in secular decline, and present themselves in a similar way. The longer the length of the cycle, the more they have a tendency to trick investors into believing they've found a company with rapidly expanding margins that is trading cheaply compared to other high growth peers. For cyclicals, markets still tend to react as they always have: irrational exuberance during the expansionary phase, and a flee to the exits during contraction. As a result, the best time to buy cyclicals continues to be when they look their worst: when margins have contracted and valuation multiples appear more stretched than average.
As an example here, Caterpillar (NYSE:CAT) is a bread-and-butter cyclical stock, and as you can see from the chart above, operating margins track the share price quite closely. The best time to buy Caterpillar in recent history was in the depths of the recession in 2009, when the company could barely keep its head above water from an operating cash flow standpoint. Buying Caterpillar when the company appeared its strongest (with operating margins >9%) has been a recipe for burning investor money instead.
The trick with cyclicals is making sure that what you think is a cyclical company is in fact a cyclical, and not a company with a structurally impaired business model. This is where there is no substitute for due diligence, hard work, and a little bit of gut intuition.
Cross Sector Comparisons
As someone who spends a lot of time comparing companies within the same industry, I can tell you that, despite GAAP accounting guidelines, there are plenty of differences that make cross-company comparisons even within the same industry difficult. When you compare the results of several companies, you need to make sure that you are comparing apples-to-apples, and screens do a poor job of that.
Financial ratios like EV/EBITDA are pushed as a means to make cross-industry comparisons more palatable, but in reality, there are too many reporting differences on an income statement between industries to make it truly able to meet that lofty goal. Differences range from accounting variances (capitalized versus expensed interest (such as with homebuilders), the uniqueness of accounting for bank financial statements like with Wells Fargo (NYSE:WFC) versus other non-bank entities), business model differences (such as with firms with company-issued financing to customers like Ford (NYSE:F), high revenue/low margin businesses like Wal-Mart (NYSE:WMT) versus technology firms), etc. Differences are endless.
Overall, investors need to be incredibly wary when making comparisons across industries. If you're going to screen, at the very least make sure you screen within the same industry to make comparisons more likely to be similar.
The key takeaway here that I'm trying to put out there is that there are no shortcuts to beating the market. There are literally millions of participants in the markets, with every single one struggling for the tiniest fraction of an advantage over the other. In order to do better than the rest, you need to put in the time and effort. There are no shortcuts, and investors frequently use screening tools as a crutch, and a poorly built crutch at that.
As far as I'm concerned, Seeking Alpha as a whole is a far better screening method for investments than any other alternative out there. Contributors routinely put dozens of cumulative hours into researching a single company, and put all that knowledge out there for you, as a reader, to benefit from. Investors can't hope to be able to know every detail about every investment prospect out there, and the opportunity to benefit from quality research here on this site has yielded more valuable ideas for me than I could have hoped to find otherwise.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.