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A Fundamental Twist on Mechanical Stock Screens

|Includes:General Dynamics Corporation (GD), WMT
In his 1996 book, "What Works on Wall Street", James O'Shaughnessy back-tested over 40 years of stock market data to figure out the best mechanical investment strategies.  For the book, OShaughnessy tracked the returns produced by selecting stocks based on high or low values of valuation ratios such as price/earnings, profitability gauges such as return on equity (ROE), dividend yields, earnings growth -- you name it. OShaughnessy evaluated dozens of factors, by themselves and in combination with each other.

For each year from 1951 through 1994, OShaughnessy used each selection strategy to pick 50 stocks at the beginning of the year, then measured the portfolios return 12 months later.

The best-performing strategy, which OShaughnessy dubbed Cornerstone Growth, averaged an 18% per year return for nearly 50 years.  This strategy uses only three parameters: price/sales ratio, earnings growth and relative strength.  Each of these metrics represent a component of Value, Growth and Momentum.
 
Value
A price-to-sales ratios (P/S) < 1.5
 
Growth
A significant hurdle is created by requiring five (5) consecutive years of earnings growth.
 
Momentum
From the list of stocks meeting the above two metrics, OShaughnessy picks the 50 stocks with the highest relative strength for his Cornerstone Growth portfolio. 
 
A Fundamental Twist
 
Fundamental investing teaches us that there are better metrics than the simple ratios often used in mechanical stock screens.  For example, the "earnings" reported by Wall Street are not to be trusted by serious value investors.  What would happen if we replaced 'earnings' with 'free cash flow', a better guide to a firms health.  Even the 'price' in 'price-to-sales' ratio could be improved.  The 'price' here is simply the market cap, yet Joel Greenblatt uses a modified market cap called  'Enterprise Value' for his Magic Formula that accounts for cash and debt.  Let's see what happens:
 
Value
P/S < 1.5 becomes EV/S < 1.5, where Enterprise Value equals Market Cap - Cash + LT Debt.
 
Growth
Rather than Wall Street Earnings, let's require 5 consecutive years of growth in Free Cash Flow.
 
Momentum
Instead of using relative strength, a more readily available piece of information - the 52-week high price - explains a large portion of the profits from momentum investing. Nearness to the 52-week high dominates and improves upon the forecasting power of future returns.  Let's require that our stocks that meet the first two hurdles of value and growth, also be within 10% of it's 52-week high.
 
Does this 'Fundamental Twist' improve upon a simple yet powerful mechanical stock screen?   Unfortunately I don't have the computing power to backtest this new screen.  Yet personally I'd be more comfortable investing in a stock meeting these more fundamentally rigid requirements.
 
There's no online stock screener I know of that can run this screen. I can do it quickly - one stock at a time - using my macro-enabled Excel spreadsheet.  Running this on my current list of about 40 high-quality stocks yields only 2 candidates.  They are..
 
GD        General Dynamics
WMT     Wal-Mart
 
My idea to implementing this method is to use it for short to mid-term trading.  Purchase and hold the selected stocks with a 10% trailing stop.  That way if the market - or an individual stock - goes against you, you're maximum loss is 10%.  Otherwise you're holding value stocks with momentum on your side.

What do you think?  This may stray quite a bit from the backtesting done by O'Shaughnessy, but I believe it may be a step in the right direction.



Disclosure: No positions
Stocks: GD, WMT