Why are screens useful for investment research? Is it just as simple as selecting a few criteria based on your investing style, hit a few keys and “hey presto!” you’re done. No, but it can seriously help focus your efforts.
If you go to any of the usual internet investment websites, you usually find screens with varying degrees of customization. Some are pre-sets following a certain style or guru. Others allow a good degree of flexibility. Personally, I like to keep it fairly simple.
Filter: start broad, go narrow
I use the screening tool on Yahoo!Finance. My screen is actually very basic but still customized. The criteria are: forward P/E between 0 and 12, and ROE >15%. This throws up around 300 companies. I also like to know the market cap, but more out of interest than as a selection tool.
For some reason, when you use the debt: equity feature on Yahoo!Finance, I find everything gets excluded. So, I do this manually, looking for debt:equity < 1.0 and Net debt < 3x EBIT. This brings my search results down to about 130 companies. Then starts the methodical, slow manual trawl.
Next, I look at revenues and earnings trends over the last 10 years for each company. I don’t expect a perfect year on year increase, but do look for strongly positive trends in earnings and revenue growth. In fact I look at revenue growth first – I’m not very keen to invest in situations where the business is unable to consistently grow its top line.
I’m also looking at earnings growth of over 5% per year over the period. This is somewhat arbitrary, but any less is almost flat line. By setting a floor, some of the companies that qualify actually have much stronger positive earnings trends.
I also do not refer to revenue per share or earnings per share when looking at these trends. While these numbers are useful, they can be affected by change in the number of shares in issue. I want to know how the underlying business is doing.
After completing this stage on my current screening exercise, I got down to 41 companies. This included a couple of asset plays which seem to be undervalued. This becomes my watchlist.
If a company has a good positive earnings and revenue trend, it qualifies for a back-of-the-envelope valuation exercise. Back-of-the-envelope works for these companies because the exercise is not to try to predict the unpredictable – it is to work with trends so the numbers are more reliable. This still doesn’t protect absolutely against inaccuracies, but it does reduce the risk.
When performing a valuation exercise, I’m really looking to figure out a safe price below which I’d be happy to buy. My estimates are not accurate. But by using conservative assumptions, if a situation still looks good, this may lead to a satisfactory outcome.
Growth assumptions are usually based upon the lower of either the historic growth rate over the last 5-10 years or analyst 5 year projections. I’m not a big one for analyst estimates, but if their estimate of the future is lower than the historical rate you’re probably in for less of a surprise than typically rosy analyst over-estimates. Also, be careful when looking at companies that started from very low earnings a few years ago. These can give misleading growth expectations if just based on historical CAGR.
I look to define two numbers. One is the share price at which I think I can fairly safely make 15% CAGR over the next few years. The second is a sanity check DCF, using crude and unambitious growth assumptions. This is then discounted again to 70%, giving a margin of safety. The two numbers usually give a fairly close range, and I typically gravitate towards the lower of the two.
After performing the rudimentary valuation on these 40 or so companies, I now have defined a buy price. Occasionally, the buy price is below the current price. That means it’s already in my safe zone. Of the 41 companies, 11 were below my buy price at the time.
I mark the buy price on the portfolio so when they fall below, it instantly shows as red. This means I can eyeball my watchlist very quickly to see what’s below buy price, and what’s getting close. And any time I check back, I continue to get red for below buy price and green for above. Simple.
Investing by exclusion
Then the real work begins.
Now it’s a case of working through the watchlist, focusing first on the reds, and reading through the 10-Ks, company filings and other relevant news. Am I looking to understand everything about each company and become a mini-expert? No.
The purpose at this stage is to understand a bit more about the business. And to see if there are any reasons which appear that may break the so far positive trend in revenues and earnings.
You could call my approach investing by exclusion.
I start with the whole US listed market (excluding OTC and pink-sheets – much tougher to buy from a UK brokerage account). This is then whittled down by the initial screen, reduced by the debt screen and reduced again by the earnings and revenue trend reviews. I look closely at what’s left, rather than be attracted to something seemingly shiny in the first place. A bit like panning for gold.
If I had unlimited resources, a team of analysts, or unlimited time, I might use a much more all-encompassing approach. But I don’t. So, screens are like my little army of researchers who help me focus in on the really interesting ideas.
It’s not to say I don’t look at other ideas. I do try to stay open-minded. But the approach gives me an instant benchmark by which to qualify new opportunities. By the way, my list of 41 does include one company which I stumbled upon while reading – it wasn’t in the screen but did end up passing the tests.
One could argue that this exception proves why screens are a dangerous tool – because they filter out the good companies with the bad. I’m not claiming a screen will capture everything. I also recognize that there can be data delays, and certain reporting of relevant numbers can be missed with screens. Imminent spin-outs are a good example, where earnings of a division may be obscured by the parent company.
You should never rely on screens as the complete process and just invest blindly in the results (this is why screens probably get a bad name). As described here, develop an approach where screens are the starting point of your research. If used carefully, screens can allow one to get closer to many more of the opportunities of interest rather than relying on broad reading and serendipity alone.
Raman Minhas writes about using value investing, saving and psychology to help you reach financial freedom. If you enjoyed this article, join his free newsletter.