An Example Of Why Stock Screeners Are Only Step 1 In The Investment Process

by: Kevin Wiens

Summary

I recently ran across a stock screen that proposed some companies for further investigation.

When I dug deeper the company had many non-recurring items that I prefer to exclude from my analysis.

These one-time items inflated net income growth. After excluding them the company went from "fast" growth to "normal" growth.

I feel this is a good example of why stock screeners should be used as the first step in an investment process.

I recently read an article discussing stocks that are trading at attractive valuations. Basically, the entire premise of the article is based on a stock screener that has spit out some names that the screen feels are undervalued (or, at least, at value). The article then gives some color on the company and the investment thesis. This is not in-depth analysis; it just presents ideas.

I like articles like this (and stock screeners) as they give me fresh ideas to investigate.

And I did investigate one of the stocks highlighted in the article. [For the record, the company is Acadian Timber Corp. (OTCPK:ACAZF)] It happens to be a name that a co-worker pointed out to me years ago, meaning I had already half-done my research…years ago. I updated my trusty model with the financial data that I was missing (the most recent data I had was 2011) and dug a little deeper.

I can understand why the screen picked out this company: as the article stated, the Peter Lynch model likes the fast-growing company. Three- and five-year compound annual growth rates (CAGR) for net income are 46.5% and 36.0%, respectively.

However, this is where my choice of data points can make a material difference. If I simply left my presentation of growth at the above rates, one would think that this company is unstoppable. Let me shed more light on the situation: the four-year CAGR is 8.7%. This is still a healthy number; it's just not close to the first two numbers I presented.

To be fair, I can also present the six- and eight-year CAGRs, which are 14.8% and 23.7%, respectively. (The seven-year CAGR is meaningless because earnings were negative in 2007.) At some point there is no point in calculating more CAGRs. Overall, I will say the company is growing at a healthy clip since most of the CAGRs are in double-digits.

And, again, if my analysis stopped here I might still conclude that the company is on a growth rampage.

For me, my analysis does not stop here.

When I looked at the numbers it was evident that something "different" happened in 2014. Let's look at a graph of net income over time (figures in CAD millions).

(Source: annual reports.)

As we can see, net income has been on a choppy path. The "trend" is up, as one could argue that there is a reasonably straight line through the tops of the bars in 2006, 2008, 2010, and 2014; however, that is only because of a strong 2014, where net income is up nearly 500% over 2013. I would argue that there is not a true trend in this graph. To me, extrapolating the stated growth rates as a trend would be a mistake.

However, these are the numbers used by the screener and this is why it popped up in the article. Like I said, my analysis did not stop here - I want to know why net income is up so significantly in 2014.

My reading of the financial statements revealed some "non-recurring" items that I generally exclude from my analysis. Specifically, these items are fair value adjustments, a gain on corporate conversion, and gains and losses from Class B interest liability of a subsidiary.

When I exclude these one-time items (and the associated tax implications), my adjusted net income over time looks like this:

The adjusted net income figures have a much flatter "trend" than the stated net income numbers. The three-, four-, five-, six-, and eight-year CAGRs for my adjusted figures are 37.2%, 1.3%, 5.1%, 32.7%, and 5.3%, respectively. A graphical representation comparing the CAGRs between the stated net income figures and my adjusted figures is provided below:

As we can see the adjusted CAGRs are generally materially lower than the presented CAGRs. I have excluded the 2-year and 1-year growth rates because shorter time frames will have more volatile CAGRs. (As previously mentioned, stated net income growth between 2013 and 2014 was 496.6% - for comparison, my adjusted figures give YoY growth of 64.5%.)

An 8-year CAGR of 23.7% (stated net income) versus an 8-year CAGR of 5.3% (adjusted net income) makes a big difference to one's view of growth going forward. Stock screeners are likely to use the former number and assume this is a fast-growing company. I am more likely to use the latter number and assume it is a normal-growth company.

This is an example of why stock screeners are a tool best used as the first step in an investment process and not as the basis for an investment.

(For the record, I assume there are stock screeners that use adjusted figures; I am simply pointing out that further investigation should still take place.)

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.