At some point in an investor's journey, one will wonder if screening for stocks actually work. Benjamin Graham in The Intelligent Investor systematized the process by laying out ten screens that could be used to find cheap stocks. If you have read the book, you will know what I am referring to. If you haven't, I'd recommend you to read it because I am not going to reveal them in this post. Besides, it is a good starting point if you are interested in investing.
So, screening helped Benjamin Graham outperform the S&P500 by an average of 2.5% annually, for 25 years. The question is, does this strategy still work today? Back in Graham's time, there were no computers and screening had to be done manually, but in this modern era, anyone who has their hands on a computer with internet access can easily start screening for stocks, thereby crowding out the opportunity for potential profits.
In order to find the answer, we have to first identify what Graham's screens were constructed to achieve. It is clear that Graham was looking for cheap companies with stable and growing earnings, low debt as well as companies with liquid assets that would act as a safety net to fall back on (margin of safety). He had three pricing screens among his ten criteria. P/E, P/NTA and Dividend yields. I believe these three pricing screens were central to Graham's strategy because in another book (Security Analysis) that he had written with David Dodd that delved into the specifics of what was mentioned in The Intelligent Investor, it emphasized on the three important factors that one must study to determine the attractiveness of an investment.
The Earnings, Assets and Dividend Yield.
In the following decades, lots of studies done by academics and portfolio managers have found that at least two of these screens seem to work, at least on paper. Stocks that trade at low PE and PB ratios deliver returns that beat the market on a risk adjusted basis. However, there are limitations to their effectiveness as well.
1. Time horizon: There are periods, some lasting for years where the strategies underperform the market. Therefore in order to execute this strategy effectively, an investor has to stick to the strategy even when the screens don't seem to work for him for a number of years. Also, while low PE stocks seems to dominate high PE stocks over an extended period, high PE stocks outperform in a low economic growth environment.
2. Capital Constraints: The screens work when the portfolio is diversified. Without a huge amount of capital, one cannot meaningfully diversify their risk across the universe of low PE and PB stocks. Stocks trade at low PE and PB ratios for a reason. And most of the time, stocks that trade at survival valuations have high debt burdens and run a higher risk of default or bankruptcy.
3. Liquidity and Transaction costs: Most strategies work on paper but perform badly in practice because the studies don't account for transaction costs. If one were to look at low PE stocks in the NYSE or NASDAQ, many of the stocks are Chinese ADRs and are lightly traded. Hence, an investor would face wide bid-ask spreads that may reduce the return of an investment.
To prove the three points that I have outlined above, here's a link showing how one fund manager, James Rea attempted to put Graham's principles into practice in an investment fund that he ran between 1982 and 1990s. The fund ranked in the bottom 20% of the fund universe in performance.
Don't be discouraged. I am not implying that screens don't work. In my opinion, screens helps to narrow the universe of stocks to a more manageable number, and once cheap stocks have been identified; one can work on the intrinsic value of a stock and incorporate a margin of safety to arrive at a target price. A qualitative criterion may also be applied to separate the winners from the losers.
If you are at this stage in your investing journey where you wonder if screening works, I hope that I have helped to answer your question.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.