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Sep 2, 2014

Stock Screening Tools

by Peter McMurtry

Many of us have come across stock screening tools on the Internet or on a discount broker site. These tools are set up to help the average investor select stocks that satisfy our risk tolerance and return expectations.

Stock Screens are an ingenious idea to make it easier for all types of investors to weed out bad investments and ultimately to select the next market winner. All we have to do is to set up a list of requirements that our investments must meet before we will even consider investing in them.

We have all heard of promising new companies that ultimately fail as a result of too much debt. Now we can avoid these mistakes by properly eliminating companies in poor financial condition. It all seems too easy—and in many cases it is.

Many retail investors either do not have the time, confidence or the knowledge to read financial statements and to do the research necessary to select good investments. In consequence, many of us delegate these decisions to supposed experts who, in theory, will always have our best interests at heart. Unfortunately, a combination of poor performance, high fees and a general lack of empathy from these advisors have created a new class of do-ityourself investors who think they can at least do as well as their highly paid consultants.

The proliferation of much lower fee exchange- traded funds, discount brokers and unlimited free financial advice on the Internet have established many of the tools we need to improve our net worth. Stock screens are an example of one of these tools.

Stock screens are only one of the tools we need to select great investments. My article will provide the pros and cons of stock screens and will also offer some useful tips to make the screens more effective. However there is no substitute for in depth research that can uncover many hidden issues that screens often miss. For example, when one company takes over another and management espouses a rosy future, care must be taken to ensure that changes in accounting have not been implemented to paint a brighter scenario than is actually the case.

Although stock screens are very useful, most investors are at the mercy of the actual screens they use. The screens available to the retail investor vary dramatically by quality and are not nearly as effective as the much more costly ones available to pension and mutual fund professional investors. For instance, a proper screen for choosing energy stocks really must include historical and projected production growth rates per barrel and per share, operating and finding costs per barrel, net reserve additions and free cash flow per share numbers. For financial stocks, interest rate spreads, the percentage of non-performing loans, and the current and projected yield curve (level of interest rates across all maturities) are valuable criteria for comparison purposes. Unfortunately most retail stock screens do not incorporate industry-specific criteria.

We are normally inclined to include many criteria in our screens to ensure that we do not end up with stocks we don’t like. Frequently when we use this approach, the screen’s final list of eligible candidates is only a handful of names, most of which we have never heard of before. The simplest way to overcome this drawback is to use multiple screens, selecting only a few criteria from each one. For example, you can create a value screen only with criteria like trailing and projected price/earnings multiples, price/free cash flow, price/book value, and price/sales. You can also establish a financial condition screen that incorporates ratio criteria like debt/equity, net debt/EBITDA (earnings before interest, taxes and depreciation), interest and dividend coverage and working capital ratios. Lastly we can create an Earnings Growth screen that compares both trailing and projected growth in sales, operating  and net earnings, and dividends, including per share numbers, and free cash flow numbers if available. Once these three screens have been printed and reviewed, you can then choose stocks that are on all three lists if your requirements include criteria from each one.

The drawback to most screens is that they clearly do not measure the qualitative factors like quality of management, market share in an industry and unique cost advantages.

For turnaround situations, stock screens normally do not pick up improving fundamentals until after the fact. For example, if a company’s earnings are suffering and their financial condition is looking bleak, the combination of new management and a more active shareholder group may well be able to improve the company’s fundamentals over a period of time. Investing in these types of companies at this time may prove fruitful, but no stock screen will pick up this improvement in its initial stages.

As long as you know the important criteria to invest in a company or an industry in advance, stock screens can be quite useful. Historically investing in highly cyclical Canadian mining companies is not an easy task. Many investors use the wrong stats and ratios such as low price/ earnings multiples to make their selections. Unfortunately investing based on price earnings multiples for mining companies has rarely proved effective. When a mining company has a low price/earnings multiple, its earnings most likely have peaked. On the other hand, investing in a mining company when the price/earnings multiple is very high is the best time as the company’s earnings have probably bottomed. On the other hand, using a low price/earnings multiple to invest in a non-cyclical company is an effective strategy because a low valuation implies that earnings are bottoming for the non-cyclical company.

For cyclical companies, especially mining, using price/book value ratios is much more useful. Mining companies’ shares prices typically bottom at one times book value. Book values for mining companies are normally positive, whereas their earnings are frequently negative; thus it is harder to compare one company over another.

Screens can be effective for comparing how a company looks relative to its competitors in the same sector or industry.

In summary, stock screens are frequently used today to help the investor both weed out the poor investments and to identify the best companies to purchase. It is important to keep in mind that stock screens are no substitute for doing thorough research on a company or industry. They are simply to be used as a first step in the investment selection process. Stock screens rarely pinpoint companies in transition as they are not forward-thinking in nature. Most stock screens do not provide industry-specific data that is essential in the selection process. Before using the stock screens, becoming familiar with industry-specific ratios will make your job a lot easier. It is advisable to create several different types of screens–one for value, growth and financial condition and then to compare them for common names. Stock screens are great tools and lots of fun to use, but only use them as a means to an end. If you do this you will not be disappointed.

Peter McMurtry, B.Com, CFA, Financial Writer