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Shares: How to use stock screening to pick shares

Created:

29 September 2006

Written by:

Dan Oakey

Most of the approaches detailed in these investment guidesassume you are already interested in a stock and want to know where to dig more dirt. Stock screening, by contrast, assumes that you will buy more or less any stock providing it meets your investment criteria.

The perfect stock would have fast-growing revenues that it was turning into cash. It would be paying out a market-beating dividend but still be lowly rated in terms of its price-earnings (PE) ratio. It would be backed by solid assets or a wall of cash, and would earn a handsome return on capital.

This kind of stock may sound like a pipedream, but what stock screening does is aim for this kind of perfection and see what crops up along the way. It would not be feasible without computers and company data. But since both are easily available, anyone nowadays can search through a database of company accounts and specify the sort of company they are looking for.

For example, you might decide to target steady earners that, for one reason or another, are out of favour with the stock market. In that case, you would look for shares with a PE of less than 10, a dividend yield of more than 4 per cent and a return on capital of over 15 per cent. Apply that screen across the FTSE 350 market, discarding stocks that do not meet all three criteria, and only a few stocks will show up.

Using Investors Chronicle's stock-screening tool, available as part of the IC Advantage package, the whole process took me about 45 seconds. But speed is not the only factor in favour of stock screening.

This approach to stock selection is also ideal if you are one of those people who tend to get carried away by a good investment story. Growth and technology stocks thrive in a climate where rising markets start to feed on themselves. Without any real backing from revenues or profits, certain stocks and sectors become 'hot' and it can take a resolute investor to resist the charms of the latest stock market darling.

Stock screening avoids this kind of emotion, does away with excitement, and has zero room for gossip, newspaper rumours or bulletin-board tips. The only things that will get a stock through the screen are when the fundamental company accounts improve or when the share price falls to a level that makes it attractive.

It is also ideal if you're a ditherer. You may be tempted to keep on researching a stock for far too long - and never get round to parting with your cash. There is always a reason to prevaricate. One more set of results, one more broker's note, one more trading update - and then you'll invest. Only, by that stage, there's another share that has caught your eye and you put off the whole thing again.

With stock screening, you deliberately restrict the universe of stocks that you will look at. You filter out most of the historical record, so there is no need to trawl through 20 years' worth of annual reports. The threat of information overload is reduced because you rely on your computer and a select set of accounting data.

What's more, by adopting this approach, you put yourself on an even footing with every other investor. This is not always possible with other research techniques. For example, imagine you want to spot companies that are about to report profits or earnings that are far better than the City expects. If you could do so, you would stand to make hefty profits as the share price reacted to the good news.

Unfortunately, to do so you would need better-than-average knowledge of what the company was about to announce. Short of insider information, the best you could hope for was a revealing look at the real state of the company. But if that's what you're aiming for, you're up against every investment bank and research house in the country. Good luck to you if you fancy your chances, but the odds are not with you.

Does it work?

So, are the odds that much better with stock screening? To date, the answer is yes. A group called the American Association of Individual Investors (AAII) has been logging the results of over 50 stock screens for around six years. Its vice-president and head of stock screens, John Bajkowski, has set up screens based on the stock-picking principles of all the great investors, such as Ben Graham and Warren Buffett.

His evidence is that 46 of the AAII's screens have beaten the US benchmark index (the S&P 500) over the past five years. Some screens have returned over 300 per cent during that time, a period in which stock markets have struggled even to recover to their dot-com peaks of 2000.

More impressively, Mr Bajkowski has found that certain screening systems seem to work consistently, year after year.

The sample stock screen that I refer to above was not based on any back-testing - it was just an example I devised on the spot. But the best screens encapsulate real investment wisdom. In a nutshell, they try to replicate in a few simple rules the experiences of ultra-successful investors.

Almost invariably, these are people who have patiently waited for the market to throw up pricing anomalies. This usually happens when people flee the stock market en masse during times of panic, or dump low-growth, steady dividend shares in favour of highly speculative growth stocks.

When the timid return to the market, the shares previously left behind roar back to life. The best way not to get caught up in excessive optimism or pessimism, say the stock screeners, is to use the impersonal, methodical approach that they take.

That's not to say it's rigid. You can screen for cheap value stocks or bargain growth stocks. You can identify momentum stocks whose share price has outpaced every conceivable measure of fair value and buy them on the assumption that the momentum will continue. Or you can screen for the shares that have fallen the most in the previous three years and buy them on the assumption (backed by years of historical data) that share prices tend to overreact.

You can also combine stock screening with traditional share selection in two ways - one obvious, the other less so. The obvious way is that even when you've narrowed down the field to just a few stocks, you will probably still want to use analysis of the company's fundament- als, its sector, business model or share-price chart to decide whether to make a purchase. This is often the only way to weed out misfits.

To take a simplistic example, a company may be on a wonderful dividend yield only because that yield is calculated using the last payout and the current share price. If it announced a massive cut in future dividends and the share price collapsed, that would send its (historic) dividend yield in the right direction but for the wrong reasons. So stock screening does not mean the end of due diligence.

The less obvious way to use stock screening is to challenge your current investments. Suppose you own shares in Reuters, you can use a stock screener to find other media stocks that pay out a similar dividend but trade on a lower PE ratio. You can then ask yourself what justifies the higher rating. There could be a good reason or it could be just the sort of anomaly to persuade you to switch investments.

• The IC Advantage package also includes regular exclusive, online-only articles on stock screening and a weekly stock screening email.

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