Stock screens: the antidote to the 'too clever' investor

But in reality, outside the professional sphere, the heroic acts of forecasting and assumption that are necessary to achieve such valuation feats are well out of most people’s reach and comfort zones.

Fortunately, there are more down-to-earth strategies that are far easier for private investors to apply when searching for winning shares, and stock screens can be a massive help. These strategies are built on enduring evidence about how both people and stocks behave rather than a goal of forecasting omnificence.

Take contrarian value investing. In this case, all investing is definitely not value investing.

Making money from a contrarian value strategy by buying out-of-favour shares is based on an awareness that when companies get into trouble, the market often overreacts. Should the storm clouds clear, as they often do, cheap shares bounce back, sometimes spectacularly.

There’s a common-sense reason why this opportunity exists based on human behaviour.

The field of psychology has demonstrated that a range of our shared traits makes it very hard for us to look beyond present circumstances towards something that is much better, or for that matter worse, than we’re currently experiencing. In the moment, we fail to appreciate the potential for things to improve.

The same psychological tug is also there for anyone creating forecasts from which to calculate intrinsic value.

Where stock screens come in

An excellent way to escape the collective stupor and see the opportunities in front of us is with stock screens. Screens don’t have the psychological baggage created by human emotions. Screening for stocks that display some well-chosen characteristics can alert us to situations investors are known to typically misjudge. This doesn’t negate the need to thoroughly research stocks, but it does provide a promising starting point for those efforts.

This method may not ooze the sophistication or complexity of an intrinsic-value approach, but it’s much easier for private investors to apply and can be startlingly effective.

A case in point is the contrarian value screen I devised when writing the Investors’ Chronicle’s weekly stock screening column (see table). The screen looks for companies trading at feeble multiples of sales but with a history of decent profitability. This represents a straightforward way to search out companies that may have fallen on hard times based on a low valuation, but which have the potential to bounce back based on their track record.

This type of value investing is one of four investment styles that are well recognised by both finance professionals and academics as producing outperformance over time, which have been thoroughly empirically tested using broad-brush financial metrics.

Quality investing is another approach with a sound long-term pedigree. The common-sense reason it works can be explained by our tendency to think of progress in terms of straight lines rather than daring to imagine the upward-sloping curves caused by compounding.

Momentum investing – buying rising shares in anticipation of more of the same – can also be the source of powerful outperformance. This is particularly true when share price momentum is supported by improving fundamentals, which reduces the risk of chasing rainbows.

And the tendency of less volatile shares to outperform over time, a fourth well-researched strategy, is best thought of as a reflection of our disinterest in the type of dull, conservatively run companies that tend to fit this mould. That may be why low volatility is so potent when combined with good dividend track records. After all, dividends are a sign management thinks there is nothing more exciting to do with cash than return it to shareholders.

The power of these investment approaches does not lie in trying to put a precise value on stocks. Nor is it overly important how exactly the phenomena have been backtested. What really matters are the underlying ideas and their ability to identify situations that others tend to ignore, overlook, or avoid. Well-designed screens can help alert us to stocks that fit these strategies.

My book Four Ways to Beat the Market provides details of market-beating screens based on these four strategies along with everything needed for someone with a basic knowledge of investing to become a stock screening whizz. This includes simple explanations of how to understand and use company accounts and financial ratios through to the psychology and practicalities of the four strategies, and examples of how to separate winning screen suggestions from duds.