Stock screens are a powerful tool in a stock investor’s toolbox. They can help you cut through the market noise and figure out the best stocks to buy based on your investment objective and goals.…
Stock screens are a powerful tool in a stock investor’s toolbox. They can help you cut through the market noise and figure out the best stocks to buy based on your investment objective and goals.
Screeners are great for “getting quickly to the objective versus subjective parts of decision making,” says Doug Roman, managing director of equities at PNC Capital Advisors.
This can make screens a bit of a bore: “The subjective parts of the process are the fun part,” Roman says, “but they’re also the part that can hurt you the most.”
It’s within the murky realm of subjectivity that most of our behavioral biases lie. Biases like the confirmation bias which has us seeking out favorable information about our investment philosophies and holdings and ignoring the unfavorable.
By focusing on hard-cold facts and variables, screens help investors avoid these behavioral biases and their negative effects, Roman says. The trick is figuring out how to set a stock screener.
How to create a stock screener? Useful though they are, stock screeners can also be daunting: So many variables, so little time. Where is a stock investor to begin?
Begin with your goals, says Rich Messina, senior vice president of investment product management at E-Trade Financial Corporation in New York. Your goals for your money will dictate which stock screen variables you should focus on.
For instance, if your goal is to aggressively grow your portfolio, you “may want to screen for stocks with a high beta,” Messina says. “High-beta stocks have greater volatility, and could have above-average returns versus the broader market, if you’re willing to take above-average risk.”
Fundamental stock screener variables. If you have a buy-and-hold objective, on the other hand, you “may look to screen by fundamental indicators, rather than technical or short-term indicators like daily price movement,” he says.
Such a growth-oriented investor might focus on company financials through variables like high revenue or high earnings growth rates, says Robert Johnson, a professor of finance with the Heider College of Business at Creighton University and co-author of “Strategic Value Investing.” Meanwhile “a value-oriented investor may screen for companies with low price multiples, like price-to-book and price-to-earnings.”
He gives an example of a stock screen a value investor might use:
— P/E < market P/E
— Price-to-book value < 2
— Dividend yield > 2 percent
— Market capitalization > $10 billion
— PEG (or the P/E ratio divided by the expected five-year growth rate) < 1.5
— Stock price > $5
Market capitalization is important because it’s “a proxy for liquidity,” Johnson says.
Stock screeners “can sometimes produce thinly traded stocks or funds that end up being more volatile than you may be comfortable with,” Messina says. Wide spreads and small market caps can both signal an illiquid or potentially volatile stock.
Also “avoid jumping on the bandwagon,” Messina says. “When screening for stocks consider names you may not recognize; they could be more attractive than the names making headlines.”
Start broad and combine stock screen variables.Whatever it is that’s important to you, “it’s best to start very broad, then narrow down your criteria,” says Jeffrey Swett, managing director at The Swett Group of UBS Financial Services in Boston. “For example, start with geographical region, then market capitalization, sector, industry, dividend yield” and so forth.
Roman breaks the various factors investors can screen by into four categories. “You have your value, momentum, quality and technical” variables, he says. When using stock screeners, it’s best to include variables within all of these categories because they each look at stocks in a different way.
Value variables might be criteria such as P/E or more complex variables like EBITDA and free cash flow. But in general, simpler is better with value variables, he says.
Likewise for momentum: “Price momentum works really well as simple as it is,” he says. If possible, look for price momentum with a 30-day delay to screen out short-term price fluctuations.
He also looks at analyst earnings revisions to see whether their estimates are going up or down, and standard unexpected earnings surprises, but they’re not available on all stock screeners.
To translate quality into an objective measure, PNC looks at the standard deviation of EPS. Companies with more stable earnings patterns tend not to go down as much when the market declines, he says. A lower standard deviation of EPS also provides greater confidence of future earnings and continuity going forward, he adds.
Other quality measures to consider are improvement in return on equity, debt-to-equity, debt-to-assets. And “S&P has a financial strength rating which we like,” he says.
The last variable is the technical analysis. He saves this one for last because it involves stock charts, which require interpretation and thus can be more subjective.
“The more subjective part of your investment process should be the last step,” he says. So once you’ve screened for value, momentum and quality, then you can look at stock charts.
The limitations of stock screens. As dangerous as the realm of subjectivity can be, it’s still an important part of stock selection.
While stock screeners may be effective for scrubbing a list of stocks, they’re “not effective at analyzing more abstract, yet critical, information about companies,” Swett says. Information such as “how well-positioned a company is with regards to patents and other intellectual property, and the research and development efforts of their competitors.
“One should certainly not invest in all companies that pass an initial screening process,” Johnson says. “The screening process should identify those firms that warrant further attention.”
Use stock screens to tell you when to sell your stock. Before you press “buy” on your final choices, make sure you know what will cause you to sell your stock.
A strong sell discipline is more important than a buy discipline, Roman says. “A sell discipline based on objective factors forces you to do things you don’t want to do, which is probably a good thing.”
Your stock screen variables can inform your sell discipline, he says. For instance, if you’re buying a stock for valuation reasons such as that it’s in the bottom decile in terms of P/E, maybe you sell it when its P/E rises above the industry average.