Therefore it is becoming important to try to concentrate on the numbers that will have the most impact on future stock prices. I have picked up 2 books to help me screen the screener input:
Your Next Great Stock
- Jack HoughJack Hough writes the screening analysis in Smart Money and SmartMoney.com. In this books, he outlines 11 different strategies using fundamental information.
Beat the Market - Invest by Knowing What Stocks to Buy and What Stocks to Sell
- Charles D. Kirkpatrick IICharles Kirkpatrick has written books on Technical Analysis and has perfected some screens described in the book. You can get more information at http://www.charleskirkpatrick.com/.
Out of these 2 books, a couple of numbers have risen to the top. Here is a quick list:
Price-to-Sales
Both books rely on the price/sales ratio in some of their screens. It is used by Kirkpatrick in his most successful screen (the Bargain list) which is up 95% since December 30, 2005 to date. His Bargain portfolio is up 161% in the same period - Kirkpatrick advocates going to cash gradually during market downturns which he measure with MA crossings (a little complicated for this posting). In any case, not too shabby since the S&P500 is up only around 7% in the same period. In this screener, Kirkpatrick uses relative values for the price-to-sales ratio, comparing the ratio from one company to all others. He ran a lot of testing to arrive at the best range of relative values. Not that easy to screen for although one software contains custom screen created to match Kirkpatrick specifications - High Growth Stock Investor. Not cheap, but there is a trial period. Jack Hough keeps it simpler, screen for a Price-to-Sales ratio below 1.5. Easy enough! His screen contains other criteria (like Kirkpatrick's), but the Price/Sales ratio is the cornerstone. Both Hough and Kirkpatrick cite the work of O'Shaughnessy who ran some simulations and found that $10,000 invested in high Price/Sales ratio stocks would be worth $19,000 in 2003 while the same amount invested in low Price/Sales ration stocks would be worth $22 millions! Low Price/Sales stocks returned on average 16% a year. By adding requirements for earnings growth and price momentum, the simulation returns more than $53 millions by 2003. Pretty strong evidence I would say. The advantage of the Price/Sales ratio over say, the P/E ratio or any cash flow ratio is that it is difficult to manipulate - accountants can adjust earnings almost every quarters. Sales are sales...
Price Momentum
This seems like a natural, but too often, it feels wrong to invest in a company that has a great run! What if you caught a top. In his book, Hough cites some studies that have been done to show that investing in stocks that are within 5% of their 52 week high and selling stocks within 5% of their lows have beaten the market by an average of 7.8% per year. Compound that over 20 years and you can start planning for a nice retirement. Obviously, other factors should be used to weed out hyped up stocks, but the evidence is pretty strong. Kirkpatrick uses a relative strength percentile factor in his Bargain List portfolio, looking for stocks with a percentile greater than 97. He uses his own calculation to arrives at this number, but the thesis is similar. Better to buy stocks performing better than the average!
Earning Growth
There, the 2 books diverge - they both stress the importance of earning growth but Hough is forward looking while Kirkpatrick looks to the past. Kirkpatrick seems to have little faith in projected earnings (and who can blame him there) so he relies on his own relative calculations, using operating earnings over 4 quarters as compared to the 4 quarter total one quarter earlier. He uses operating earnings to get around adjustments and special charges that make it impossible to make accurate comparisons. He uses 4 quarters to get around the seasonality that could affect some businesses. The calculated ratio is then used to rank companies between 0 to 99. Interestingly enough, Kirkpatrick does not use this criteria in his best screen, relying solely on relative performance and Price/Sales. Hough in his book shows a little more faith in the system and describes a screen using the PEG ratio. He advocates a PEG ratio between 0.2 and 1.5. The cutoff at 0.2 is to weed out any special earning report such as settlement that would distort the earning picture. In his screen, Hough combines the PEG ratio with some price momentum criteria (see above). Obviously, the PEG ratio is only as good as the analysts predictions so it is important to use this criteria on companies that have wide enough coverage to get reliable figures. But he cites a screen from the AAII who has beaten the market pretty handily based on screening stocks for a PEG between 0.2 and 1.
Price-to-Book
This criteria does not appear in the Kirkpatrick book, but Hough makes a good argument for inclusion in his book. He cites the work of Joseph Piotrosky from the U. of Chicago who found that low P/B ratio stock beat the market by an average of 6% per year (which is confirmed by other studies). However, he also found that only 1/2 the stocks returned by the screen contributed to all the gains so he needed more criterias to weed out potential winners. He came out with 9 of them. I will not list them in this article (you can read the book) but the P/B ratio is the cornerstone of the screen. Hough advocates screening for companies whose P/B ratio is in the bottom 25% of the stock universe you are screening against. This is also one ratio that can vary greatly from one industry to another so this has to be taken into consideration.
In my opinion (as well as the 2 writers above), these criteria are amongst the most important ones to screen for. Hough uses others in other screens, but this will be the topic for another article. Good hunting!
