Fundamentals - What to Screen For (Part 2)

In a previous post I outlined some fundamentals that you can screen for to look for quality stocks. That set of values was the one that stood out for me out of the 2 books that that mentioned. However, in his book (Your Next Great Stock), Jack Hough outlines other factors that are sometimes ignored. Here are a couple more.


Accruals (from Free Cash Flow and Earnings)
Most investors are stuck on looking at earning, but as we saw in the last post, earning can be manipulated. In addition, earnings do not necessarily represent how much cash a company is adding to the kitty box due to the rules of accounting used by all businesses - accruals accounting. Under these rules, income is added as it is accrued (not when it is collected) and expenses are subtracted as they are incurred (not when they are paid). In his book, Hough uses the example of his barber who starts accepting credit cards - he might sell $2000 of services per week as usual, but if 1/2 his clients use credit cards to pay, he'll have only $1000 in his kitty box until he gets paid by the credit card company. But he can still count on $2000 of income. It gets trickier with large businesses depreciating and amortizing large equipment or software as payment are counted over many years even if made in one shot! Hough outlines ways that businesses can use accruals to boost their numbers. Obviously, something to always keep in mind. Next Hough outlines a strategy to look for something a bit counterintuitive - to look for companies with negative accruals. Accruals are calculated by subtracting free cash flow from earnings. His argument (supported by many studies) is that companies with negative accruals usually have hidden earnings while companies with positive accruals might actually be inflating earnings. He cites in particular a couple studies from Richard Sloan (an accounting professor at U. of Michigan) who found out that a portfolio which bought companies with negative accruals and shorted companies with positive accruals beat the broad market by 10% a year between 1962 and 1991. Sloan published another article supporting his research a couple years back and showed again that companies with high accruals showed poor earnings moving forward. Sloan's findings have been put to work by many institutional investors and hedge fund and they are now called the accrual anomaly.  In 2006 Joshua Livnat (a professor at NYU) and Massimo Santicchia (of S&P Investment Services) found that the anomaly still yielded positives results despite the fact that large investors were actively trading using it. They also discovered that the accrual anomaly was stronger with smaller to mid-size companies. Now, accruals are not usually listed in most financial web site, but it can be calculated if your screener shows Free Cash Flow and Earnings. Hough suggests looking for companies whose trailing 12-month free cash flow minus trailing 12-month net income is greater than zero. In his screen he adds other factors, but feel free to add any of the factors described in the other post.


Insider Buying
Executives willing to eat their own cooking can be a decent predictor as long as you know what to look for. In his book, Hough goes to great length to explain insider buying. This is sometimes a tricky subject as the reasons for the buying are not always black and white - a canny executive might be accumulating shares to consolidate his position for example. But most often, they have a better understanding of their businesses than the public at large. Obviously, for them to trade on nonpublic information is illegal, but it is a gray area as to what is nonpublic! In any case, Hough outlines a study that was done by Citibank in 2006 on insider transactions done in the UK. The analysts were looking for factors that affected the stock price after that transactions took place. The factors were:

• Large stock purchases - Bigger purchases would predict better returns but purchases too large (as a percentage of the float) had actually the opposite effect.
• Who made the stock purchases - Executives has more impact than board members.
• Numbers of executives making a stock purchase
• Size of the companies - Stock purchases in smaller company with little analyst coverage did better.
• Timing - A stock purchase following an earning surprise was a good predictor. In addition, purchases made while a stock had a strong performance was usually a good sign.

Hough suggests looking for insider purchases of more than $100,000 but keeping the total shares purchased at less than 5% of the available shares. The number of insiders buying also has to be greater than 2. To keep with the results of the study, he also suggests looking for companies of less than $10 billion market value covered by less than 6 analysts.


Interestingly enough, Hough does not elaborate on insider selling. I would be curious to see if it has the reverse effect on the stock price! Maybe someone has published a study on that.