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.
New screeners present you with a wealth of numbers - all the price ratios you can digest, earnings numbers, cash flows, and so on. It is becoming impossible to sort out though the ocean of information that companies release every quarter now. In addition, can you rely on analysts anymore? Apparently, bloggers do a better job of rating companies than street analysts!
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 Hough
Jack 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 II
Charles 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!
