Stock Selection Process: The Quantitative Screen

Stock Picking Process - Quant Screen

With so many individual stocks in the global equity markets to choose from, it is important to be able to follow a disciplined process for finding, evaluating, and monitoring stocks. In this article, I will focus on the initial step required to reduce the universe of stocks to a manageable number.  In future articles, I will address the detailed analysis required for evaluating stocks and the monitoring process once a stock has been added to the portfolio.

The quantitative screen

There are currently almost 13,000 stocks in the Morningstar.com database, primarily U.S based companies but which also include foreign companies with ADR’s (American Depositary Receipts) traded in the U.S.  That is a fairly large number of stocks to sort through in order to find a few high quality investments to add to our portfolios. In fact, I would say it would be almost impossible and certainly not practical to identify the ‘needle in a haystack’.

One way to narrow down the list and make it more manageable is to use a quantitative screen that defines one or more criteria that each stock must meet in order to be considered. The criteria can include valuation measures, growth rates (historical and/or forecasted), risk metrics, measures of financial stability, sectors, market capitalization, or number of employees, to name a few.  The range of combinations of metrics is practically limitless.

For example, the American Association of Individual Investors (AAII) has a screen called Murphy Technology. It is designed to identify technology stocks with high research and development spending, strong margins and growth, but selling at attractive values.  There are data points available on each company that allows for such a specific search by combining some of these data points and setting minimum or maximum levels that each company must meet in order to be included in the list. Depending on the results of the screen, you can either add or reduce the number of criteria, or make each criterion more stringent or more flexible to reach a certain number of companies.

At PM101, I use a combination of three different screens to narrow down my universe of potential investments into three buckets:

  • Dividend Growth Companies;
  • Pure Dividend Yield Companies; and
  • Growth at a Reasonable Price (GARP)

Dividend Growth Companies

The dividend growth screen attempts to identify companies that currently pay a dividend and are well-positioned to grow that dividend over time. In this screen, while a dividend yield is required, the level of the dividend yield is less important than the forecasted ability for the company to increase its dividend.

This screen is comprised of data points that measure the levels of cash flow the company generates and the historical dividend growth trend. The premise of this screen is that companies that have raised the dividend in the past probably have favorable dividend policies and may be more likely to increase them in the future.

At this point in the process, I don’t know if that is the case, but the idea is to use a quantitative method to identify companies with favorable dividend policies. This will be confirmed with qualitative analysis once the list has been narrowed. The other major component of this screen is that it requires adequate levels of cash flow. The premise being that some of these cash flows may be returned to shareholders in the form of higher dividends. Again, only further analysis will confirm this.

Pure Dividend Yield Companies

This screen identifies companies with a high dividend yield combined with a valuation overlay to narrow down the list to a manageable number. Many of these companies fall through the cracks of other screens because the dividend may be volatile, or the cash flow measure used may not be consistent across all industries. For example, REITs report funds from operations (FFO) as an industry standard for cash flow, which can be quite different from GAAP (Generally Accepted Accounting Principles) measures of cash flow used by companies in other industries. For this reason, I created a pure high yield screen that uses valuation criteria only to narrow down the list of companies.

When I refer to valuations as a way to narrow down the list, I am referring to a criteria the limits certain price multiples to below a certain level, either an absolute number or relative to the company’s long-term average price multiple. Most online screening tools provide several options to choose from for valuations such as price/earnings, price/book, price/cash flow, price/sales, etc. You could either look for multiples that fall within a certain range or compare it to another metric, such as a competitors valuations or the company’s own historical valuation averages.

I use this measure to narrow down a list that remains too long even after all of the other criteria have been screened for.  It is quite possible to miss opportunities by using this approach and I may end up with stocks that are cheap for a reason.

Growth at a Reasonable Price

This screen looks for companies with some growth potential but that are trading at levels below what is warranted by its growth prospects. This screen looks for companies with revenue growth above a certain level, combined with minimum return on equity, high levels of cash flow, and valuations that are below the long-term average of the stock.  Once again, I just want to remind you that this screen only serves to narrow down the list of companies for further analysis. Companies that pass the screen aren’t necessarily good candidates to invest in. The screens are just a way to identify companies for further analysis.

Of the three screens, the Growth at a Reasonable Price (GARP) screen provides the names of companies that will provide growth to my portfolio, albeit using a conservative approach. It is conservative because it uses current valuation levels to determine the level of safety cushion that could be priced into the stock. The alternate approach, and the more aggressive approach, would be to invest in companies purely for their growth prospects with less regard for valuation levels.

Why use multiple screens?

There is nothing wrong with using one screen. Stocks identified with one screen will have similar characteristics at the time the screen is applied but it doesn’t necessarily indicate that a portfolio made up of those stocks will lack diversification.  Since many screens are based on quantitative information on a stock at a given moment in time, the list of stocks that result from a screen can be quite diverse across regions, sectors, industries, etc. So don’t be afraid to design one screen and stick to it. More than likely, you will tweak that screen or find that you lack stocks in your portfolio with specific characteristics. To fill that gap, it’s likely you will have to use a different screen to identify possible candidates.

PM101 uses three screens because of the strategy used to build portfolios.

  • Dividend growth companies tend to be more stable than non-dividend paying companies so these companies are the stabilizers within our portfolio.
  • Dividend yield companies tend to fall within certain sectors and also generate higher levels of income than average companies.
  • And finally, the GARP companies are a conservative way to invest in growth companies. (as I mentioned earlier)

That rounds out the three principal portfolio management objectives: wealth preservation, income, and growth.

An example

Using Morningstar.com, I selected the following criteria to come up with a list of candidates with high earnings growth estimates and valuations below their long-term average.

  • Price / Book Ratio (Current) <= P/B ( 5 Year Average) or Price / Cash Flow Ratio (Current) <= P/CF (3 Year Average); and
  • Price / Sales Ratio (Current) <= P/S ( 5 Year Average )or Price / Cash Flow Ratio (Current) <= P/CF (3 Year Average) ; and
  • Return on Equity % over Trailing 12 Months >= 15; and
  • Free Cash Flow (Year 1) >= Free Cash Flow(Year 2); and
  • Market Capitalization (mil $) >= 20000

The screen produces 54 companies, which in my case, is a very manageable number. You may want to make the criteria stricter or looser to increase or decrease the number of companies that pass the screen.

Once you have a narrowed down list you can focus in on a few interesting companies. My personal approach is to glance at sectors or industries that look attractive. Otherwise, it wouldn’t hurt to read a bit about each company to find out a little more about what they do. Once a target company has been identified, the in-depth analysis begins.