This One Factor Will Isolate Huge Winners… Quickly

If you’re a do-it-yourself type of investor you might be overwhelmed trying to make heads or tails of all the information at your disposal.

And that’s totally understandable. 

Sifting through the information bombarding us every day is like being a five-year-old in a candy store with only enough money to buy one thing.

One of the quickest ways to filter out the noise and drill down to a short list of investment winners is to use a stock screen.   

It used to be that only professionals had access to anything beyond just basic screens – but that’s all changed. With the explosion of information products on the Internet, individual investors now have access to many of the same screening tools that the pros use.

I want to take a moment to demystify how to use a stock screen – and then we’ll finish up with something I like to refer to as the cherry on the top.

It’s an additional input that will take you quickly to tremendous gains…

Using a Screener for the First Time

First off, let’s spend a moment discussing a question I bet a lot of you are already asking… why would I even want to use a screen in the first place?

If you’ve been investing for any length of time you probably remember sifting through Value Line publications at the library in order to zero in on potential investment choices.

At the time these were great, but now, the idea of going down to the library and reading through a printed edition of a book (with information that could be totally  outdated by the time I get my hands on it) sounds about as outdated as using a rotary phone.

Second, and probably even more important, by using a screener you remove your emotional bias.

Every successful investor or trader has some sort of system or predetermined guidelines that dictate their investing decisions.

The benefit of a predetermined plan is that it takes a lot of the emotional bias out of your investing decisions. For instance, if your predetermined strategy calls for only investing in large-cap domestic stocks, then you would never even need to consider a small-cap company from a developing economy… no matter how sexy the story.

I could write a book, or a series of books, on the different strategies that investors use, but for the purposes of this article let’s stick to a pretty simple set of parameters based on Benjamin Graham’s and Warren Buffett’s value investing thesis.

For the purposes of today’s article I’m going to keep things simple and limit our screening criteria to some favorites from the school of value investing: Price-to-Earnings, Price/Sales, Price/Book, and Debt/Equity. For all these criteria I only want to see (or allow to pass through the screen) stocks that are less than the median of the S&P 500.

There are a lot of free screening tools out there. Personally, I like the screens at ZACKS (zacks.com) or at CNBC.com.

Just to set the record straight…I don’t receive any compensation from ZACKS or CNBC. I just think the screens listed above offer a lot of functionality – and the best part is that they’re free.

We’ll use the ZACKs screen today using the following criteria:

Current Price: $5.00 or more
Price-to-Earnings: less than the median of the S&P 500
Price/Sales: less than the median of the S&P 500
Price/Book: less than the median of the S&P 500
Debt/Equity: less than the median of the S&P 500

If you’re following along you should get a list of approximately 361 companies. Obviously that’s not very helpful… and historically that list hasn’t performed all that well either.

Quick note (or warning if you prefer): If you’re not a statistical nerd like me you can just skip to the next section. On the other hand, if looking at patterns in number sounds like fun, follow along with me.

Assuming the following sample period: April 15, 2011, to March 13, 2014.

If you ran that same screen mentioned above once every four weeks and rebalanced your holdings accordingly at the time, you’d have experienced a total return of 49%, versus a 46.6% return from the S&P 500, over the same time period.

Like I said, that’s not even worth the effort.

Now let me show you the screening input that will give those returns a real boost – or the cherry on top of your cheesecake, as I like to refer to it!

Upward earnings revisions!

Now… Knock Returns Out of the Park

I’ve spent time in the past articles discussing the how valuable upward earnings revisions are to stock performance.

If we update our previous screen criteria and only allow companies that have experienced three or more full-year upward revisions in the last four weeks, we get a totally different outcome.

Here’s what our new screen would look like:

Current Price: $5.00 or more
Price-to-Earnings: less than the median of the S&P 500
Price/Sales: less than the median of the S&P 500
Price/Book: less than the median of the S&P 500
Debt/Equity: less than the median of the S&P 500
Full Year Upward Revisions: 3 or more in last 4 weeks

Using the same assumptions from the previous example, our new strategy would deliver a 75.4% return versus a 46.6% return from the S&P 500, over the same time period.

That’s amounts to 61.8% more performance by simply adding upward earnings revisions to our screen!

Of course, the results of my screening example could easily deliver too many companies to invest in all at once, or maybe the idea of rebalancing every four weeks isn’t your thing. I totally understand that.

You could make a valid argument that using a single sample time frame doesn’t give us a large enough pool of data to study - and that would be fair, too.

But, more than anything, in today’s article I wanted to get you thinking about a couple of things: 1) developing a standardized (un-emotional) way to identify new potential investment ideas, and 2) using the cumulative knowledge of professionals (by way of analyst revisions) to help sift through the sea of potential choices.

Professional analysts might not always be right, but they do have the ear of traders and institutions – both of which represent the kind of capital that can really put the wind in a stock’s sails.

If you have some more screening ideas, take a moment to share them with fellow readers in the comments section below. In a few months we can circle back and see whose ideas would have performed the best.

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