Value Screening US Stocks – Example with 7 “Picks”

Wednesday, September 1, 2010

Screening can turn up some good US stock values in today’s market (see my article “Investors Give up on Value Stocks – Should We?” for explanation). Below is an example in which I set the hurdles high, yet still had 7 leading companies clear every one.

The example’s importance is not the specific companies my screening produced. Rather, it’s the fact that well-known, high quality companies are priced so attractively that they can pass multiple stiff requirements. This is highly unusual and why it behooves investors to turn off the news programs and hit the computers with their own criteria. They likely will be surprised at the companies that score “desirable.”

Some screening basics

First, pick good screening software. Use a screening program with reliable US stock data and the ability to conduct the testing you deem important.  During my career, I used Compustat – it is outstanding, but expensive. Now I use Financial Visualizations ( This free online service has a large data set with very good screening capabilities. Results can be exported to a spreadsheet program. Lists, screens and portfolios can be saved for future use.

Second, plan out the screening process. Like when traveling, it’s important to have an itinerary. This means thinking through what’s important and the order of its importance. Hate the idea of a highly leveraged company in today’s economy? Then put a low debt test toward the beginning of your search.

A common mistake is to jump in, then add, change and remove criteria depending on the results that fall out. There is a time for that, but it’s at the end of the planned screening – not at the beginning. Otherwise, you will likely turn off the computer with a head full of confusing results, no real knowledge gained and, worse, no attractive investments in hand.

Third, make the screening process fulsome. Picking only one or two measures, especially if set at extreme levels, guarantees finding oddball stocks that happen to have wildly desirable characteristics. However, any in-depth analysis quickly shows the underlying problems and the investment’s undesirability.

A perfect example: Many investors and investment advisers have been screening for high dividend yields. Doing so turns up about 150 companies yielding over 10%. Of those, how many might be quality investments? That’s easy to answer: absolutely none! While many investors might be gun shy about owning stocks, there are plenty of savvy ones as well as professionals who have the willingness and resources to take advantage of special situations. The fact that a stock yields over 10% is a sure sign that something is amiss. Does that mean that all 150 stocks are destined to crash? No. Some will actually do well. The question is, which ones? Buying such stocks carries special risks, often difficult to analyze or even understand, and that makes them unfit for almost all income investors. This is a perfect example because it shows where screening needs to have qualitative judgment added – mainly the common sense to say that something that looks too good is bad.

Screening example – searching for confidence

I have written that I believe the best way to conquer fear and uncertainty in the stock market is to focus on finding a few desirable companies. (For example, see “Missing the Trees for the Forest – Look at Individual Stocks” – November 16, 2009.)

So, with the thought that many investors still fret about owning US stocks, I developed the following screening to provide the highest level of comfort. Starting with the database of 6,371 issues, here is how the screening progressed (bold numbers show the number of those that met the requirement):

  1. The company is an operating company –Therefore, no exchange traded funds [ETFs] or closed-end funds. 5,086
  2. The company is headquartered in the US – Since March 2009, investors put more money into international stock mutual funds than US ones, so clearly US stocks is where the concern is highest – and the potential reward is likely best. 4,244
  3. The company is large – Size in this market represents strength, so market capitalization of at least $10 billion. This requirement really cut the number of stocks. 242
  4. The company’s stock is well followed – When analysts and institutions track a company, the stock is more likely to have good liquidity and a good information flow. Requirement: In the Standard & Poor’s 500 Stock Index. 229
  5. The companies are well financed – When stock prices are low, raising money by issuing new stock is undesirable. Therefore, adequate financial resources are important both to weather adversity and take advantage of opportunities. Requirement: Long-term debt less than 25% of long-term capital. This also cut the number significantly. 84
  6. The company pays a dividend, but not too much – The payout ratio (dividends as a proportion of earnings) tells us how much is being paid out. Without any dividends, investors need to have faith that valuations will be based appropriately on earnings. Today, many question that belief, so a tangible dividend income is important. As a rule of thumb, paying out 50% of earnings is considered an acceptable level, so requirement is less than that. 74

All of the above was to ensure the companies had conservative quality characteristics. Now we can bring in stock price and look at valuation.

  1. The dividend yield is at least 2.5% – That’s the current 10-year US Treasury bond yield, so it makes a good starting point. This requirement also cut the number significantly. 14
  2. Current price/earnings (P/E) ratio below 15 – We are far enough past the earnings trough for most firms so that, while perhaps not at a normal level, the earnings should be adequate to provide a reasonable P/E ratio (unlike the very high or non-existent ones in March 2009). 12
  3. Forward P/E ratio below 10 – Savvy investors look forward, not back. This forward P/E means using the estimated earnings for the next 4 quarters as the divisor (“current” uses the past 4 quarters, already reported). A P/E of 10 is low, but I felt it was necessary because so many investors express doubt that Wall Street has forecasts right. In spite of companies coming in above expectations for each of the past 5 quarters, these investors keep thinking that there are large, adverse forces that can reverse the trend in the future. 9

The last two items are technical indicators. Investors have different levels of understanding and comfort with technical analysis, so I am using broadly watched measures, not for trading purposes, but to get a confirmation that the stock is at a level connoting value.

  1. Below the 200-day moving average – This long-time measure takes the last 200 daily closing prices and averages them. If the current price is below that average, it tends to confirm that the stock is lagging. 8
  2. Below the 52-week high by 10% or more – Investors often compare a stock’s current price to its high and low prices over the trailing year. More than knowing where the stock is in that range, it allows us to ensure that the stock is acting normally. For example, since the stock market is down about 10% from its 52-week high (in April), we would expect stocks we might want to buy to be down as much. This test confirms it. 7

That does it. We now have list of 7 stocks that meet all the criteria.

What a screening list does provide – and what it doesn’t

Note that the 7 stocks that made it are from only 4 industries: Aerospace/defense, insurance, oil & gas, and technology. This result is typical. Complete, diversified portfolios are necessarily made up of companies possessing different strengths. One screening process will not identify all holdings. If it did, it would indicate the portfolio was non-diversified. However, for finding a stock that matches an investor’s desires, screening can be an effective approach.

The benefit of altering the criteria

I mentioned that tweaking the screening criteria after the results are in can be useful. The computer is literal, so it will not tell you that it found a stock that almost made it through. For example, if I relax the dividend yield requirement from 2.5% to 2%, three additional companies appear: Microsoft (MSFT), with a 2.2% yield, along with Murphy Oil (MUR) and Texas Instruments (TXN), each with a 2.1% yield. Likewise, just over the line of my 25% maximum long-term debt criterion is Marathon Oil (MRO) with a 25.4% reading. Given the other desirable characteristics of these four stocks, they should probably be considered. Note, however, that we are still operating within the same 4 industries.

Added benefit: Understanding the value of non-selected stocks

The results table, developed from the selected criteria, is also useful for analyzing other stocks. By putting them into the table, we can see both why they didn’t make the final list and where some of their added benefits are. (There could be others, which are not included in the criteria – e.g., earnings growth rate and profit margin.)

So… Doing a screening in today’s market can turn up some good investment opportunities because so many investors are ignoring the values that exist. It won’t always be this way, so now is a fine time to look – and act.

Note: The stock market’s rise today caused some shifting in the list above. This is a good reminder that screening results can be fleeting if market activity picks up. The 4-month slide from April has given investors the feeling that there is no reason to rush into anything. However, whenever good values exist, any pickup in interest can make them evaporate quickly.

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John Tobey on Seeking Alpha

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September 2010