Life would be much easier if stock screening was as easy as putting variables into a computer. The fact is stock screening is the beginning exercise of stock selection, not the end point.
That’s because you’ve got to look deeply into the numbers and underlying trends to find the kind of irregularities that clarify what the numbers–accidentally or no–conspired to obscure. For instance, meteoric revenue growth is positive, but this growth should be considered in conjunction with a cold hard look at the company’s revenue recognition policies, with an eye toward changes that made delivering top line growth a little easier.
That said, you need to start with a good set of screens for stock selection. Here’s ours:
A dividend greater than 2.5%
A dividend which has increased in the past three years
A beta below one (compared to the S&P 500)
Revenue growth for the past three years (even if a year like 2007 or 2008 happens, and my options get highly limited, this rule stands.)
Margin growth for the past three years (operating margin or gross margin)
P/B lower than that of peer group, and Price/Cash Flow lower than that of peer group.
I use this information to look at three aspects of a stock. First, is the cash flow I will receive. Obviously dividend-paying stocks are the best. Countless analyses confirm they offer less volatility and better long-term returns than those stocks not paying a dividend. And if a company has a history of increasing its dividend, it tends to be the stronger performer in its group.
Second item I look at is future growth. I mean actual future growth, not what an extremely talented accountant can come up with. Revenue is a good place to look because it’s nearly impossible to manipulate over longer periods of time. In addition, a company growing revenues (rather than just looking to cut costs) to increase its margins suggests a more enlightened and talented management team capable of delivering superior long-term returns.
Finally, I like to look at the valuation through the price-to-book and price-to-cashflow ratios to see what they are vis a vis peers. Book value is a good number, but there are many traps in it such as older assets held on the books at historical prices that may have actually increased in value, or decreased faster than the company depreciated it. Still, for a first look, these two ratios, in combination with an understanding of your cashflow and future growth prospects, are good places to start.
