While savvy investors may argue all day about which trading strategies work best, few would dispute that stock screening is a useful tool when it comes to getting an initial fix on a basket of potential investment candidates.
When celebrated investor Benjamin Graham began penning his investment philosophy back in the 1930s, his teaching went on to inspire generations of investors. But without a great deal of time and good quality data, the ability to mirror quantitative value strategies like those of Graham or John Neff has remained beyond the reach of most private investors.
It is only with the relatively recent emergence of accessible data and computers to work through it that a new world of insight & analysis has been available to the investing masses. No longer do you need to rely on hearsay - or the potentially biased recommendation of analysts - to generate stock ideas. While screening is not entirely new – some fund managers and academics have been doing it for decades – retail investors now have the chance to input their own pre-defined financial criteria and quickly identify which companies in the market are meeting them. Screening also allows investors to implement much more of a checklist-based approach to investing which, as discussed, can be effective in correcting the behavioural biases we all tend to suffer from when we’re investing.
Trade Your Way
Screening means that investors can take important ratios and parameters such as the P/E, market cap, revenues, profits and margins (plus a great deal more), and compare companies across the whole market or a given sector at a glance. By amending the parameters, a basket of potential stocks can be produced that may suit an individual’s trading strategy and risk profile. For those in search of ideas and inspiration, screening also provides the chance to replicate the financial criteria used by some of the world’s most successful investors to see which companies might theoretically be of interest to them.
For instance, for those with an interest in seeking out value stocks that might be poised to outperform the market, the F-Score approach espoused by Joseph Piotroski, a celebrated accounting professor at the Stanford Graduate School of Business, might be worth a look. The problem is that Piotroski judged each stock against nine accounting-based criteria, spanning profitability, leverage, liquidity, funding and efficiency. That’s all very well if you want to scrutinise one stock – but Piotroski urged investors to apply the F-Score to the cheapest 20% of stocks in the market. That’s a problem for investors, very few of whom would have the time and resources to do it… unless they have access to a decent screening tool!
Key advantages of Stock Screening
- Time Better Spent: Investment screens allow investors to scrutinise the entire market for companies that meet a pre-defined set of financial criteria – saving time and arduous research that can be better spent on further, qualitative investigation of the qualifying companies.
- Learn From the Best: Guru stock screens offer an insight into the selection stipulations of some of the world’s most successful investors. While matching the full range of millionaire-making criteria might be difficult (and/or at times impossible), trying to apply proven expert theories will produce a huge amount of inspiration if nothing else.
- Avoid Pitfalls: Using quantitative screening is a first step to overcoming natural behavioural biases in investing. Systematic checklists can help to mute the risk of making irrational decisions about when to buy and sell a stock based on gut feel, and instead gives the investor the tools to find bargains when others are running for cover.
- Shape Your Strategy: Screening tools can help shape an investment approach by offering the tools to find stocks that meet a defined philosophy – whether it is Value, Growth, Momentum, Bargains, Income, Shorting or Quality.
Drawbacks of Stock Screening
- Risks of the Rear View Mirror: Stock screens typically use historical information, which should be treated with care when making assumptions (although some metrics such as the Forward PEG do take account of forecasts). Concepts such as the Efficient Market Hypothesis dispute that any of this information can predict the likely future performance of a stock, although EMH has largely been debunked. Nevertheless, investors should be wary of using the past to predict the future.
- Quantitative vs. Qualitative: Despite comparing a wide range of financial data, stock screens don’t generally take account of qualitative factors such as management expertise or track record, sector patterns or cycles and, in the case of resource stocks, independent reports. Further research on these is essential.
- Dated Data: Stock screens are only as good as they data they use so make sure yours has the best possible information (or make allowances if it doesn’t). We favour any screening software – like our own, of course! – that uses the Thomson Reuters data-set, as we regard that as the best fundamental database globally. Likewise, comparing a company that reported its financials yesterday with a stock that produced its results six months ago may produce a distorted view, so care should be taken.
- Screening Trade-offs: Using conservative screening parameters – such as restrictive P/E Ratio requirements – risks disqualifying a potentially large number of companies that may be of interest for other reasons, such as small cap Oil & Gas, Mining and even Technology stocks, so the first priority is of course to decide on your underlying investment strategy and carefully think about the implications of your parameter choices.
Stock screening of course can't replace judgement. It is essential to note that it should be just a first step in the process of making investment decisions based on your own risk-reward trade-off. Naively applying the metrics that Warren Buffett or Peter Lynch are assumed to have used by a given author will likely result in disappointment and the emphasis on past performance should be treated with great care. However, as a starting point in refining a strategy and identifying potential stock candidates, stock screening software must rank among the most vital tools available for investors.