One very popular method of getting investment ideas is running stock screens. For those of you not very familiar with ‘screening’ here is a basic video. The idea is to filter out companies using basic parameters like Market Capitalization, Average Daily Trading Volume, Price to Earnings ratio to cut the investable universe to a more manageable level. Then comes a closer look like checking profitability (ROE, ROIC) , growth (revenue and earnings growth) and different valuation metrics (P/E, EV/EBITDA, P/B) to narrow the list even further for closer inspection.
However, stock screen has its fair share of issues. It is useful to know these while using screens and comparable sheets. I am in no way saying that we should avoid using screens altogether but rather saying that they should be used while remaining aware of the shortcomings.
- First of all the forward looking estimates do not show the ‘conviction’ level of the analysts. Conviction in an idea is actually very important for buy side analysts and fund managers. The numbers in the stock screens and comparable sheets are quite devoid of emotions.
- Secondly, filtering on the basis of valuation multiples like P/E can also be quite misleading at times. The earnings used to calculate P/E may have non-recurring items. The earnings base of the previous year also could be substantially high or low due to cyclical nature of an industry. Quality of earnings is also a related issue that screens cannot distinguish.
- Thirdly stock screens are easy to run and thus almost anybody can use it. By that logic (not applicable in all circumstances) opportunities to make easy money by investing in companies identified through screening will not stay long. In most cases, the stocks that look cheap on a P/E basis and having a high consensus earnings growth estimate is probably cheap for a reason.
I think that people should can use stock screens with a slightly different goal in mind. Instead of trying to find the best investable names, people should rather use it to remove ideas not worth pursuing. So the first step involving the Market Cap and Liquidity criteria will remain the same. On the second stage, investors should drop names based on few filters like extremely high valuation multiples, very low return on capital (over a business cycle) etc. From this level onwards, the screen should not be used. Instead, each company should be researched individually to decide whether they call for further investigation. Personally, I would just start with corporate governance standards and major shareholders list even before looking at the business model.
There are other ways of getting investment ideas that could supplement this method. Sell side analysts, investment magazines, global themes (e.g. changing demographics, lower oil price) etc are methods that people have used. Most buy side analysts use a number of methods to get ideas.