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The market has been strong recently, and many experts expect it to remain so at least until the end of the year.
I've found that the best stocks to own in this type of market share two characteristics: 1) strong price charts and 2) already strong, but accelerating, earnings growth.
You could find such stocks by devising an online screen with the right search parameters, but you don't have to. The rocket scientists who designed MSN Money's StockScouter have already done the heavy lifting.
In case you're not familiar with StockScouter, it's a sophisticated stock rating system that quantifies a stock's appreciation prospects over the next six months. The system evaluates many different factors in four categories:
- Fundamentals. StockScouter tracks historical and expected future earnings growth, often termed earnings momentum.
- Ownership. It identifies insider and institutional buying and selling.
- Valuation. It compares valuation factors such as price-earnings ratio and price-sales ratio to recent growth.
- Technical. It rates recent stock-price action.
Using a proprietary formula, StockScouter combines a stock's score in those four categories to come up with a combined grade ranging from 1 to 10, in which 10 is best.
The StockScouter system was devised to work in all types of markets: weak, strong and everything in between. However, as I mentioned earlier, in strong markets, two categories rule: Fundamental and Technical.
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Not a problem. You can use MSN's Deluxe Screener to check stocks' individual category scores and their total grades. So my screen looks for top-rated stocks based on StockScouter's fundamental (earnings momentum) and technical (stock-price movement) scores.
StockScouter's scoring system doesn't cover everything. For instance, it doesn't consider profitability and debt, two factors that I've found work for pinpointing the best stock candidates. So I added those to my screen.
As I said, this screen picks stocks for a strong market. They become risky bets if the market softens. How do you know when the market is right? The Nasdaq Composite Index ($COMPX) best represents these stocks. Consider the market strong when the index is above its 50-day moving average, and weak when below.
Here's how I created my screen:
Earnings momentum
StockScouter evaluates historical and forecast earnings growth, recent changes in analysts' earnings forecasts and earnings-surprise history to compute its Fundamental grade.If you're not familiar with the term, "earnings surprise" is the difference between the earnings that analysts were expecting and what the company actually reported. Positive surprises (reported earnings beat forecasts) greater than 1 or 2 cents a share typically incite analysts to increase forecasts for future quarters, which usually drives share prices up.
StockScouter's analysis is complex, assessing, among other factors, earnings growth sustainability, the timing of forecast changes and each analyst's experience level.
Unlike StockScouter's 1-to-10 overall scoring system, for individual categories, it uses A to F letter grades, where A is best.
Screening parameter: Fundamental Grade = A
Technical
As a fundamentally inclined investor, I'd like to think that everything you need to know about a stock could be divined from financial statements. But the market doesn't work that way. Many successful stock-picking strategies, both in the value and growth categories, rely on a strong price chart to spotlight the best candidates.Most such strategies use relative strength -- a measure of how a stock has performed compared to the overall market -- to pick the strongest stocks from a technical perspective.
But StockScouter evaluates a stock based on its own chart, not how it compares to the overall market. While it likes strong stocks, StockScouter gives its highest scores to stocks with consistent and steady uptrends. It penalizes stocks with volatile price charts.
Screening parameter: Technical Grade = A
Profitability
Two companies that report the same earnings are not necessarily equally profitable.For example, say two companies started operations a year ago, and both racked up $10 million in earnings for the year. But let's say Company A's shareholders had to invest $100 million in assets such as plants and equipment to get started, while Company B's shareholders only needed $50 million to get their project off the ground. Company A owners only netted a 10% return on their investment, while Company B shareholders received a 20% return ($10 million divided by $50 million).
Return on assets (ROA), a widely used profitability measure, is net income divided by total assets. Obviously, the higher the ROA, the more profit a company can reap for each invested dollar.
I required a 15% minimum ROA, which limits the field to the most profitable stocks (less than 10% of all U.S. companies). Try reducing your minimum to 10% or 12% if you want to see more candidates.
Screening parameter: Return on Assets >= 15
Debt
High debt isn't necessarily a problem. For instance, there's nothing wrong with paying 5% to borrow funds that you can invest for 10% return. However, buying high-debt stocks means that you have to dig into their financial statements to make sure that they're generating enough cash to service their debt.For me, simpler is better, and I avoid the issue by sticking with low-debt stocks. The debt-to-equity ratio, which is long-term debt divided by shareholder equity, is a standard debt measure. A zero D/E means the company carries no long-term debt. The higher the ratio, the higher the debt.
What's high debt? That depends on the company's industry. So, rather than specifying a particular maximum, I require that passing stocks must have D/E ratios no higher than 50% of their industry average.
Screening parameter: Debt-to-Equity Ratio <= 0.5*Industry Average Debt-to-Equity Ratio
My screen turned up 13 stocks in a variety of industries. Since tech stocks are strong participants in the current market rally, it's not surprising that four tech picks showed up on my screen.
| Company name | Industry name | Return on assets (%) |
|---|---|---|
Technical & system software | 26.2 | |
Business services | 22.9 | |
Textile - apparel footwear & accessories | 36 | |
Scientific & technical instruments | 27.7 | |
Diagnostic substances | 23.2 | |
Technical & system software | 34.1 | |
Business services | 29.8 | |
Wireless communications | 55.9 | |
Internet software & services | 18.9 | |
Rubber & plastics | 33.6 | |
Information technology services | 25.5 | |
Business services | 28.4 | |
Real estate development | 19 |
As is the case with all screens, consider the stocks listed as candidates for further research, not a buy list.
Harry Domash controls a position in Crocs, which was mentioned in this article.
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