Using screens to find good stocks and funds

By Jon Markman

Investors face each day with a mind-boggling array of at least 16,000 stocks and mutual funds traded in the United States from which to select. The choice can be daunting, a plan of attack critical.

Until about five years ago, the data required to make a well-informed choice was so hard to obtain and interpret that most people wisely left the effort to professionals. But information-processing technology and federal securities rules have accelerated so fast in private investors' favor recently that it is now possible for just about anyone with access to a computer and a Web connection to get their hands on all the numbers they need.

Indeed, the real problem today is narrowing down the long list of available statistics to find the ones that matter. And that's why one of the key weapons in any aspiring investor's arsenal should be a stock-screening engine such as the one on our site called Deluxe Screener.

Screening is nothing more than the use of a computer database to search for stocks that meet certain statistical criteria. Among pros, the skill is pervasive. Whenever you read a market pundit in Barron's declaring that she only buys large-capitalization stocks with high growth rates and low price-to-earnings ratios, for instance, she's telling you that she typically starts the search for new stocks with a screen.

To become adept at this art, a private investor must learn which criteria to search for, and then how to interpret and exploit the results. Until recently, commercial stock-screening engines allowed investors to look for a strictly limited number of criteria, and their databases held statistics that were as much as a month old. In contrast, Screener has hundreds of statistical criteria to choose from – and very little is more than a day old. Because the Screener allows you to compare those criteria against each and apply mathematical formulas against them, the number of screens you can create is virtually infinite.

How to create a useful screen

Of course, not every screen you can invent is worth creating. So how should you go about creating useful screens?

You must start with a basic understanding of stock or fund fundamentals and psychology as well as a market hypothesis. We'll skip over a lot of those basics for now -- you can find them in links on the left of this page. As for the hypothesis, imagine that you're a scientist in a lab. You're trying to prove a theory or solve a puzzle. In this case, the puzzle has two parts: First, what statistical factors make up market-beating stocks? Second, what stocks are characterized by those factors?

The first part of the puzzle is the hardest by far, and the subject of reams of studies by academics and professionals. Money manager Jim O'Shaughnessy suggested in two of the books, "Invest Like the Best" and "What Works on Wall Street," that three factors win persistently over time:

• Cheapness -- as measured by the price-to-sales and price-to-earnings ratios.

• High relative strength -- or market-beating performance in the past 12 months.

• Small size -- or market capitalization of $150 million to $5 billion.

Hypotheses can come in many other forms as well. In fact, just about every time you read an article or see a financial TV show in which a well-regarded money manager reveals his investing paradigm in statistical terms, you can try to put those ideas to work with a screen on this site.

Screening by criteria for stocks and funds

Here's how to put a typical hypothesis to work. Let's say you read in "What Works on Wall Street" that O'Shaughnessy believes the market favors companies with price-to-sales ratios of less than 1.5; a market capitalization greater than $150 million; earnings growth rates in the past year of at least 1% and high 12-month relative strength. To learn what stocks meet those criteria today, you can follow these steps:

• From our Investing page, click on Stock Screener, listed in the lefthand column.

• You're now facing the Screener's control panel. There are three fields that require data entry. On the left is the "Field Name." Click inside the blank space, and a menu of 13 items will pop up, each followed by an arrow. When you run your mouse over each item's name, another menu will pop up from the direction of the arrow that shows stock-related criteria from which you can choose. Explore each of these menus to discover the wide range of statistics from which you can build screens.

• Mouse over the "Company Basics" menu item, and you'll see eight new sub-items appear. Mouse over "Market Capitalization" and left-click. The words "Market Capitalization" then pop into the Field Name.

• Next, click in the "Operator" space to the right. Choose ">=", which means "greater than or equal to."

• Then click in the "Value" space at the far right. This is where you always either enter a number or a criteria to compare against the "Field Name." Mouse over "Custom Value," click, then type "150 Million" and press Enter. You'll see the number "150,000,000" appear.

Now you've finished the first criteria of your new screen. If you click the "Run Screen" button, you'll see some numbers at the very bottom of the screen that say, "The result returned the 25 best-fit matches out of several thousand." You've just reduced the number of stocks to consider by more than half. Now enter the rest of the O'Shaughnessy formula:

• Click in Field Name, mouse down to Price Ratios, then click on "Price/Sales Ratio." In the Operator field, enter "<=", for "less than or equal to." In the Value field, click on Custom Value again, type in 1.5, and press Enter on your keyboard again. You'll see that the list has been whittled down even further.

• Click in Field Name again, mouse down to Growth Rates, click on "EPS Growth Year vs. Year", then choose ">=" as your operator. In the Value field, type in 1 (for 1%), and press Enter on your keyboard again.

That's the final list of stocks that meet O'Shaughnessy's criteria. But you're not done yet, because every screen needs to be ordered in some way. O'Shaughnessy, you'll recall, sorts his lists by 12-month relative strength. So here's the final screen element:

• Click in Field Name, mouse down to Trading and Volume, and click on "12-Mo. Relative Strength." Then in the Operator field, choose "High as possible." Now you've got your list.

The same philosophy can be used with mutual funds, only this time you're selecting from funds based on "Investment Objective," so you can choose between large-cap value funds, growth funds or emerging markets, to name a few. You can sort based on expenses, eliminating those funds that charge front-end loads or with overall expense ratios of more than 1.5%, a typical industry standard. The key is to create these lists as a means to reduce the number of investment options to a manageable number for research purposes.

How to act on your findings

Now what should you do with this information? Many investors, often known as "stock pickers," use the names netted in a screen as a launching pad for further research. They might buy one or more -- or none -- of these names. Other investors, known as "modelers," use screens as mechanical, programmatic ways to buy stocks. They will buy the top five, 10 or more stocks that result, and hold them for a set period of time. O'Shaughnessy is in the latter camp; he buys the top 50 names that result from the screen above for his mutual fund, and holds them for one year.

Whichever route you choose, here is one more thing to keep in mind: Screening criteria come in two basic flavors -- "hard" and "fuzzy." The former includes specific, hard numbers -- like O'Shaughnessy's search for stocks with price-sales ratios of less than 1.5. The latter include non-specific "wish-list" numbers, like O'Shaughnessy's search for stocks with relative strength "as high as possible."

If you create screens with multiple "fuzzies" -- like stocks with price-sales ratios as high as possible, earnings growth as high as possible and relative strength as low as possible -- the software tries its best to "score," or weigh, all three elements equally before presenting a list. But the results are unpredictable; you may get stocks that do very well in two elements but poorly in the third. The best solution: Use hard criteria for the bulk of your screen, then sort that result set by a single, final, fuzzy one.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.