Practical Stock Screening | How to Create stock screens that make sense

Stock screening lets us apply quantitative criteria to the broad universe of stocks in order to narrow the list down to a few companies. It allows us to focus our attention on a smaller but more promising group of stocks.

The experts view stock screening effectively as a multi-stage process:

• The first step is to clearly define the objective of our Screen

• Next, we must come up with primary criteria that locate stocks that match our screening objective

• Then we need to create a set of secondary criteria that ensure that the companies passing the primary screen do not meet our objectives by coincidence, but because they truly meet our objectives

• Finally, we must keep in mind that even the best screen represents only a starting point for in-depth analysis

Objectives for a Stock Screen

Why should one have well-defined objectives before they start to create a screen?

Consider this example of a young couple. This young couple does not have much wealth but what they do have is a long time horizon to invest their money. They are looking to accumulate wealth and are willing to accept greater risk for the prospect of great returns. They might choose to focus their investment in high-quality growth oriented companies. On the other hand, an older couple close to retirement has a much shorter time horizon. They will sure be more concerned with preserving their wealth. This couple might choose to focus on high-quality stocks that have higher dividends and lower price volatility.

The objective should therefore reflect one's return objectives, risk tolerance and investment philosophy. Clear, focused, narrowly defined objectives lead to the best screens. Usual broad screening objectives include seeking growth stocks, value stocks or even stocks with positive price momentum. One must refine these objectives further to reflect the specific types of stocks that the investor is looking for, before the stock screening process is started.

For example, the young couple may decide to seek growth stocks in the expansion stage of their life cycle with strong earnings momentum. whereas the close-to-retirement couple in the example might seek large cap companies in the maturity stage of their life cycle with say, above-average dividend growth rates.

Primary stock screening criteria

For someone looking for growth stocks, the primary criteria should provide him with a list of companies that are in the growth stage of their life cycle, and not mature cyclical firms examined during a cyclical peak. Thus one should construct primary screening criteria that flows naturally from the objective, and attempts to filter only those companies that meet the objective.

How do the filters work? The filtering is done by comparing a company's data against some base data. The comparisons can be done based on absolute or relative conditions. Relative conditions can be used to compare a company's current data to that of the industry, market or the company's own historical average data. For example, one may be screening for companies whose price-to-earnings (P/E) ratio is less than that of the market. As the market goes up, comparing against market's PE ratio will become less restrictive and allow companies with higher price-to-earnings ratios to pass.

Using Relative conditions

Some popular criteria such as margins and asset turnover ratios for example, are very industry specific. They should therefore be used primarily on a relative basis. They are meaningful only when compared to peers, industry averages or company historical averages. Stock screening that compares company data to historical averages or peer company elements can be useful. Some companies trade at higher PE ratio multiples because of superior growth prospects. So screening just for companies with P/E ratios below that of the market may lead to a collection of bad stocks that deserve low P/E ratios and are not really under priced. Using a relative screen that compares a company's PE ratio to its historical average or against its expected growth may be a better way to point out potentially mis-priced stocks.

Using Absolute conditions

Then there are criteria that make best use of absolute conditions. For example one might like to screen for companies with a price-to-book-value (P/B) ratio below 1.0. Here you are comparing a company figure against some constant that does not change with time. As the market goes down, lower overall market levels will lead to lower valuations, the number of companies passing the P/B ratio will increase. When market levels go northwards and towards extremes, no suitable companies may pass the screen.

Common mistakes

A common mistake while using a stock screener is having a list of criteria that are reasonable individually, but when combined turn out to contradict the objectives of the screen. For example if one is looking for potentially high-growth companies then one should not combine conditions that seek high earnings-growth with high dividend yield requirements. Companies that are in a high-growth trajectory usually need all the cash for business expansion and thus cannot afford to dole out huge dividend payments. Combining criteria like these may lead to oddball stocks passing muster, negating the very objective of the screen.

Other common mistakes include combining too many criteria that filter the same type of companies. For example stock screening for low P/B, Low P/E, low price-to-sales or high dividend yields, will for the most part list the same type of stocks.

In any stock valuation exercise investors are advised to look for trends in profitability, financial health and growth figures over a number of years and not to rely on only the current data, which may only be coincidental. Is the company getting better, more efficient? So stock screening criteria should also be employed to examine trends over a number of years, the more the better, usually for at least last 5 years. Using filters that only compare spot parameters are unlikely to lead to much.

Secondary or conditioning criteria

We might have started with a clear objective and created strong primary screening criteria, but even with that we can expect a number of companies to slip past this screen -that do not embody the type of company we are seeking. for example our high dividend yield screen may contain some companies ready to pare their dividends, and our growth screen will probably have some mature cyclical companies at their cycle peaks.

Therefore the stock screening process must include secondary or conditioning screen criterion. The conditioning stock screening criteria should help to ensure that the companies passing the screen did so because they meet the screens defined objective. The secondary stock screening criteria are different from the primary criteria in the sense that if these were used by themselves to filter companies, they would not locate companies that met our objective.

For example a secondary criteria for a high dividend yield screen would filter for companies in such a way to help establish that the dividends are secure. It might include a criterion that specifies a maximum level of dividend payout ratio (dividends divided by earnings) of less than 50% to seek companies that are not paying out more than half their earnings in the form of dividends. It is a conditioning screen for a high dividend yield screen because by itself it does not say whether the dividend yield is high or low.

Stock Screening - only a starting point for in-depth analysis

When performing any stock screening, it is useful to keep in mind that there are no miracle screens that produce lists of guaranteed winners. A well-designed screen however, would provide us with a list of stocks that hold some promise.

In creating a screen, we should keep the following points in mind:

• Develop a clear, narrowly defined objective, keeping in mind the type of stocks that meet our investment philosophy and objectives

• Construct primary criteria that will locate companies that match our objective. Avoid using rules that will cancel each other out or are redundant

• Construct a set of secondary criteria that help ensure that companies pass the primary criteria for fundamental reasons rather than by chance

• Remember that even the best designed screen is only a preliminary search for investments using a small set of quantitative factors
  

A complete in-depth analysis that explores both quantitative and qualitative factors should follow any screen.