The problem with stock screening

Finding companies to invest in

Excluding wonderful businesses

Let’s look at the strengths and weaknesses of screening tools as a way of identifying companies to invest in.

You get investment ideas from many different sources: the media; analysts’ reports; ideas from friends; screening tools; seeing a successful franchise chain near where you live; and so on.

Screeners

Many readers will know what a screening tool is. For those who don’t, here’ a brief description. It’s a tool you access through a service. Perhaps your brokerage account has one. Let’s say you like companies with low P/E ratios. You type into the service that you want a list of the 50 NYSE stocks with the lowest P/E ratios listed from lowest to highest. At the same time you can specify that you want to exclude stocks with debt/equity ratios more than 1/1 or 100% if expressed as a percent. You add that you want the list displayed in spreadsheet format with details of last five year dividend, sales and earnings growth displayed. Hit enter and voila.

Screening for investment ideas is the beginning of the process. Once you have the ideas you have to study the companies carefully.

I have a service that allows me to screen with a dozen different parameters. All very powerful. But, I haven’t used it for a couple of years!

A new model of capitalism

The business section of our Toronto newspaper is reckoned to be the best in Canada. It’s our equivalent of the Wall Street Journal. It regularly features screens prepared by analysts and portfolio managers. I glance at them. A recent one caught my eye. It contained a list of 23 companies that fit the bill.  It used the debt/equity ratio to ensure the list contained only financially strong companies.

The problem with the debt/equity ratio as a screen is that it excludes many very financially strong companies whose strength is based on intangible assets that are not shown on the company balance sheets. What is worse, it directs the investor to a list of companies that may be completely out of tune with today’s economy. These would be companies whose business depends only on tangible assets.

If a reader is not quite understanding what I am saying I invite you to read the following post: The emergence of a new model of capitalism

In truth, the best way to examine the financial strength of companies is to look at coverage ratios. See my post here. Financial strength – the debt equity ratio has serious shortcomings

ROC, ROIC, ROE

Return on Capital and Return on Equity are also commonly used screening metrics. As I noted in my post of May 30, 2022 see here, for Texas Instruments (TXN) Morningstar reports an average ROE over the last five years of over 50. It reports a return on invested capital (ROIC) over the last five years averaging over 35. By my calculation they are both closer to 5, not 50 or 35.

Screeners also allow you to subtract the Weighted Average Cost of Capital (WACC) from ROC, ROIC and ROE and screen for companies that produce returns that handsomely exceed WACC. The problem is that the absence of intangible assets on balance sheets can totally distort this metric. The list of companies the screen produces may not earn their cost of capital properly calculated.

FCF/EV

Another favorite screen is to look for companies that produce lots of free cash flow (FCF). I like the idea of using enterprise value, the sum of market cap of equity plus debt excluding cash, to produce a free cash flow yield. The problem with the screen is that it can produce a list of cash cows. These are companies that generate a lot of cash but have limited or no opportunities to reinvest the cash at high rates of return. As a result, a screen excluding companies with low FCF or low FCF/EV yields may be excluding companies that are reinvesting in the business with promising growth prospects.

P/E ratios and P/B ratios

Price earnings ratios (P/E) is a big topic. Same with Price to Book Value ratios (P/B). Suffice it to say for present purposes that some companies are spending a lot of cash creating intangible assets that may have a relatively long life. Their reported earnings are subdued because this growth capex is actually expensed. They may have high price earnings ratios as a result, while at the same time they are building up intangible assets that don’t appear on the balance sheet. A few years ago, for fun, I produced a screen that gave me the U.S. companies with the highest P/E ratios! The list was quite instructive. It contained a good selection of some extraordinary businesses. A screening exercise that looked only for low P/E companies would, by definition, exclude these wonderful businesses. You can do the same with P/B ratios.

Conclusion

This post hasn’t attempted to look at all the metrics one can screen for. Screening is a way of coming up with a list of companies that merit further study. Unfortunately, if not done with care, it can end up a list of old worn out cash cows while, at the same time, excluding from consideration companies that are more in tune with the modern economy.

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To read more about the search for wonderful investments, take a look at the Motherlode

Chapter 40. Finding and studying companies to invest in

That Chapter contains these Sections:

40.01 News media

40.02 Positive media stories generally indicate the end of superior performance

40.03 Analysts’ reports and other sources

40.04 Methodical approach

40.05 Analysts’ reports more

40.06 The earnings estimate game

40.07 Herding and the short term

40.08 Reading deeper in sell side analysts’ reports

40.09 An aside about facts vs opinions

40.10 Analysts’ reports continued

40.11 Conclusions re sell side analysts’ reports

40.12 Independent research

40.13 Company website, quarterly and annual reports

40.14 Meetings with company officials

40.15 Alignment of interest

40.16 Scuttlebutt and other sources

40.17 Use of watchlists

40.18 Conclusion

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.

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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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