Your Next Great Stock

by Jack Hough

Next Great StockStock screens involve using software to quickly scan a large database of information and evaluate thousands of stocks. They are capable of reducing the field of stocks to a dozen or so prime suspects based on a few variables. Your Next Great Stock presents 11 popular screening strategies created and back-tested by renowned professors and practitioners. They all follow five basic principles: (1) they worked well in the past, (2) there’s a good explanation for why they’ve worked, (3) there’s no hidden explanations, (4) they’re practical to implement, and (5) they can be translated into the language of a stock-screening tool.

When it comes to picking a stock screener, there are many options to choose from. MSN Money offers a free Deluxe Screener with more than 100 variables, including industry averages, and can export your results to Excel. The drawback is that it doesn’t include a formula builder. A formula builder allows you to create and screen for your own variables, such as dividing operating income by sales to screen for operating margins. For this type of feature, you will need something like the powerful and easy-to-use SmartMoney.com screener, available online for a minimal fee. For the most capable screener, Zacks offers a premium version for a more substantial price.

The following strategies can be used to generate a manageable short list of stocks. These stocks can then be researched further to determine whether company fundamentals justify a purchase. Additional variables are added to ensure companies are of a decent size and that sufficient volume exists for others to take the other side of your trade. While Hough offers clever names for these screens, I have retitled them here to more closely link the names with what they screen for. Variables with asterisks (*) can optionally be used to reduce the field of screen survivors further.

  1. Price Momentum: This screen searches for stocks that have gained nicely over the past year but haven’t dipped in recent weeks. Results from this screen can change each day.
    • Share price within 5% of 52-week high
    • TTM Sales > $100 million
    • Average daily trading volume > 100,000 shares
    • * One-year sales growth > 20%
    • * Insider ownership > 5%
  2. Value Stocks with Price Momentum: This screen searches for underpriced stocks whose recovery has already begun. PEGs that are too low are excluded since they are likely the result of one-time surges in earnings that don’t reflect companies’ true performance.
    • PEG ratio < 1.5
    • PEG ratio > 0.2
    • Share price within 5% of 52-week high
    • TTM sales > $100 million
    • Average daily trading volume > 100,000 shares
    • * PEG ratio < 1.0
    • * EPS estimate raised within past four weeks
  3. Positive Earnings Surprises: This screen searches for stocks with recent upside earnings surprises resulting from booming business (rather than accounting tweaks or cost cutting).
    • Past-quarter upside earnings surprise > 5%
    • Past-quarter upside earnings surprise > industry average
    • Past-quarter sales surprise > 5%
    • Past-quarter sales surprise > industry average
    • Standard deviation of estimates < industry average
    • TTM sales > $100 million
    • Average daily trading volume > 100,000 shares
    • * One-year sales growth > 15%
    • * Forward P/E < industry median
  4. Research and Development: This screen identifies companies that are plowing funds into research and development and therefore about to cash in on a breakthrough.
    • TTM R&D spending >= 5% of sales
    • TTM R&D spending >= 5% of assets
    • TTM R&D spending > prior 12-month R&D spending
    • P/R&D < 20 (if possible, P/R&D < industry average)
    • * P/R&D < 15
    • * Three-year sales growth > 12%
    • * Forward P/E < industry median
  5. Net Payout Yield: This strategy screens for companies in the Dow Jones with the highest net payout yields, defined as (dividends + share repurchases – share issuances) / market value.
    • Index = Dow Jones Industrial Average
    • Have screener display amounts for dividend spending, share repurchases, and share issuances for each of past five quarters
    • Export to Excel and manually calculate TTM net payout yields
    • Choose the 10 companies with the highest yields
  6. Bold, Lone Analysts: This screen searches for lone analysts who issue earnings estimates that stand far apart from an otherwise close consensus. Analysts are unlikely to be so bold unless they’re sure they’re right.
    • Market value between $500 million and $5 billion
    • Exactly one current-year earnings estimate increase within past week
    • Exactly one current-year earnings estimate increase within past four weeks
    • Past-week increase in current-year earnings estimate in top 25% for industry
    • Look up details on each changed estimate to tell whether it was a bold revision (away from consensus) or a herding revision (closer to consensus)
  7. Ratings Improvement: This screen identifies the most-upgraded stocks in the most-upgraded industries. You’ll need a capable stock screen like Zacks Research Wizard.
    • Market value between $200 million and $10 billion
    • Screen for stocks with more upgrades than downgrades over the past week
    • Export results to Excel and sort the stocks by industry
    • Calculate the average number of net upgrades for each industry
    • Select stocks with the most net upgrades within industries that have the most net upgrades
  8. Insider Purchases: This strategy follows the share purchases being made by insiders, namely by top executives.
    • Dollars spent on insider purchases > $100,000
    • Shares purchased by insiders < 5% of outstanding shares
    • Number of insider buys >= 2
    • Market value < $10 billion
    • Number of analysts in current-year earnings consensus <= 6
    • Check to see which insiders are buying shares, focusing primarily on executive purchases
    • * P/E < industry average
    • * Six-month share price gain > S&P 500 gain
  9. Accruals: This screen tracks companies whose earnings are less than their free cash flows, defined as earnings + depreciation + amortization – capital investments – change in working capital. This strategy excludes companies whose earnings are inflated due to accruals.
    • (TTM FCF – TTM Net Income) > 0
    • Market value between $200 million and $10 billion
    • Three-year annualized earnings growth > 15%
    • One-year earnings growth > three-year annualized earnings growth
    • P/E < industry median
  10. Price-to-Sales Ratio: This screen searches for bargain stocks as identified by low price-to-sales ratios, which are more predictive of future returns than price-to-earnings ratios.
    • TTM sales > $200 million
    • Average daily trading volume > 100,000 shares
    • P/S < 1.5
    • Past-year earnings growth positive
    • Three-month share price appreciation > database average
    • Six-month share price appreciation > database average
    • * Sales growth > industry average
    • * Earnings growth > industry average
  11. Price-to-Book Ratio: This screen identifies stocks with low price-to-book ratios, in addition to adding a number of other variables to improve returns.
    • P/B in bottom 25% of database
    • TTM earnings (excluding one-time items) positive
    • TTM earnings (excluding one-time items) growing
    • TTM operating cash flow positive
    • TTM operating cash flow > TTM earnings
    • Debt/assets ratio in most recent quarter < year-ago quarter
    • Current ratio in most recent quarter > year-ago quarter
    • Net share issuance not positive
    • TTM gross margin > prior 12-month gross margin
    • TTM asset turnover > prior 12-month asset turnover
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