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Issue No. 28 – May 30, 2005 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
It’s time for some filter maintenance. After watching the Cash Rich Company filter and the Net Insider Buying filter, it is more apparent that these two filters are not sufficient reason in themselves to purchase a stock. They are not useless but a cautionary note needs to be added. If a stock passes one of the master trader-investor filters or meets other screening criteria and it also passes the Cash Rich or Insider Buying filter, it would add weight to purchasing the stock. The Cash Rich and Insider Buying filters should be treated as check lists rather than watch lists. For this reason two new filters are added this week, the John Templeton Value filter and the Martin Zweig Growth filter.
1.1 John Templeton Value Filter (Source: AAII)
This is a brief summary of John Templeton’s screening criteria. More background information can be found on the website. Value investors search for stocks that are attractively priced relative to some measure of intrinsic worth. They most often look for solid companies whose stocks are trading at low multiples of price relative to book value, cash flow, earnings, dividends, or sales. This contrarian way of thinking looks for such stocks with the hopes that these low multiples are temporary, that the company will withstand Wall Street’s wrath and prices will eventually rise as Wall Street realizes the true worth of the firm.
This is the investment philosophy adhered to by
John Templeton, one of the best-known investment advisors today. While in
college, Templeton studied under one of the forefathers of value investing,
Benjamin Graham. Templeton likes to compare current price-earnings
ratios to five-year average annual price-earnings figures when looking for the
lowest multiple stocks. There are two hidden aspects of this first screening
criterion: Not only does it require the current price-earnings ratio of the
stock to be lower than its five-year average, but in addition any passing
company must have been traded for at least five years and had positive annual
earnings per share for each of the last five fiscal years.
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When screening against five-year averages, useless numbers can sometimes slip through the cracks in a screening technique. Beyond negative earnings, which lead to meaningless price-earnings ratios, unusually low earnings may also throw off standard price-earnings ratio screens. Short-term drops in earnings due to extraordinary events may lead to unusually high price-earnings ratios. As long as the market interprets the earnings decrease as temporary, the high price-earnings ratio will be supported. Because the average price-earnings ratio model relies on a normal situation, these “outlier” price-earnings ratios must be excluded. To eliminate companies with these extreme price-earnings ratios, an additional filter was applied to the Templeton approach that excluded any stocks with ratios above 40 for any of the last five fiscal years.
Templeton believes the income statement should show
consistent earnings growth as well. EPS growth is one of the primary benchmarks
used to measure company performance. The Templeton screen looks for stocks with
positive earnings growth over the last 12 months and over the last five-year
period. Beyond an overall growth figure, individual investors should look at
the year-to-year trends, since long-term growth rates can easily mask the
variability and risk of the underlying figures.
The expected five-year growth estimate captures
Templeton’s future probable earnings prerequisite. His desire for consistent
growth in the future is portrayed by a positive earnings growth estimate
filter.
Templeton also seeks companies with competitive
advantages. This can be detected by comparing a stock’s forecasted earnings
growth figures to the forecasted growth of its industry. Firms with earnings growth
estimates greater than or equal to the industry median more than likely have a
competitive advantage.
In addition to forecasted earnings growth rates,
Templeton feels increasing earnings are important. In replicating the Templeton
strategy here, only five years were required to remain consistent with the low price-earnings
ratio provision.
The next set of criteria concerns operating margin.
Operating margin, or gross profit margin, paints a picture of how efficiently
the company’s management is operating within the framework of the company’s
generated profits. Templeton’s emphasis here is recent stability and
consistent increases – in this case, however, over a shorter period: positive
operating margins over the last 12 months and for the latest fiscal year.
Continuing the competitive advantage theme, further
criteria for favorable operating margins were added. The screen required the
recent 12-month and current-year operating margins to be greater than or equal
to industry medians for the respective periods. Industry medians are
particularly important in this area as benchmarks because operating margins
tend to be very industry-specific.
Templeton also compared current operating margins to
previous margins. The additional filter required current operating margin to be
greater than the five-year historical average operating margin. Screening for
the most recent 12-month timeframe reduces the probability of ADR stocks
passing the filter, as ADRs are not required by the Securities Exchange
Commission (SEC) to post or file quarterly or monthly figures.
Templeton also monitored the balance sheet, looking
for companies showing good financial strength. Templeton believes a strong
financial position enables any company to work through the difficult periods
often experienced by overlooked, out-of-favor stocks. Acceptable levels of debt
vary from industry to industry, and for that reason the last criterion screens
for companies with total liabilities relative to assets in the current quarter
that are below their industry norms. This particular ratio is used here because
it considers both short-term and long-term liabilities. Again, since ADR
stocks are not required to provide quarterly results, screening for quarterly
data limits the prospects from the international stock group.
In addition to researching company reports, pouring
over financial statements, and analyzing each stock’s industry, Templeton also
placed a great deal of importance on several qualitative factors: quality
products; sound cost controls; and the intelligent use of earnings by
management in order to grow the firm.
Templeton also looked for any potential catalyst that
might change the perception of a stock and spark interest among star-gazing
investors, which in turn would cause the stock’s price to rise. Catalyst-type
events include the creation of new markets and products and could also extend
to potential mergers and acquisitions, as well as favorable changes within the
company’s industry.
During difficult financial times, many investors seek
shelter under the sturdy umbrella of a value investing approach. “Be prepared
emotionally and financially for bear markets,” warns Templeton. “If you are
really a long-term investor, you will view a bear market as an opportunity to
make money.” Remember that fundamental stock screening is only a
starting-point, and the results of any screen are simply a list of companies
that meet a set of objective criteria. Before any investment decisions are made
about any passing stock, additional research and further analysis are
necessary.
1.2 Martin Zweig Growth Filter (Source: AAII)
Martin Zweig leans toward the growth methodology. Whereas, value investment strategies tend to seek out neglected or undervalued firms, growth investing looks for companies exhibiting sustainable or increasing growth in sales or earnings. It is rare to find a purely growth-oriented or purely value-oriented stock selection strategy anymore. Most screens only lean toward one style or the other. Martin Zweig was named stock picker of the year two years running in the 1990s by the Hulbert Financial Digest and has served as chairman of the Zweig Funds. In his book “Martin Zweig’s Winning on Wall Street” (Warner Books, 1997), he outlines his strategy for identifying companies with strong growth in earnings and sales, a reasonable price-earnings ratio given the company’s growth rate, buying by insiders (or at least an absence of heavy insider selling), and relatively strong price action. The Zweig screen is based on his approach.
Zweig divides stock-picking into two categories-the
shotgun approach and the rifle approach. The shotgun method, which Zweig
advocates, entails screening publicly available data on a number of stocks
using predetermined criteria. This more mechanical approach allows individuals
to follow a large number of stocks at one time, spending a limited amount of
time on any one company. In contrast, the rifle approach involves the in-depth
analysis of a select number of companies. The analysis may cover accounting
methods used, trends in the company and industry, and a variety of economic
variables impacting the company. Zweig points out, however, that this approach
is unrealistic for the average individual investor because it requires full-time
analysis of the market.
Zweig begins his search by examining quarterly earnings and sales. Here he requires positive growth in earnings per share between the most recent fiscal quarter and the same quarter the prior year. Same-quarter growth is a better benchmark than sequential-quarter growth because seasonal patterns are less likely to be an influence. Zweig also examines the same-quarter growth in earnings per share going back several quarters. He warns of stocks with negative or “skimpy” growth rates on a same-quarter basis. The first filter specifies that the same-quarter growth rate in fully diluted earnings per share from continuing operations for each of the last four fiscal quarters is greater than zero.
Since sales drive earnings, Zweig is also interested in companies that maintain their sales as well as those that are experiencing increasing sales growth. To identify such companies, he first requires that a company have positive growth in sales as compared to the same quarter the prior year. Beyond positive growth in same-quarter sales, Zweig also likes companies that are able to increase this same-quarter growth rate. To capture this element, the screen compares the same-quarter growth rate in sales for the last fiscal quarter to the same-quarter growth rate in sales for the previous quarter.
Zweig also looks for companies with persistent, rising
earnings on an annual basis. Here, the screen requires that a company’s
earnings per share for the last four quarters (trailing 12 months) be greater
than or equal to the earnings per share for the last fiscal year as well as
requiring year-to-year increases in earnings per share for each of the last two
fiscal years. Zweig is also impressed with stocks that exhibit “strong” longer-term
growth rates. To isolate companies that meet this requirement, the screen
specifies a three-year annualized growth rate in diluted earnings per share
from continuing operations of at least 15%.
Zweig makes a point of discussing the relationship
between sales growth and earnings growth. He points out that one cannot draw
any negative conclusions when earnings do not grow as fast as sales without
further study. He points to competition and price cutting as potential
culprits, but the expenses required to introduce a new product may also serve
as an explanation.
On the other hand, he is leery of situations where earnings growth far
outstrips that of sales. While it may be possible in the short term for a
company to improve earnings through cost cutting, ultimately increases in sales
are what drive long-term earnings growth. If you see a company with a long-term
growth rate in earnings that is substantially greater than the growth rate in
sales, this is a red flag warning to study the sustainable nature of the
growth. In the interim, however, it is possible for a company to increase its
earnings at a rate higher than that of sales due to operating efficiencies,
financial leverage, etc. For this reason, a screen that would require sales
growth to outpace earnings growth could punish good companies. Therefore, the
screen instead implements the same sales growth requirement as for earnings-the
compounded growth rate in sales for the last three-year period must be at least
15%. This way, the screen seeks out companies that are growing at a healthy
clip for both earnings and sales. It is then up to you to perform further
analysis to decide whether the favorable growth conditions will persist in the
future.
The next element Zweig looks for is increasing
momentum in earnings growth, both over the short term and longer term. Zweig
compares the growth rate in earnings between the last fiscal quarter and the
same quarter one year prior, to the growth in earnings between the sum total of
the prior three fiscal quarters and the same three quarters one year ago. Zweig
did make an exception here, not wanting to exclude companies that had
experienced strong growth in earnings per share for the last quarter,
especially if they might be able to continue that growth going forward. For
that reason, he also accepts companies whose same quarter growth rate for the
most recent quarter is at least 30%.
Zweig also compares the growth in same-quarter
earnings for the last fiscal quarter to the longer-term growth, hoping to find
companies where the quarterly growth rate was higher. For this element, this
screen requires that the same quarter growth rate in earnings per share be
greater than the three-year earnings per share growth rate. The criteria that
make up the screen will return companies that are benefiting from the current
business cycle and market environment. As economic and market conditions change
over time, the industries that make up the bulk of the passing companies will
probably change as well.
The other key element of Zweig’s stock selection is
the price-earnings ratio. Zweig avoids living on the edge—he believes that a
price-earnings ratio can be too high or too low. On the low end, he feels
that there are two types of companies – those that are experiencing financial
difficulties and those companies in neglected industries. The risks of
investing in financially troubled firms, in Zweig’s opinion, are too great to
justify the investment in them, since the risk of these firms going under overshadows
any potential “value” in these stocks.
Neglected stocks, on the other hand, are ignored by
the market because of bad news surrounding the company itself or the industry
in which it operates. In some cases, this overly negative view subsides and the
stock goes on to enjoy above-average price appreciation. Studies have shown
that these stocks tend to outperform higher price-earnings ratio stocks in the
long run. However, due to the nature of the screen, it is doubtful that it will
return any neglected companies in the final results. Zweig notes that if you do
run across a company with a very low price-earnings ratio, given the growth
requirements of the screen, you should immediately examine the balance sheet
for any potential problems.
On the other end of the spectrum, Zweig gets nervous
about stocks with very high price-earnings ratios. These stocks run the risk of
facing the wrath of the market if they fail to meet expectations. The higher
the price-earnings ratio, the higher the expectation for that company, and the
more painful the fall should it fail to meet them. Ideally, he selects stocks
whose price-earnings ratios are near or slightly above the “market” average. He
avoids stating an absolute ceiling, citing the fact that they rise and fall
over time. The price-earnings ratio constraints for the screen consist of a
minimum level of 5.0 (to avoid potentially troubled firms) and a maximum level
of one and a half times the median price-earnings ratio of the entire universe
of stocks.
In his book, Zweig spends a good amount of time discussing
price action and relative price strength of individual companies. As a minimum,
Zweig compares the movement of the market and that of the individual stock. He
is in search of companies that have outperformed the overall market. A stock
may be rising in price, but if it fails to gain at the same rate as the overall
market, you are still losing out. For that reason, Zweig eliminates those
companies that are underperforming the market as a whole, especially when the
market is performing well. He theorizes that if a company is as good as it
appears, it should perform at least as well as the overall market. The screen
eliminates those companies whose price strength relative to the S&P 500 over
the last 26 weeks has been below zero.
To round out the screen, supplemental criteria were
applied to further ensure the integrity of the companies we ultimately want to
examine. The first of these eliminates those companies traded as American
Depositary Receipts, or ADRs – foreign listed companies that are traded on U.S. exchanges. The screen also excludes companies categorized as part of the
miscellaneous financial services and real estate operations industries, which
usually consist of closed-end mutual funds and real-estate investment trusts.
Lastly, the screen addresses the difficulty that can arise when attempting to
invest in stocks that are lacking liquidity – they have relatively low daily
trading volume. The screen requires companies to have an average monthly
trading volume (based on the last three months) in the top 75%.
The results of any stock screen are more of a starting
point than a finish line. With the database winnowed down, it is time to
examine each of these stocks using some other factors that Zweig feels are
relevant. Zweig makes a point of mentioning that you should not pay too much
for a company that has a high level of debt. Companies that carry higher levels
of debt also carry with them higher risk levels, mainly due to the higher fixed
costs associated with interest expense. Since the level of debt a company
can safely carry tends to depend heavily on the industry in which it operates,
it is best to compare an individual company’s level of debt to that of its
industry.
You won’t find Zweig buying companies that are making
new lows. He states very plainly that he is on the lookout for companies whose
stock prices are on the rise, especially when those increases are spurred by an
unexpected earnings announcement. Those companies that pass the screen would
represent a “watch list” of companies. Zweig watches for these companies to
announce their quarterly results and then follows a two-step process. First, he
confirms, based on the new quarterly or annual data, that the company would
still be included on the watch list. If that is the case, the second step would
be to check the price performance on the announcement day. The price
behavior following an earnings release can serve as a barometer that measures
the market’s reaction to the news. If prices fall following an earnings
announcement, chances are the market’s expectations were not met. Studies have
shown that, in cases such as these, the negative impact on the stock’s price could
last for up to a year. It is for this reason that Zweig chooses not to “fight
the tape.” He overlooks those companies whose prices fall “significantly” on
the day the latest quarterly results are announced. Likewise, an announcement
that is better than what the market was expecting could have a positive
impact on the stock price for a long time.
In general, Zweig is more concerned with heavy insider
selling than a lack of insider buying. Zweig uses insider buying and selling
activity over the last three months as potential buy and sell signals – three
insider buys indicates a potential buy signal and three insider sells, a
potential sell signal. He also prefers his signals to be unanimous, meaning at
least three insider buys and no sells for a buy signal and at least three
insider sells with no buys for a sell signal. Web sites such as
moneycentral.msn.com track insider activity over the last three months.
When following any stock screening strategy, it is
important to remember that the process is only a first step. Martin Zweig’s
principles help to reveal a collection of companies exhibiting strong earnings
and sales growth, reasonable price-earnings ratios relative to the overall
stock universe, and strong relative price strength that can prove to be an interesting
starting point.
1.3 Free Month of Advisory Service in Exchange for Your Comments
If you want a free month of either the stock or options advisory, just send an email to Systems@WiserTrader.com by June 6, 2005 with a brief constructive comment or testimonial about the quality of this newsletter. Be sure to include whether you prefer the stock advisory or the options advisory. Your email gives WiserTrader.com permission to use your name on the website, but not your email address. All constructive responses, positive or negative, will earn a free month of advisory service, whether or not it is used on the site. Your input is appreciated.
2.0 Market Analysis
Industry leaders in Table 1 rank from highest to lowest. Relative strength is given in Table 2 and VTO market sentiment in Table 3.
