Issue No. 4 – December 13, 2004
Because the markets are a bit unsettled, the usual stock screen provided no new short term optionable stock picks suited for a trading time frame of a few days to a few weeks. It was thought that this would be a good time to provide information on longer term stock screens based on tools and information provided by the American Association of Individual Investors. Two screening methods were found that provide stock picks for trades lasting in the range from several weeks to years, depending upon where one’s trailing stop losses are set. The Growth Momentum stock screening method is for momentum stocks while Peter Lynch’s stock screening method is for value stocks.
A word about trading time frames is appropriate. Let’s separate time frames into short term, intermediate term and long term. Long term investing is for 5 years or more and applies to instruments that have at least a 10 year history of proven average annual gains. Intermediate term investing is from a few months to 5 years where global economic and industry trends are taken into account. Short term trading applies to time periods up to a few months where natural small oscillations in an established stock price trend are taken into account. A fourth category that we do not intend to participate in is day trading where hourly technical behavior and current events are taken into account. Each time frame has its own strategy and it is important to keep the rules for each time frame separate. In a future newsletter these will be delineated for you in a table.
This
approach focuses on companies with proven records of earnings growth while
still in a stage of earnings acceleration. It was developed by a well
know author.
When screening for quarterly
earning increases, it is important to compare a quarter to the same quarter
last year--i.e., this year's second quarter compared to last year's second
quarter. As a confirmation of the quarterly earnings
screen, you should check the industry group and locate at least one other
noteworthy stock. Strong industry fundamentals should
show up for a number of companies.
Winning stocks had a steady and
significant record of annual earnings in addition to a strong record of current
earnings. The system tries to identify the strong
companies leading the current market cycle. The screen specifies a
minimum annual growth rate of 25% in earnings per share from continuing
operations over the last five years. This criterion
proved to be the second most restrictive screen when used independently.
A stock needs a catalyst to start
a strong price advance. In his study of winning
stocks, it was found that 95% of the winning stocks had some sort of
fundamental spark to push the company ahead of the pack. This
catalyst can be a new product or service, a new management team after a period
of lackluster performance, or even a structural change in a company's industry,
such as a new technology. These are very qualitative
factors that do not lend themselves to screening easily, however it is
possible to study the companies passing the preliminary screens to see if any
catalysts exist. A second consideration that the author emphasizes is
that investors should pursue stocks showing strong upward price movements. The author says that stocks that seem too high-priced and
risky most often go even higher, while stocks that seem cheap often go even
lower. Stocks that are making the new high list while
accompanied by a big increase in volume might be prospects worth checking. A stock making a new high after undergoing a period of
price correction and consolidation is especially interesting.
The author feels that decisive investors should have sold a stock long
before it hits the new low list. The author's newspaper highlights stocks
within 10% of their 52-week high and this was the criterion established for
this screen. Used independently the screen allows
about one-third of the companies to pass the filter.
As the catalyst starts pushing the
price of a company's stock up, those firms with a smaller number of shares outstanding
should increase more quickly than those with a large number of outstanding
shares. The author found that 95% of the winning
stocks had fewer than 25 million shares outstanding, while the median for the
group was 4.6 million. We used a screen for stocks to have fewer then 20
million shares outstanding. The author warns against selecting low-priced
stocks with small capitalization and no institutional ownership, because these
stocks have poor liquidity and often carry a lower-grade rating.
The author is not like the patient
value investor looking for out-of-favor companies and willing to wait for the
market to come around to his viewpoint. Rather, he
prefers to scan for rapidly growing companies that are market leaders in
rapidly expanding industries. After identifying a strong industry, the
author warns against avoiding the market leaders by purchasing
"sympathy" stocks that are similar but significantly cheaper when
examined by factors such as price-earnings ratios and weaker price performance. These stocks often continue to languish while the market
leaders continue their strong rise.
The author suggests using relative
strength to identify market leaders. Relative strength
compares the performance of a stock relative to the market as a whole.
The author recommends only looking for stocks with a percentage rank of
70% or better—stocks that have performed better than 70% of all stocks. If you wish to make the market leader screen
more stringent, he suggests only considering stocks that have relative strength
rankings of 80% or 90% with a chart base pattern. When monitoring your
portfolio, he recommends that you sell off your worst performing stocks and
keep your best-performing stocks a little longer. You
should try to avoid letting your ego dictate your actions. It
is best to recognize a mistake early, before it becomes a major problem.
The author feels that a stock
needs a few institutional sponsors for it to show above-market performance. Three to 10 institutional owners are suggested as a
reasonable minimum number. He warns that while some institutional
sponsorship is required, once everyone has jumped on the stock it may be too
late to buy into it.
The final aspect of the system
looks at the overall market direction. While it does
not impact the selection of specific stocks, the trend
of the overall market will have a tremendous impact on the performance of your
portfolio. The author finds it difficult to fight the trend, so it is
important to determine if you are in a bull or bear market. If
you are selecting your own stocks, he feels that it is important to follow and
understand what the general market averages are doing every day. When the market peaks and begins a major reversal, he
emphasizes that you should try to put 25% of your portfolio into cash. It is important that you act quickly, especially if you
have purchased your stocks on margin.
If the last four or five stocks
you purchased after a careful analysis are not showing a profit, it may signal
a negative shift in the general market. Other items to
look for at a market top include heavy volume without significant price
progress and the divergence of key averages. At market
tops you will often find stocks that were past market
leaders faltering, while poor-quality stocks are showing up on the most active
lists. When the market starts down, it sometimes takes time for the
volume to build. The author warns that market can be
slow to acknowledge the downtrend. As a useful fundamental confirmation
of the market action, he suggests following the actions of the Federal Reserve. A series of increases to the discount rate is often a
precursor to both a economic and market decline.
Peter Lynch believes that one should invest only in industries and companies he understands and that he should know the specific reason that he is buying the stock. One’s analysis should center on the factors that will move the stock price. He should for low P/Es compared to earnings growth and dividend yield, he should look for P/E in lower range of historical average and he should look for P/E below industry average. One should study the pattern of earnings, especially how they reacted during a recession. Then he should look for a low level of debt, especially bank debt Net cash per share should be high relative to stock price. But one should be wary of earnings growth rates above 50%. Small companies should be favored in a search; they have more upside potential. One should look for low percentage of shares held by institutions and number of analysts following stocks. Insider buying by a number of insiders is a positive sign. If the company is buying back shares, this will support the stock price and probably indicates the company has been ignored, but that management is confident.
Applying the Lynch Screen
Much of the analysis advocated by Peter Lynch is subjective in nature, requiring hands-on analysis. As Peter Lynch stresses, it is possible to succeed at investing, but you must be willing to do your work. While Peter Lynch is a bottom-up, kick-the-tires type of stock picker, some of his principles are useful screening criteria. The first screen excludes financial firms. Peter Lynch is a big fan of financial stocks and presents a series of screens he uses to help select banks and savings and loans in "Beating the Street." We had to exclude them from the general screen, however, because their financial statements cannot be directly compared to other firms. The first screens require a current price-earnings ratio below the industry and below the company's five-year average price-earnings ratio. Our screen also uses the ratio of price-earnings to the earnings growth rate plus the dividend yield. A ratio less than or equal to 0.50 is specified as the cut-off. Lynch is wary of companies growing too quickly, so the next filter specifies a maximum earnings per share growth rate of 50%. Lynch is also wary of companies with too high an institutional interest. A screen limiting firms to those with percentage of shares held by institutions below the universal median is included in the Lynch screen. The final filter requires that the total liabilities to assets for each company be less than its industry average.
The market consolidated this week, showing some resilience to negative news of
terrorist attacks in
Week ending 12/12/04:
Indices for the Week:
Dow Jones -0.2%
NASDAQ 100 -0.5%
S&P500 Index +0.1% Russel 2000 -1.1%Monthly Leaders:
Sector:
Health Care
Industry:
Computers
Home Construction
Monthly Laggards:
Sector:
Utilities
Industry:
Precious Metals
Consumer Electronics
Gold for past Month:
USD +4.30%
CAD +5.10%
CHF +0.63%
GBP -0.65%
EUR +0.40%
JPY +1.34%
The short term trading screen used for Table 1 looks for optionable stocks whose percentage relative strength over the past 6 months is greater than 95%, EPS Growth over the past 12 months is greater than 80% and are within 5% of their 52 week high. Maximum P/E’s for these momentum stocks are less than 30. If such stocks can be found that fall within a leading or emerging sector and industry, that is considered a plus.