Stock selection criterion

Stock selection criteria are methods for selecting a stock for investment. The stock investment or position can be "long" (to benefit from a stock price increase) or "short" (to benefit from a decrease in a stock's price), depending on the investor's expectation of how the stock price is going to move. The stock selection criteria may include systematic stock picking methods that utilize computer software and/or data.

Objectives

The objective of stock selection criteria is to:

(1) maximize the total return on investment (appreciation plus any dividends received) for the targeted holding period

(2) limit risk (according to an individual's risks tolerance levels)

(3) maintain an appropriate degree of portfolio diversification.

Selection components

The analytical components utilized by investors as stock selection criteria may include one or more of the following:

Sector analysis

Sector analysis involves identification and analysis of various industries or economic sectors that are likely to exhibit superior performance. Academic studies indicate that the health of a stock's sector is as important as the performance of the individual stock itself. In other words, even the best stock located in a weak sector will often perform poorly because that sector is out of favor. Each industry has differences in terms of its customer base, market share among firms, industry growth, competition, regulation and business cycles. Learning how the industry operates provides a deeper understanding of a company's financial health. One method of analyzing a company's growth potential is examining whether the amount of customers in the overall market is expected to grow. In some markets, there is zero or negative growth, a factor demanding careful consideration. Additionally, market analysts recommend that investors should monitor sectors that are nearing the bottom of performance rankings for possible signs of an impending turnaround.

Quantitative cumulative value analysis

Quantitative cumulative value analysis: This method is also commonly referred to as fundamental analysis. Fundamental analysts consider past records of assets, earnings, sales, products, management, and markets in predicting future trends in these indicators and how they may affect a company’s future success or failure. By appraising a firm’s prospects, these analysts determine a stock’s intrinsic value and assess whether a particular stock or group of stocks is undervalued or overvalued at the current market price. If the intrinsic value is more than the current share price, then this stock would appear to be undervalued and a possible candidate for investment. While there are several different methods for determining intrinsic value, the underlying premise is that a company is worth the sum of its discounted cash flows (DCF). The DCF is the value of future expected cash receipts and expenditures at a common date, which is calculated using net present value or internal rate of return. This means a company is worth the combined sum of its future profits, while at the same time being discounted in consideration of the time value of money. This value, as determined by the discounted cash flow analysis or its equivalents, consists of two components:

1. Current value ratios, such as the price-earnings (P/E) ratio and price-book (P/B) ratio. The PE ratio, also called the multiple, gives investors an idea of how much they are paying for a company’s earning power. The higher the PE, the more investors are paying, and therefore the more earnings growth they are expecting. High PE stocks – those with multiples over 20 – are typically young, fast-growing companies. P/B is the ratio of a stock’s price to its book value per share. A stock selling at a high PB ratio, such as 3 or higher, may represent a popular growth stock with minimal book value. A stock selling below its book value may attract value-oriented investors who think that the company’s management may undertake steps, such as selling assets or restructuring the company, to unlock hidden value on the company’s balance sheet.
2. Earnings growth which may be reflected in measures like the Prospective Earnings Growth (PEG) ratio. The PEG ratio is a projected one-year annual growth rate, determined by taking the consensus forecast of next year’s earnings, less the current year’s earnings, and dividing the result by the current year’s earnings.

Management issues

Management issues involves examining perceptions about management and perceptions by management. It includes various qualitative judgments regarding the competence of current and prospective company management, as well as issues related to insider buying, future strategies to increase operations and market share. Most large companies compensate executives through a combination of cash, restricted stock and options. It is a positive sign when members of management are also shareholders. When management makes large purchases of their own stock with private funds, it may indicate that management insiders feel the company is undervalued, or that a favorable company event will occur soon. Another way to get a feel for management capability is to examine how executives performed at other companies in the past. Warren Buffett has several recommendations for investors who want to evaluate a company’s management as a precursor to possible investment in that company’s stock. For example, he advises that one way to determine if management is doing a good job is to evaluate the company's return on equity, instead of their earnings per share (the portion of a company’s profit allocated to each outstanding share of common stock). "The primary test of managerial economic performance is achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share." Buffett notes that because companies usually retain a portion of their earnings, the assets a profitable company owns should increase annually. This additional cash allows the company to report increased earnings per share even if their performance is deteriorating. He also emphasizes investing in companies with a management team that is committed to controlling costs. Cost-control is reflected by a profit margin exceeding those of competitors. Superior managers "attack costs as vigorously when profits are at record levels as when they are under pressure". Therefore, be wary of companies that have opulent corporate offices, unusually large corporate staffs and other signs of bloat. Additionally, Buffett suggests investing in companies with honest and candid management, and avoiding companies that have a history of using accounting gimmicks to inflate profits or have misled investors in the past.

Technical analysis

Technical analysis: Involves examining how the company is currently perceived by investors as a whole. Technical analysis is a method of evaluating securities by researching the demand and supply for a stock or asset based on recent trading volume, price studies, as well as the buying and selling behavior of investors. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts or computer programs to identify and project price trends in a market, security, fund, or futures contract. Most analysis is done for the short or intermediate-term, but some technicians also predict long-term cycles based on charts, technical indicators, oscillators and other data.

Examples of common technical indicators include relative strength index, Money Flow Index, Stochastics, MACD and Bollinger bands. Technical indicators do not analyze any part of the fundamentals of a business, like earnings, revenue and profit margins. Technical indicators are used extensively by active traders, as they are designed primarily for analyzing short-term price movements. The most effective uses of technical indicators for a long-term investor are to help them to identify good entry and exit points for a stock investment by analyzing the short and long-term trends.

Automatic stock screening

Stock screening is the process of searching for stocks that meet certain predetermined investment and financial criteria. A stock screener has three components: a database of companies, a set of variables and a screening engine that finds the companies satisfying those variables to generate a list of matches. Automatic screens query a stock database to select and rank stocks according to user-specified (or pre-specified) criteria. Technical screens search for stocks based on patterns in price or volume. Fundamental screens focus on sales, profits, and other business factors of the underlying companies. By focusing on the measurable factors affecting a stock's price, stock screeners help users perform quantitative analysis. Screening focuses on tangible variables such as market capitalization, revenue, volatility and profit margins, as well as performance ratios such as the PE ratio or debt-to-equity ratio. For example, an investor may want to do a search using a screen for all those companies that have a price/earnings ratio of less than 10, an earnings growth rate of more than 15%, and a dividend yield of more than 4%.

Stock screeners

Many Investors take advantage of software programs or online subscription services that allow them to select stocks based on a customized set of conditions and variables. Some examples of various types of stock screening services are:

• Detailed screening using multiple factors and predefined screens. The service rates over 5,000 publicly traded companies on a 10-point scale, using an advanced mathematical system to determine a stock's expected risk and return. It compares the fundamental and technical qualities of stocks to measures that have proven statistically predictive of stock performance in the past. It then assigns an expected six-month return to each stock based on this statistical profile and balances that return against expected volatility. The ratio of expected return (weighted-average most likely outcome) to expected volatility, or risk, yields the stock's final overall rating. Ratings are displayed on a bell curve, meaning there will be fewer 1-10 ratings and far more of 4-7 ratings
• Screening using multiple factors and predefined screens. Utilizing nearly twenty predetermined screens covering an array of investment strategies, including strong forecasted growth, large-cap value, small-cap growth, and Dogs of the Dow. It also provides a large number of Stock Price Variables which are particularly suitable for day traders.
• A screening service that covers a range of trading strategies and also includes a search based on Morningstar stock ratings. By searching stocks according to these ratings, investors are accessing analyst research on the company’s quality. One variable is minimum capitalization: one of six different values is selected by the user as the smallest market cap desired in the search results.

Composite scores

In financial analysis, a composite is a balance sheet and/or profit and loss statement representing averages for the accounts of a number of companies in the same industry or sector. The accounts of a particular company can thus be compared with a composite to identify abnormalities. Many stock selection methods have emerged which involve evaluating a composite score by combining several factors. Some of these methods include:

Scoring companies

• Some companies use the composite duration time-period covers the upcoming six months. Scores are rated on a scale from one to ten (highest). The primary components used in this analysis include the following:

1. Fundamental: Ability to meet earnings expectations, rate of earnings growth, upgrades/downgrades
2. Ownership: Insider and institutional buying/selling
3. Valuation analysis: P/E, price/sales (P/S) ratio, and PEG ratio
4. Technical: change/consistency, 50-day moving-average crossover. A crossover is a point on a stock chart when a security and an indicator intersect. Crossovers are used by technical analysts to aid in forecasting future movements in a stock’s price. In most technical analysis models, a crossover is a signal to either buy or sell

• Another example is a quantitative model designed to help investor-clients manage market risk. The Score reduces the market risk level to a single number for interpretation purposes. Scores range from 0 to minus 4 for Longs, attempting to reveal levels of technical deterioration and guiding investors to an exit point. Scores range form 0 to plus 4 for Avoids, attempting to show levels of improvement and guiding investors to an entry point. This model is based largely on a variety of technical indicators.
• This system rates stock investments on a scale ranging from one to four (best) stars. The score is based largely on valuation methods (placing a value or worth on an asset) using cash flow analysis.
• Stocks are rated from one to ten (highest). Short-term ratings cover the upcoming week. Between 1995 and 2006, the highest rated stocks outperformed the S&P 500 by a better than 12-1 margin over the next five days. Long-term ratings cover the upcoming 12-month period. From 1995–2007, 81 percent of stocks with long-term ratings of 10 increased in price one year later. 79.1 percent of stocks with ratings of 9 increased in price one year later.

Rules of thumb

Fund manager Peter Lynch in his two best-selling investment books entitled One up on Wall Street (1989) and Beating the Street (1993) has outlined several strategic rules of thumb or criteria that should be evaluated when considering a particular security investment:

Market cap

Market capitalization less than $5 billion - Lynch generally avoids large, well-known companies in favor of small-cap stocks that still contain significant upside potential. Most fund managers define small-caps as companies with market capitalizations under $1 million. Institutional investors often use market one investment criterion, requiring, for example, that a company have a market capitalization of $100 million or more to qualify as an investment. Analysts look at market capitalization in relation to book value for an indication of how investors value a company’s future prospects.

PEG ratio < 1.2

PEG ratio below 1.2 – The PEG ratio is a valuation metric that compares a company’s price-earnings ratio with its projected growth rate. Small, high-growth stocks generally trade at higher PEGs compared to the big-caps. If the PEG ratio is around 1, the company is considered fairly valued. A PEG ratio that is much higher than 1 indicates an overvalued company, and a PEG below 1 indicates an undervalued company. While the PEG ratio can effectively provide insight in certain evaluations, it is limited by its overriding focus on earnings growth. Revenue growth, cash flow, dividends, debt, and numerous other factors are also critical in determining value. Additionally, while PEG is useful for smaller companies it may be misleading for big-caps, since sustained growth is less important to their total returns. PEG is most useful when supplementing a thorough discounted cash flow analysis or relative valuation.

Earnings growth 15–30%

Five-year earnings growth between 15% and 30% per year - In investments, earnings growth refers to the annual rate of growth of earnings, or the amount of profit a company produces during a specific period, usually defined as a quarter (three calendar months) or year. Earnings typically refer to after-tax net income.. When the dividend payout ratio is same, the dividend growth rate is equal to the earnings growth rate. Earnings growth rate is a key value that is needed when the DCF model, or the Gordon's model as used for stock valuation. Companies that exceed a 30 percent earnings growth rate are confronted with two fundamental problems: (1) sustaining a high growth-rate over the long term is extremely difficult; and (2) stocks growing that rapidly are usually already being actively covered by Wall Street analysts, and Lynch prefers less well-known names and avoiding competition.

Debt ratio < 35%

Debt-to-Equity (D/E) ratio below 35 percent - If a companies debt levels are excessive, it often proves extremely difficult for managers to raise sufficient cash to finance continued expansion. Without expansion into new markets, corporate growth eventually slows down. Companies with lower debt often have better prospects for future expansion. Additionally, in the event of an economic slowdown, these firms should be in better shape to weather any storms. Regarding debt-equity ratios, Lynch cites 0.33 (25% debt compared to 75% equity) as normal for a corporation. Additionally, he believes a debt-equity ratio of 4 reflects a weak balance sheet. Buffett echoed Lynch’s avoidance of companies that have significant debt. He argued that debt is “the weak link that snaps you." A good business "will produce quite satisfactory economic results with no aid from leverage" while a company with significant debt will be vulnerable during economic slowdowns.

Institutional ownership 5–65%

Institutional ownership ranging between 5% and 65% - Institutional investors are organizations that trade large volumes of securities. Percentage institutional ownership is the fraction of shares outstanding owned by mutual funds, pension plans and other institutional investors. Most well-known stocks have at least 40% institutional ownership. Usually more than 70% of daily trading on the New York Stock Exchange is from institutional investors. Peter Lynch, among many other investors, uses institutional ownership to gauge market interest. He believes stocks with low institutional ownership have the best return potential. When mainstream Wall Street analysts identify a stock, price growth can be dramatic with the support of institutional money. Lower levels can be associated with greater price volatility.

Dividend yields

When yields on long-term government bonds exceed the dividend yield (annual percentage of return earned by an investor on a common or preferred stock) on the S&P 500 Index by 6 percent or more, Lynch recommends selling stocks and purchasing bonds. He recommends this as a type of value-contrarian-safety strategy, claiming that when this situation occurs investors should enjoy the "risk-free" investment of bonds, they are either yielding exceptionally well or the stock market is over-valued. Either way bonds make more sense than stocks at that time. This is the only exception to Lynch's assertion that stocks are always better investments compared to bonds. (See Fed model)

Cyclical stocks

For cyclical stocks it is recommended to purchase when the P/E ratio is High, and sell them when the P/E ratio is Low. The opposite of normal practice. Cyclical stocks tend to rise quickly when the economy turns up and fall quickly when the economy turns down. Examples are housing, automobiles and paper.

Cyclicals can be a rewarding investments if purchased at their bottom price, so it helps to seek opportunity in depressed stocks, rather than analyzing potential reasons why a cyclical will take losses. When cyclical stocks are crushed by a weak economy and it appears things could not possibly worsen, cyclicals usually hit their bottom.

Lynch goes on to explain the PE ratios for cyclicals, advising the time to buy is when their PE hits a historic high, because 'Wall Street' has caught on to cyclicals and often begins discounting them before the overall market tops-out (i.e., ends a period of rising prices and is expected to stay on a plateau or decline). When a cyclical stock is at a low PE ratio, alongside record-high profits that have grown for several years, the market is anticipating a downturn. When a cyclical reaches a high PE on very low earnings, the price may be ready for an upturn because earnings will be at or near their nadir.

Stock selection effectiveness

In A Random Walk Down Wall Street, Burton Malkiel (b. 1932), an economist from Princeton University, argues that asset prices typically exhibit signs of random walk and that one cannot consistently outperform market averages. Random walk is a theory about the movement of stock and commodity futures prices hypothesizing that past prices are of no use in forecasting future price movements. According to the theory, stock prices reflect reactions to information coming to the market in random fashion, so they are no more predictable than the walking pattern of a drunken person. This book is frequently cited by those in favor of the efficient-market hypothesis, a theory that market prices reflect the knowledge and expectations of all investors.

However, there have been numerous studies indicating that some investment strategies have outperformed the market for long periods of time. For example, in 1986, Roger Ibbotson, a finance professor at the Yale School of Management, studied the relationship between stock price as a percentage of book value and investment returns in Decile Portfolios of the New York Stock Exchange, 1967–1984. His study reveals that stocks with a low price to book value had significantly better investment returns over the 18-year period than stocks priced high as a percentage of book value. During that period, the compound annual return for the market capitalization weighted NYSE Composite Index was 8.6%.

In 1987, Werner F.M. DeBondt and Richard H. Thaler, Finance Professors at the University of Wisconsin–Madison and Cornell University, respectively, examined stock prices in relation to book value in "Further Evidence on Investor Overreaction and Stock Market Seasonality", The Journal of Finance, July 1987. All companies listed on the New York and American Stock Exchanges, except companies that were part of the S&P 40 Financial Index, were ranked according to stock price in relation to book value and sorted into quintiles, five groups of equal number on December 31 in each of 1969, 1971, 1973, 1975, 1977 and 1979. The total number of companies in the entire sample ranged between 1,015 and 1,339 on each of the six portfolio formation dates.

The investment return in excess of or (less than) the equal weighted NYSE Index was computed over the subsequent four years for all of the stocks in each selection period. The four-year returns in excess of (or less than) the market index were averaged. The compound annual return (investment return, discounted retroactively from a cumulative figure, at which money, compounded annually, would reach the cumulative total) in excess of the market index from the lowest 20% of the stocks, in terms of price/book value, was 8.91%. For each $1,000,000 invested, the low price/book value stocks returned $407,000 more on average than the market index in each four-year period.

The book What Works on Wall Street by James O'Shaughnessy tests most of these criteria. Although some are found to be questionable, he finds that all the ratios based on price (price-to-earnings, price-to-sales, price-to-cash flow, and dividend yield) give better returns.

See also

• Fundamental analysis
• Technical analysis
• Stock valuation
• Peter Lynch
• Absolute return
• Mosaic theory
• Tactical asset allocation
• Stocks for the Long Run
• Quality investing
• Portfolio theory