Don’t let stock screens mislead your investments

by admin on January 12, 2012

In general stock screens are very useful, but don’t let them be your ultimate guide when you are ready to invest, here is why these tools can be dangerous some times:

Recently I tried to run a stock screen using the following rules from the selection of rules available on the website:

Stocks with total debt to equity ratio – less than 10%  
Debt is a source of capital, just like shareholders’ equity, that can be a boon if companies use the proceeds to earn profits well in excess of the cost of the debt, but can be a drag when times are tough, since interest and principal must be paid whether or not the company is flush with cash.

Risk-averse investors can limit consideration to companies whose debt burdens are manageable, as would be the case for those whose debt-to-equity ratios are 50% or less. One could even allow the ratio to go higher, even to 100% if cash flows are sufficiently stable and ample to cover interest expense.

The total debt to equity ratio is calculated as follows: 
(Short-term Debt + Long-term Debt due in one year + Long-term Debt)/Shareholders Equity

Earnings growth last 12 months – greater than 10%
This is the growth in earnings over the last four quarters (compared with the prior four quarters). Under normal circumstances, a firm that posts a quarterly growth rate of at least 15% could qualify as a growth company.

In choosing the period of time over which growth should be measured, there is a continual tug-of-war between a rate that depicts what’s happening right now (an always important Wall-Street consideration) versus the long term (i.e. five years), which may be more representative of the sort of growth rates a company might achieve on average over a prolonged period. A trailing 12 month period is widely used because of its ability to combine the flavors of both. It has a lot of the immediacy investors cherish but by using four quarters instead of one, it provides at least a modest clue regarding sustainability.

Return on equity last 12 months – better than industry median
Stock market gurus constantly tell us to evaluate management but it seems hard to do in the real world. However, Return on Equity is a ratio that can help. The formula is:

Net income/Shareholders Equity

If Company A and company B both earn an annual profit of $20 million, but Company A accomplished it using $400 million of equity capital (a 5% return) while Company B did it using only $100 million of equity (a 20% return), Company B would obviously be considered far more profitable.

The trailing 12 month return measures how the company is doing right now. You should resist the temptation to look at an even more recent period, like the latest quarter, since many business are impacted by seasonal variation. A 12-month period properly portrays the company’s current profitability.

A company that earns 12% on its equity can be considered successful, since fewer than 25% of all companies are able to do this.

Market capitalization – between $1,000 M and $5,000 M (Mid cap)
Market Capitalization, the most basic measure of company size, is price per share multiplied by the number of shares outstanding. Mid cap in theory have more growth potential than large caps, in other words they have more room for growth since their market is not mature yet.

Ongoing volume surge: 5 day average vs 20 day average
Trends in trading volume can help us measure the intensity of Wall Street’s interest in a particular stock.

Those whose volume over the past five days are at least 10% above the average volume over the past 20 days have obviously been attracting much more interest in the investment community and may be worth examining.

But the reason for this increased interest may not be favorable. Therefore, a test like this should be combined with others that can help identify bullish situations.

When I ran the filter it gave me 47 results that “in theory” should be good candidates for a potential investment, one of the stocks that met this criteria was Northern Oil & Gas, Inc. (NOG), at first stock looked like a good investment, however when I took a look at the cash flow I saw that it was actually negative; this was the same problem Enron had when it filed for bankruptcy, everything on their books looked great, except the company was not generating any free cash flow. Take a look at the graph below, it shows shareholder equity vs. long term debt. When I saw it I though “I found a jewel!!”… the company has virtually no debt and shareholder equity is heading toward the sky!

Northern Oil & Gas Shareholders Equity Chart

Northern Oil & Gas Shareholders Equity Chart by YCharts

Now take a look at this one showing price vs free cash flow. You may say. “are you kidding me?” well that’s what I said. Eventhough the company is generating $96,380M in operating activities at the same is loosing  $343,137M in investment activities, and the free cash flow TTM today is -$243,006M. This company is loosing money like there is no tomorrow, but you don’t see it just by running stock screens.

Northern Oil & Gas Stock Chart

Northern Oil & Gas Stock Chart by YCharts

So why didn’t you see this when you use the stock screen?, Stock screens have some limitations, and in this case doesn’t have the option to filter by price/free cash flow so I wasn’t able to filter this stock based on that criteria. If I invest based only on these results I would get a very unexpected and unwanted surprise shortly. If I want to see price/free cash flow I have to use or read a company’s financial statements. Every stock screen has its advantages and disadvantages, but in general the ones I like the most are:

  1. This is one of my favorites, it allows me to filer by descriptive fundamental and technical parameters, It is free of charge and very user friendly.
  2. The wizard rule on the site allows me to create or modify complex filters very easily, it has also a long list of useful predefined screens that are ready to use
  3. This allows me to filter by certain valuation parameters proprietary only from ycharts
  4. This site allows me to see in real time the distribution of my criteria among all stocks

Stock screens are a very useful to use to find good investment opportunities, but never, seriously never, make an investment only because your stock screen suggests a candidate that on paper looks great. Remember, stock screens are just another tool, but you still have to do your homework, read the company’s annual reports, consult their most recent financial statements, and visit their  website and search on the web and specialized sites to find out what others say about the stock.

Are there any other stock screens you like? Please share your comments below.

Previous post:

Next post: