Friday, February 15, 2008

Stock screening ideas

I have begun to heavily involve myself in stock selection. Its very interesting to learn and read financial statements, the history of a company, its current growth drivers and its competitors. Each stock has its own story to tell. And herein lies my problem. That of there being too many publicly traded companies on the stock exchange for a human to do any fruitful analysis of a stock if we select to go in any particular lexicographical order.

Apropos to this, I have been reading a bit and have learned of a few nice ideas. The foremost of the lot is proposed by Joel Greenblatt in his book titled "The Little Book That Beats The Market" http://www.magicformulainvesting.com/book.do . The strategy that the book proposes is very simple in itself. All that we need to do is look for good companies at bargain prices. And for that, all we need to do is look for companies that give a high Return on Capital Employed (ROCE) or high Return on Assets (ROA). Such companies automatically become good since they are producing better results than their competitors and have a greater sustainability to do so going ahead. And we need to get these companies at bargain. So add to it that these companies should have a high Earnings Yield or a low P/E ratio. And you are pretty much done.

All my other reading point out that this book is pretty much correct. But as Joel Greenblatt goes on to say in the last chapter, there would be a few of us (like me), who like to think that no automatic stock selection criteria is greater than our individual capacity to select good stocks in the long run. Essentially each one of us likes to belive that we are Warren Buffets all. Or the cynic in us gets the better of our logical reasoning and having read a bit more than recommended, believes that since no automatic stock selectioin criteria worked over the long term (for example the Dogs of the Dow theory), even this is not going to work. All that it boils down to is that I like to hand pick my stocks. And this above criteria comes in real handy to get me started.

Add to the above two criterias, I found some others. All common sense, no nonsense at all. I will just list them and try to rationalize them from whatever I know.

  • High Return on Capital Employed (ROCE): Shows how good the managment is, since it extracts the most out of whatever resources are available to it. Return on Assets (ROA) or Return on Equity (ROE) can also be variably used. It should be fixed at a minimum of 10%.
  • High Earnings Yield or Low Price-to-Earnings (P/E): This actually denotes how much return an individual shareholder is entitled to. I marked it to a P/E of 4. Although if you are a sophisticated investor with access to large data, you can probably go for high values of the ratio EBIDTA/EV (i.e. Earnings Before Interests, Depreciation, Taxes and Amortization / Enterprise Value )
  • Low Debt / Equity ratio: Fixed at 70% and less. Any higher and there are going to be problems with the operation of the entity each time there a adverse rate move by the central banks. Although this would preclude the banking sector (which far as I know shows a high debt on its balance sheet)
  • Market Capitalization: 100 crores minimum. I don't want people to run away with my money. That figure seems reasonable enough to keep the interest of other investors also piqued so that I am not the only one tracking the stock.
That's pretty much the initial screen I would apply during my stock selection. And then rank the companies on all the parameters. Those that come up higher on the list of combined rankings make the grade for my personal scrutiny and study.

That I don't fully understand the financial statements of all the sectors is a story for another day. But the above parameters at least allow me to know, which stocks I want to look at and do research on.
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