November 5, 2014

How to Find Great Ideas with Stock Screening

There are 52,063 stocks out there in the world. Over 10,000 in the US alone. You can invest in just about any one of them. How do you decide where to start?  And how do you avoid wasting countless hours building a research list that won’t generate actionable ideas?

For many, the solution is stock screening – using custom criteria to narrow down the investment universe. With today’s technology, you are limited only by the screens you can think of. Looking for a German appliance-maker with double-digit revenue growth and recent insider buying? You got it – it’s only a click away.

Investor opinion of screening spans the gambit. Some think it’s a waste of time. Others couldn’t live without it. We’re a believer screening is as good as you make it so today, we’d like to share our methods for finding great ideas with screening.

Selecting a Screening Research Tool

Step one is finding a screening tool to use. Your options range from free web applications to $20K/yr professional services like Bloomberg. Here are a few tools we have used:

Yahoo! Finance (free) – a free screener that covers the basics. Screen across basic profitability metrics, valuation ratios, and analyst estimates.

Financial Times (free) – a basic screener much like Yahoo Finance, but with access to global markets. The screener also supports 50 fundamental criteria, making it more powerful than the Yahoo! screener.

The Screening Company ($25/mo) – this tool take screening to a new level. You can access the entire universe of stocks and sort by almost any fundamental/technical criteria you can think of. The best part is being able to write functions for your own free form criteria.

Note: The rest of this post will feature examples from the Screening Company Screener.

Shrinking the Investing Universe

We’re a practitioner of 80/20 investing. Essentially, this means figuring out the 20% of your investing activities that are delivering 80% of your results.

We like to start by asking, “what markets/businesses do we have no chance of investing in?”

Don’t be scared of missing out on a great idea by excluding entire markets/sectors. You will miss a lot of good, even great ideas. But we are on a mission to optimize our investing time.

For us, this means:

  1. Micro and Small-caps Only

Reader’s will know we feel the best opportunities lie where institutions can’t reach them: in the small and illiquid. Micro-caps are often defined as under $300M market cap, but for our screens, we start with a $50M cutoff.

  1. No Banks/Financials

Investing in financials is a different game. Balance sheets have a unique structure and cash flow statements are often meaningless. We don’t have much experience investing in financials, so out they go.

  1. No Mining/Resource Companies

Junior mining companies usually don’t have revenues and are valued on the basis of their deposits. These companies consume heaps of capital, dilute shareholders, and then only rarely make it to production.  Analyzing these businesses is beyond our skillset.

  1. Non-Chinese

Screen for Chinese companies in the US/Canada and you will find plenty trading for less than cash or P/E ratios under 2. Why? Because enough investors have been burned by fraud that the market no longer believes the reported numbers.

We’re sure there are gems out there, but to stack the odds in our favor, we eliminate these risky stocks.

  1. Operating Business

While we will consider unprofitable companies, pre-revenue companies are typically off-limits. This simple constraint takes out ~25% of the stocks from our shrinking universe.

  1. Full Reporting

There is nothing more frustrating than thinking you found a growth company trading at 2X earnings, only to find out the financials are from 1997. Adding a recent filing date constraint ensures we only consider companies that are currently filing with the regulators.

The last constraint we apply is to require the stock price be above $.05. This eliminates companies that have diluted shareholders into oblivion.

This is how our starting screen typically looks:

Notice how our investment universe has shrunk from over 50K to a more manageable 6K. This is still a lot to handle, so let’s take our screen one step further by targeting an exchange.

Targeting an Exchange

We like to start our research with a hypothesis for why a company is undervalued. Selecting an obscure exchange can be a great way of uncovering perfectly good companies suffering from investor neglect.

For our money, nothing beats the TSX Venture Exchange. The Toronto Venture Exchange exists for one purpose: to fund early-stage mining ventures. Most everything else gets ignored. The general rule is, if it’s profitable, Canadian investors aren’t interested!

After shrinking the universe and targeting a market, the options are endless. You could start with classic value screens and go for low P/E or P/B.  Momentum or growth screens. Technical or fundamental criteria. It really depends on your investing strategy.

Here are two of our favorite screens we use to source ideas:

  1. High FCF Margins

FCF margins refer to the percentage of revenues a company converts to free cash flow. High FCF margins typically results from:

  1.  A low-CAPEX business model
  2. Competitive advantages and pricing power

Micro and smallcaps with high margins are usually companies that dominate a niche market – these have made some of our best investments.

Here’s a screen for TSX Venture companies that meet all our criteria and have high FCF margins:

chart

This screen turns up two our favorites – COV and XX – as well a few we missed but have had great runs recently – PHO and EBN.

  1. High Growth/ Low Float

Independently, these are two of our favorite qualities. Low float reflects how management has financed the business in the past and the ownership they have in it. And growth is almost always a positive for a company.

But put together, these factors can be like rocket fuel for a stock as investors rush in to a thinly traded growth stock. Arguably our best ideas have come from this simple screen.

Here’s a run with Y/Y revenue growth > 20% and float <25M shares:

chart

Here we get another solid idea list, complete with three of our favorite ideas at the moment – HTL, RW, and PKT.

Conclusion

With screening, we’ve managed to turn the entire investment universe into lists of 30 or so names we can work through in under a day. We have optimized our investing time and uncovered some under-the-radar opportunities.

Of course, your screens will likely look different than ours. Perhaps you have a specialty in community bank investing or a knack for junior miners. It’s all about finding your comfort zone and sticking to it.

Disclosure: Paul and Brandon are long COV, PKT, RW, HTL, and XX