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Recent articles by Harry Domash: • Value stocks that live up to the name, 7/31/2005 • Follow analysts to their sweet-spot stocks, 7/17/2005 • Worry-free stocks for summer buyers, 7/6/2005 More... |
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Heres a screen based on factors that big investors say they follow most closely to help you find stocks they'd love. By Harry Domash When mutual-fund managers and other big investors -- with billions of dollars under their control -- buy and sell stocks, they move share prices. How's a small investor supposed to stay a step ahead of such moves? By figuring out how the heavy hitters think. Heres how. Merrill Lynch periodically surveys institutional money managers to find out how they pick stocks. For its most recent survey, Merrill gave the big investors a list of 26 factors to choose from. Merrill published results from the more than 200 managers who responded. I selected the eight most popular factors, and built a screen to find stocks meeting all eight requirements using MSN Moneys Deluxe Screener.
Surprisingly, at least to me, the most popular selection factors were a mixture of earnings momentum and fundamentals. By earnings momentum, I mean that the managers look for stocks with accelerating earnings growth, increasing earnings forecasts, and recent positive earnings surprises. By the way, although Merrill asked money managers for their favorite selection factors, it didnt ask what values they assigned to those factors. So I had to fill in the blanks. Ill explain in detail as I describe the screen. Predictable surprises Earnings surprises topped the money managers' favorite factors. An earnings surprise is the difference between the consensus of analysts forecasts and the actual reported earnings. Its a positive surprise if reported earnings beat forecasts and a negative surprise if the companys earnings came up short. Many investors believe that surprises come in bunches. That is, a positive surprise is usually followed by more of the same in future quarters, and vice versa. I dont know whether thats the reason, but considerable research shows that positive-surprise stocks outperform the market for months after the surprise, and that negative-surprise stocks underperform. Related news and commentary on MSN Money
MSNs screener has a parameter set up specifically to isolate positive surprise stocks. You can find it by first selecting Advisor FYI in the field name and then looking in the Analysts Projections section.
More of the big mo' In addition to earnings surprises, two more earnings-momentum factors made Merrill's top eight: earnings forecasts and accelerating earnings growth. A stock price usually moves up after analysts significantly increase their forecasts, and down when they cut them. Interestingly, consensus forecasts often move in trends. Thats understandable. When one analyst changes his or her forecast, others covering the same stock fire up their spreadsheets to see if theyve missed something. Often they decide that they have and they revise their forecasts in the same direction. So, the first forecast revision often triggers more of the same. As with earnings surprises, MSNs screener has a parameter specifically for finding stocks with recent positive consensus-earnings-forecast revisions.
Accelerating earnings growth compares the most recent quarters year-over-year earnings growth with longer trends. For instance, if a stock has historically grown earnings at a 20% clip, it has positive momentum if last quarters earnings grew by 25%. You can screen for that condition by comparing a stock's most recent quarterly year-over-year earnings growth to its last fiscal years growth rate. For my screen, I want the most recent quarter's earnings growth 5% higher than the most recent fiscal year's.
To assure that earnings growth isnt faltering, I also required that the current fiscal years forecast growth (Current Year Growth Rate) be at least 5% higher than a year ago.
No anomalies The way the math works, stocks with particular combinations of negative earnings and negative earnings growth can pass the above tests. Since I dont think that was what Merrills money managers had in mind, I added three search parameters to rule out those anomalies.
The first two tests eliminate stocks with negative earnings growth in the most recent quarter or in the last fiscal year. The third test rules out stocks if this years forecast earnings growth is negative. Fundamentally sound The remaining five of the top eight parameters involve valuation, profitability, and debt measures. The price-to-book ratio compares the recent stock price to shareholders' equity, which is called book value when expressed on a per-share basis. Since Merrill didnt ask for values, I had to guess at what the pros had in mind. The average P/B ratio for the S&P 500 ($INX) is a little below 3. At the top of valuations, though, are Internet Information Providers, with an average 9 P/B, one of todays hottest industries. So I chose a high number, arbitrarily picking 10 for my upper limit.
The price-to-cash-flow ratio compares the recent stock price to a company's per-share operating cash flow. The average P/CF ratio for the S&P 500 is 13. But I decided, again, to go with a higher number, this time 40, to let in the Internet companies, whose average P/CF is around 36.
By the way, Google Finally, in the valuation department, the price-to-earnings-growth ratio compares the P/E ratio to forecast earnings growth. Usually, PEG ratios below one signal undervalued stocks and those with PEGs above 2 are overvalued.
That convoluted statement, listed under "Advisor FYI" and "Price Ratios," instructs the screener to rule out stocks with PEGs above 2. Even Google, with a 1.7 PEG, passes this test. Profitability matters Return on equity measures profitability by comparing the bottom line after-tax income to shareholders equity. A company cant grow earnings faster than its ROE without raising additional cash. Most money managers that Ive talked to wont consider stocks with ROEs below 15%.
Debt The debt-to-equity ratio, which compares long-term debt to shareholders equity, is a popular debt gauge. The higher the ratio, the higher the debt. However, whats high and whats low varies with industry. So, Merrills surveyed managers probably compare a companys D/E to its industry and avoid stocks with D/Es higher than the industry average.
My screen turned up 21 stocks with a preponderance of home builders and banks, along with oil and gas stocks. Given the buzz about the housing bubble and the shrinking yield curve, which hurts bank profits, many money managers would likely overrule the screen and avoid home builders and banks.
The momentum style that Merrills money managers favor is a relatively short-term strategy (think weeks). The screen should help you figure out which stocks these big players are looking at. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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