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 with out it. I’m a believer screening is as good as you make it so today, I’d like to share my methods for finding great ideas with screens.
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 I 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
I’m a practitioner of 80/20 investing. Essentially, this means figuring out the 20% of your investing activities that are delivering 80% of your results.
I like to start by asking, “what markets/businesses do I 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 me, this means:
1. Micro-caps Only
Reader’s will know I feel the best opportunities lie where institutions can’t reach them: in the tiny and illiquid. Micro-caps are often defined as under $300M market cap, but for my screens, I start with a $50M cutoff.
2. No Banks/Financials
Investing in financials requires different mental models than most other businesses. Balance sheets have a unique structure and cash flow statements are often meaningless. I don’t have much experience investing in financials, so out they go.
3. 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 my skillset.
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.
I’m sure there are gems out there, but to stack the odds in my favor, I eliminate these risky stocks.
5. Operating Business
While I will consider unprofitable companies, pre-revenue companies are typically off-limits. This simple constraint takes out ~25% of the stocks from our shrinking universe.
6. 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 I only consider companies that are currently filing with the SEC.
I’m not opposed to investing in dark companies but for a first pass, full reporting makes life a lot easier.
The last constraint I apply is to require the stock price be above $.05. This eliminates companies that have diluted shareholders into oblivion.
Put together, this is how my 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
I like to start my 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.
Here are my three favorite exchanges to hunt on:
1. TSX Venture Exchange
If I could invest in only one exchange for the rest of my life, this would be it. 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!
2. UK Alternative Investments Market (AIM)
Critics correctly note that investors would be better off had this exchanged never existed, having lost nearly 25% since its inception in 1996. Let their negativity be your advantage – there are tons of profitable niche companies floating on this exchange.
3. US OTC Markets
You will find plenty of pump and dump schemes and frauds on what is known as the wild west of US investing. Hidden in the junk, however, are some America’s most promising growth companies. Start on this exchange to find them before institutions.
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 some custom screens I use to find ideas that mirror my investing style:
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:
- A low-CAPEX business model
- Competitive advantages that afford pricing power
The classic example is Moody’s with its astounding 35% FCF margins. This quality often indicates the presence of moats and this screen is one of the best ways I know of finding them.
Here are the results of a screen for US OTC companies that meet all our criteria and have high FCF margins:
This screen turns up many micro-caps that I have invested in (OPRX, NROM) or researched intensively in the past (ITSI, PBSV). Many of these are little companies with great business models.
2. High Insider Ownership / Low Institutional Ownership
If I could have just one piece of information to invest on, it would be insider ownership. The only thing better than investing alongside these owner-operators is getting in before institutions.
Here are the results of our screen with insider ownership > 20% and institutional ownership < 20%:
Right away we find a core holding (OPRX) and a stock at the top of my research list currently (INTZ). DIRI and JGPK are also interesting ones I know a few saavy investors are in.
3. High Growth/ Low Float
I like both of these qualities separately. 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.
Put together, these factors can be like rocket fuel for a stock as investors rush in to a thinly traded growth stock.
Here’s our screen with TTM/TTM revenue growth > 30% and float <5M shares:
Down on the list is a classic example of this effect, PFHO – a stock up nearly 600% y/y. USEL is an interesting story but I can’t say I have heard of any others on the list. Looks like I have some work to do!
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 mine. Perhaps you have a specialty in community bank investing or a knack for junior miners. It’s all about defining your circle of competence and sticking to it.
So, what are your favorite screens for finding great investing ideas?
Disclosure: Long OPRX