Analysts Corner

Creating Stock Screens That Make Practical Sense

By John Bajkowski
When designing the manual for Stock Investor, AAIIs stock screening and fundamental analysis computer program, we wanted to include samples of a few basic screening criteria. We quickly saw that it is easy to come up with a list of meaningful screening criteria, but applying them in useful ways is challenging. Screening is the application of quantitative criteria to a broad universe of stocks in order to narrow the list down to a few companies. It allows you to focus your attention on a smaller but more promising group of stocks. It is best to look at screening as a multi-stage process: You must first clearly define the objective of your screen. Next, you must construct primary criteria that locate stocks that match your screening objective. Then, you need to construct a set of secondary criteria that ensure the companies passing the primary screen did so because they truly meet your objectives and not out of coincidence. And last, you must keep in mind that even the best screen represents only a starting point for in-depth analysis. Defining a Clear Objective An objective should always be developed before constructing a screen. The objective should reflect your return objectives, risk tolerance, and investment philosophy. Return objectives encompass not only the total return, but the relative contribution from capital gains versus dividend income. Risk tolerance refers to how easily the investor copes with volatility in both an absolute and relative sense. Relative risk concerns the performance of a stock in relation to the market; whereas, absolute risk concerns the performance of a stock independent of the market. Investment philosophy encompasses the style an investor uses to select stocks. For example, a young couple usually has little wealth John Bajkowski is AAIIs financial analyst and editor of Computerized Investing. The primary screening criteria should flow naturally from your objective, and should attempt to filter only those companies that meet your objective. If you are a growth investor, it should provide you with a list of companies that are in the growth stage of their life cycle, and not mature cyclical firms. Screening criteria filter stocks by comparing a companys numerical or quantitative figure against some base figure. When defining your criteria you will need to decide if you wish to use absolute or relative conditions. Relative conditions compare a company figure against a number adjusted for the current level of a company, industry, or market as a whole. For example, you may be screening for companies whose price-earnings ratio is less than that of the market. As the markets price-earnings ratio goes up, the screen will get less restrictive, allowing companies with higher price-earnings ratios to pass. Some criteria should only be used on a relative basis. and a long time horizon. They are seeking to accumulate wealth, and are willing to accept greater risk for the prospect of greater returns. They might choose to focus their investment on growth-oriented companies. On the other hand, a retired couple has a shorter time horizon and will be more concerned with preserving their wealth. Therefore, they might choose to focus on stocks that have higher dividends and lower price volatility. Clear, focused, narrowly-defined objectives lead to the best screens. Some common broad screening objectives include seeking growth stocks, value stocks or even stocks with positive price momentum. But before the stock screening process is started, these objectives should be further refined to reflect the specific types of stocks that the investor is seeking and the best way to measure these stocks. The young couple in our example may decide to seek growth stocks in the expansion stage of their life cycle with strong earnings momentum. The retired couple in our example might seek gas and electric utilities with above-average dividend growth rates. Primary Screening Criteria

Ratios such as margins and turnover are very industryspecific and become meaningful only when compared to industry norms or company trends. Screens that compare company data to other company elements or historical averages can also be useful. Because of growth prospects, some companies normally trade at a higher price-earnings ratio multiple. Screening for just companies with price-earnings ratios below that of the market may lead to a collection of bad stocks that deserve low price-earnings ratios and are not really underpriced. Using a relative screen that compares a companys price-earnings ratio against its historical norm or against its expected growth may be a better way to point out potentially mispriced stocks that warrant a closer look. Alternatively, you can choose to compare a company figure against some constant that does not fluctuate over time. An example would be a screen for companies with a price-to-book-value ratio below 1.0. As higher overall market levels lead to higher valuations, the number of companies passing the price-to-book ratio will decrease. If market levels go to extremes, no suitable investments may pass the screen. Some value investors use absolute screens such as this to modify their exposure to the markets. During periods in which the market is priced high, fewer attractive investments appear to replace the overvalued securities that have been sold, which leads to a net reduction in equity assets. One of the biggest mistakes in criteria construction is having a list of criteria that are reasonable individually, but when combined turn out to be contradictory. If you are looking for potential high-growth companies, then you shouldnt team up a requirement for high earnings growth with a requirement for a high dividend yield. Companies that are truly growing usually need to use cash for expansion and cant afford to pay high dividends. Combining the criteria in this way will negate the objective of the screen, probably leaving the investor with a list of oddball stocks. By the same token, too many criteria filtering the same type of companies are often combined. If you are looking for contrarian or out-of-favor stocks, screening for low price-earnings, price-to-book, price-to-sales, or price-tocash-flow ratios or high dividend yield will, for the most part, list the same type of stocks. Your screening efforts would be better spent focusing on the criteria that best indicate the type of companies you are seeking and on criteria that you really understand well. Table 1 displays sample primary screening criteria using growth objectives and sample criteria using value objectives. Secondary or Conditioning Screens Even with a clear objective and a well-built primary screen, you can expect a number of companies that do

not embody the company type you are seeking to slip past your screen. Your high dividend yield screen will probably contain some companies ready to cut their dividend and your growth screen will probably capture some mature cyclical companies examined during their normal cyclical upturn. While screening is designed to be a preliminary stage in the security selection process, the screening process should include a secondary, or conditioning, screen. The conditioning screen should help establish that companies passing the primary screen did so because they meet the screens ultimate objective. These differ from the primary screening criteria in that if they were used by themselves to filter companies, they would not locate companies that meet your objective. A primary screen for high-dividend-yielding stocks may include a criterion for companies whose dividend yields are above that of the companys five-year average. This will lead to companies with relatively high dividend yields. A conditioning screen would analyze those companies to help establish that the dividend is relatively secure. It might include a criterion that specifies a maximum payout ratio (dividends per share divided by earnings per share) of less than 50% to seek companies that are not paying out more than half of their earnings in the form of dividends. It is a conditioning screen for a highdividend-yield scan because, by itself, it does not indicate whether the dividend yield is high or low. Table 1 lists sample conditioning criteria for a primary screen with a growth objective, and sample conditioning criteria for a screen with value as a primary objective. All Screens are Preliminary When designing stock screens, keep in mind that there are no miracle screens that produce lists of guaranteed winners. A well-designed screen, however, should provide you with a preliminary list of stocks that hold some promise. In developing a screen keep the following points in mind: Develop a clear, narrowly defined objective, keeping in mind the type of stocks that will meet your investment philosophy and objectives. Construct primary screening criteria that will locate companies that match your objective. In constructing primary screening criteria, avoid using rules that will cancel each other out or that are redundant. Develop a set of conditioning criteria that will help ensure that a company passed the primary criteria for fundamental reasons rather than by chance. Remember that even the best designed screen is only a preliminary search for investments using a small set of quantitative factors. A complete in-depth analysis that explores both quantitative and qualitative factors should follow any screen.

Table 1. Primary and Secondary Screen Examples For use with AAII's Stock Investor program (version 2.1)

Value Screening
Objective: To identify companies whose market price is low relative to value measures based upon factors such as sales, earnings, dividends, cash flow or assets. Price-Earnings Emphasis Primary Screen Examples Current price-earnings ratio below firms five-year priceearnings ratio Current price-earnings ratio below industry average Current price-earnings ratio below market average Current price-earnings ratio below an absolute level Secondary/Conditioning Screen Examples Focus earnings potential of company: Require minimum level of earnings growth Require minimum level of revenue growth Current price-earnings ratio less than half of earnings per share growth rate Require increasing or stable profit margin over time Require profit margin above industry average profit margin Focus on companys financial strength: Specify companys maximum level of debt to total assets, or Specify companys maximum level of total debt to capital, or Specify companys maximum level of debt to equity Price-to-Book-Value Emphasis Primary Screen Examples Current price-to-book-value ratio less than 1.0 Current price-to-book-value ratio below firms five-year price-earnings ratio Current price-to-book-value ratio below industry average Current price-to-book-value ratio below market average Secondary/Conditioning Screen Examples Focus on quality of book value: Low ratio of intangibles/goodwill to book value Focus on earnings potential of company: See secondary/conditioning variables for price-earnings emphasis Dividend Yield Emphasis Primary Screen Examples

yield Current dividend yield above industry average Current dividend yield above market average Current dividend yield above an absolute level Secondary/Conditioning Screen Examples Focus on maintenance of dividend payment: Specify maximum level of payout ratio Specify minimum level of earnings growth Focus on growth potential for dividends: Specify minimum level of earnings growth Focus on Liquidity: Specify minimum quick, or current, ratio Focus on companys financial strength: Specify companys maximum level of debt to total assets, or Specify companys maximum level of total debt to capital, or Specify companys maximum level of debt to equity

Growth Screening
Objective: Identify companies in stage of rapid and expanding growth with earnings momentum. Primary Screen Examples Specify minimum absolute level of historical earnings per share growth Specify minimum absolute level of forecasted earnings per share growth Specify growth rate above industry average growth rate Specify industries that are expanding at rates above that of the economy Require positive increase in annual earnings for each individual period of analysis Require increasing growth rate in earnings from period to period Secondary/Conditioning Screen Examples Focus on expanding level of sales to support earnings: Specify minimum growth rate in revenues Focus on competitive advantage of company relative to industry: Specify ratio of company profit margin to industry profit margin Specify increasing profit margin over time Focus on retention of earnings to support future sales: Specify maximum level of payout ratios Specify minimum level of sustainable growth (return-onequity x 1.0 payout ratio)

Current dividend yield above firms five-year dividend

Screening for Growth and Value Based on What Works on Wall Street
By John Bajkowski
A successful stock selection strategy is elusive for many investors. Chasing hot growth stocks often leaves investors burned, while low-priced, value stocks often only become cheaper. James P. OShaughnessy provides a detailed examination of basic investment strategies in his book What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time (McGraw-Hill, $29.95). OShaughnessy argues that the majority of investors fail to beat market averages because they do not follow a disciplined approach to investing. Instead, investors let the emotions surrounding the market overpower their judgment and push them off their planned investment course. This article examines and implements what OShaughnessy terms the cornerstone value and growth strategies he developed while testing a range of value and growth strategies using over 40 years of S&P Compustat data. The Universe OShaughnessy established two base groups of stocks from which to pick investments and to serve as performance and risk benchmarksall-stocks and those with large capitalizations. The all stocks universe was determined by selecting stocks with a market capitalization (shares outstanding times market price) of $150 million or greater. Rather than use the complete CompuStat database, OShaughnessy decided to focus only on stocks that a professional money manager could buy without too much difficulty due to liquidity. OShaughnessy based the $150 million market capitalization cut-off as of December 1994, and adjusted this figure for inflation so that the minimum value was approximately $26.7 million in 1952. Limiting the analysis to stocks with a market cap above $150 million effectively cuts out half the stocks currently traded on the New York, American, Nasdaq National Market, and Nasdaq Small Cap exchanges. The large cap group was determined by selecting stocks whose market capitalization was greater than the average for the overall universe. Typically only about 16% of the companies pass this filter because few very large firms push up the average market cap. Testing revealed that the large cap group had similar return and risk performance to that of the S&P 500. OShaughnessys testing revealed that micro caps or stocks with market capitalization below $25 million beat all other size groups on a risk-adjusted basis, but he argues that it is too difficult to invest in these stocks. A comparison of the OShaughnessy all-stocks universe to the large cap universe revealed that the all-stocks group had higher performance, but they also carried more risk, as measured by standard deviation of return. However, the return was sufficiently higher so that the risk-adjusted return exceeded the large cap group. Value Strategies OShaughnessy tested a number of basic value strategies on both the large cap and all-stocks universe. Value strategies use measures such as price-earnings ratios, price-tobook value ratios, price-sales ratios and dividend yields, to identify out-of-favor investments that are priced attractively in relationship to these measures. Stocks whose prices are low relative to some tangible company factor such as earnings are purchased, while companies with high prices relative to these measures are avoided. Table 1 provides a summary of the single criterion strategies tested by OShaughnessy. OShaughnessy used the CompuStat database to construct a portfolio of the top 50 stocks passing a strategy. An equal dollar amount was invested in each security, with the portfolio rebalanced annu-

John Bajkowski is AAIIs senior financial analyst and editor of Computerized Investing. Kenneth J. Michal provided research assistance.

Table 1. OShaughnessys Single Criterion Test Results

All-Stocks (Market capitalization above $150 million) Value Strategies Price-Earnings: Buy 50 stocks with the lowest price-earnings ratios. While stocks with low price earnings ratios performed better than those with high ratios, the low price-earnings stocks underperformed the all-stocks universe and had higher standard deviation. Low price-to-book value stocks outperformed all-stocks universe on an absolute basis, but also had higher risk leading to a risk-adjusted return equal for both groups. Low price-to-cash flow stocks outperformed all-stocks universe on an absolute basis, but higher risks leads to underperformance on a risk-adjusted basis. Best performing value measure for the all-stocks universe. Significantly outperforms universe on an absolute basis and risk-adjusted basis. High-dividend yielding stocks fail to outperform all-stocks universe on an absolute basis and is higher risk. Large cap, low price-earnings stocks significantly outperformed both large cap universe and high price-earnings stocks. Although strategy had higher risk, it was attractive on a risk-adjusted basis. Low price-to-book stocks strongly outperform large cap universe with somewhat higher risk. Superior strategy on both a total and risk-adjusted basis. Low price-to-cash flow stocks outperform large cap universe on both an absolute and risk-adjusted basis. Best performing large cap value strategy. Strong and consistent performance. Outperforms large cap universe on both an absolute and risk adjusted basis. Strong and consistent performance. Out performs large cap universe with little additional risk. Large Cap (Market capitalization above average)

Price-Book Ratios: Buy 50 stocks with the lowest price-book ratios. Price-to-Cash Flow Ratios: Buy 50 stocks with the lowest price-to-cash flow ratios. Price-to-Sales Ratios: Buy 50 stocks with the lowest price-to-sales ratios. Dividend Yield: Buy 50 stocks with the highest dividend yields. Growth Strategies One-Year Earnings Increase: Buy 50 stocks with the highest one-year earnings per share percentage increases.

Leads to both lower return and higher risk. Some short periods, however, do show strong performance only to be followed by very poor performance.

Five-Year Earnings Growth: Buy 50 stocks with the highest five-year earnings per share increases. Profit Margins: Buy 50 stocks with the highest net profit margins. Return on Equity: Buy 50 stocks with the highest return on equity (ROE). Relative Strength: Buy 50 stocks with the highest one-year price change.

Performance below all-stocks coupled with greater risk levels results in terrible performance.

Results in poor performance and higher risk. Buying stocks with the lowest gains leads to slightly better performance than benchmark, but at higher risk, resulting in risk-adjusted performance just below benchmark. Performance below large cap index coupled with greater risk results in terrible performance.

Underperformed all-stocks and exhibited slightly higher risk.

Performed below large cap index with roughly the same risk level. Performance below large cap index coupled with greater risk levels results in poor performance. Performance of high relative strength stocks exceeds performance of large cap universe, but with higher risk. Absolute and risk-adjusted return above large cap universe.

Performance of high ROE stocks was roughly equal to all-stocks index, but risk was higher, leading to weaker risk-adjusted performance. Performance of high relative strength stocks exceeds performance of all-stocks, but at much higher risk. Risk-adjusted return below all-stocks.

ally. Dividends were included in the return measurements, but transaction costs were ignored. OShaughnessy tested the reverse of a strategy when appropriate. For example, when testing the price-earnings strategy, a portfolio of the top 50 price-earnings companies was established and tracked, as well as a portfolio of the bottom 50. The test results confirm the conclusions of many studies emphasizing the benefit of following a value-oriented approach in selecting stocks. Growth Strategies As indicated in Table 1, OShaughnessys tests of basic growth strategies revealed that with the exception of rela-

tive strength, simple growth strategies do not compensate investors adequately for the risk possible with these strategies. High growth, high margin stocks are often bid up to unrealistic levels. Growth stock investors must watch their portfolios very carefully, quickly selling off issues with any hint of disappointing growth. OShaughnessys tests revealed that growth stocks often underwent significant periods of superior risk-adjusted performance, especially during strong bull markets. However, these gains were eroded over the long run during subsequent market periods. Relative strength stands out as an effective tool for the stock investor, working consistently over the 40-year test period. Relative strength compares the price performance of a security to that of a corresponding index. Stocks outper-

Table 2. OShaughnessy Cornerstone Screening

PriceEarnings Ratio (X) PriceBookValue Ratio (X) PriceSales Ratio (X) 5-Year Earnings Growth Rate (%) 5-Year Sales Growth Rate (%) 52-Week Relative Strength (%)

Company (Exchange: Ticker)

Dividend Yield (%)

Market Capitalization ($ Mill)

Description

Cornerstone Value Stocks (Ranked by Dividend Yield) U.S. West Communications (N:USW) 14.0 4.48 1.7 ARCO Chemical Company (N:RCM) BCE Inc. (N:BCE) RJR Nabisco Holdings Corp (N:RN) Imperial Oil Limited (A:IMO) Southern New Eng. Telecom (N:SNG) Chrysler Corporation (N:C) Ford Motor Company (N:F) Deluxe Corporation (N:DLX) NYNEX Corp. (N:NYN) Brascan Limited (A:BRS.A) MacMillan Bloedel Limited (M:MMBLF) Atlantic Richfield Co. (N:ARC) Bankers Trust NY Corp. (N:BT) J.C. Penney Company, Inc. (N:JCP) Moore Corporation Ltd. (N:MCL) Bell Atlantic Corp. (N:BEL) GTE Corporation (N:GTE) Dun & Bradstreet Corp. (N:DNB) Occidental Petroleum Corp. (N:OXY)
Cornerstone Value Median Large Cap Median

6.0 5.9 5.6 5.1 4.9 4.9 4.7 4.7 4.6 4.6 4.4 4.4 4.3 4.3 4.3 4.3 4.2 4.0 4.0 3.9
4.6 1.4

na 5.1 -11.3 17.9 -2.1 -42.4 37.5 31.0 -12.3 -30.7 na 42.2 -7.1 -23.6 8.7 14.7 7.7 -25.8 -7.5 17.4
5.1 13.1

na 8.6 6.0 2.9 -3.5 2.8 15.9 7.0 5.6 -0.3 na 11.8 -1.6 1.0 5.1 -1.2 1.4 0.8 2.3 -0.8
2.9 8.0

17,196.0 4,572.4 15,392.0 9,885.8 7,010.1 2,379.1 23,887.7 36,643.1 2,605.0 22,659.4 2,460.5 1,694.4 20,102.5 7,418.8 11,129.5 2,212.4 30,260.8 45,085.3 4,171.3 8,428.3
9,885.8 3,333.0

-11 -26 12 -12 -3 -29 -3 -15 -21 -19 15 -14 -8 13 -16 -9 -16 -12 -27 -11
-12 -3

Telecommun co. in 14 western states Intermediate chem. & speclty prods Telecommun servs & equip Produces tobacco & snacks Crude oil, natural gas, & petroleum prods Telecommun prods Cars, trucks, & accessories Sells cars, trucks & accessories Check printing & electr funds transfer servs Telecommun co. in northeastern U.S. & worldwide Mining & metals, forest products, oil & gas Forest prods co. Petroleum liquids, crude oil, natural gas, & coal Bank holding co. Apparel, shoes, home furnish & jewelry retailer Business forms, printing servs, labels Telecommun co. in Mid-Atlantic region Telecommun prods/servs Info. services; credit ratings, investor info Crude oil & natural gas

11.5 22.5 30.1 17.3 na 7.2 10.3 31.4 16.7 7.8 9.0 12.7 14.2 14.7 20.1 16.4 na 19.9 19.4
14.5 20.7

2.26 2.09 1.26 2.36 5.37 2.19 1.50 3.43 3.31 1.00 0.66 2.78 1.75 2.02 1.45 4.06 6.48 3.94 2.31
2.19 2.93

1.2 0.8 0.7 1.1 1.2 0.4 0.3 1.4 1.7 na 0.5 1.1 1.2 0.5 0.9 2.3 2.2 1.0 0.8
1.1 1.6

Cornerstone Growth Stocks (Ranked by Relative Strength) Brightpoint Inc. (M:CELL) 49.2 5.96 0.9 Insight Enterprises, Inc. (M:NSIT) Watsco, Incorporated (N:WSO) PHH Corporation (N:PHH) Interface, Inc. (M:IFSIA) Computer Data Systems (M:CDSI) Culp, Inc. (N:CFI) Gibraltar Steel Corp. (M:ROCK) Alberto-Culver Company (N:ACV) Scotsman Industries, Inc. (N:SCT) Leasing Solutions (M:LSSI) Spartech Corporation (N:SEH) AMERCO (M:UHAL) Avery Dennison Corp. (N:AVY) Carlisle Companies, Inc. (N:CSL) Owens-Illinois, Inc. (N:OI) Coachmen Industries (N:COA) Palm Harbor Homes (M:PHHM) Raymond Corporation (M:RAYM) Personnel Grp. of America (N:PGA)
Cornerstone Growth Median All-Stocks Median
Exchange Key:

0.0 0.0 0.5 1.6 1.1 0.4 0.7 0.0 0.7 0.4 0.0 1.7 0.0 1.7 1.5 0.0 1.0 0.0 0.4 0.0
0.4 0.4

55.0 37.0 12.3 10.8 -13.7 21.1 29.4 38.8 15.9 8.6 na 16.5 na 94.8 15.5 23.9 28.6 80.8 45.4 16.9
22.5 14.2

86.3 40.9 23.0 3.4 5.2 14.1 15.1 21.6 12.7 12.5 na 20.2 na 3.8 10.5 0.8 13.6 30.0 14.1 6.3
13.9 10.5

447.2 210.6 337.0 1,671.1 424.8 179.4 225.7 274.2 951.5 292.9 181.4 306.7 616.2 4,208.2 994.0 2,904.0 347.7 366.1 193.4 308.3
342.4 562.8

86 86 60 54 42 37 35 33 29 29 27 23 22 21 21 20 19 16 16 15
28 -5

Distrib wireless telecommun devices Direct mrkts microcomputers Climate control components Integrated management servs Interior mrkt prods Info technology servs & prods Mfrs & sells upholstery fabrics Process value-added steel prods Health & beauty care prods Refrig. prods for foodservice industry Leasing info procssng & communs equip Thermoplastic materials & molded prods Holding co. for U-Haul Speclty adhesives for labels Rubber, plastic, & metal prods Plastic pckg prods & glass containers Recreational vehicles & van conversions Produce multi-section mfrd homes Materials handling equip Personnel staffing servs

25.8 33.4 18.9 24.8 17.5 16.8 15.5 25.7 14.9 20.6 16.1 10.9 25.3 19.2 15.6 10.5 16.6 14.0 24.9
18.2 19.8

2.31 3.15 2.62 1.80 2.79 2.40 2.04 3.81 2.09 3.04 2.70 1.09 5.04 3.46 4.32 2.71 3.24 1.77 1.46
2.71 2.62

0.5 0.9 0.7 0.5 0.7 0.5 0.7 1.0 0.7 1.4 0.8 0.6 1.3 1.1 0.7 0.5 0.7 0.7 0.8
0.7 1.7

N =New York Stock Exchange

A =American Stock Exchange

M = Nasdaq

Statistics are based on figures as of February 28, 1997. Data Source: AAIIs Stock Investor/Market Guide, Inc. and I/B/E/S

forming the index have positive relative strength, while stocks lagging the performance of the index have negative relative strength. Relative strength measures help to uncover pockets of exceptionally strong or weak performance. It seems that stocks in motion tend to maintain their upward or downward momentum. Multifactor Strategies OShaughnessys studies revealed that it was possible to combine a number of the factors to establish selection criteria, superior in risk and return, to the single factor criteria. For example, pairing a value measure such as priceto-sales with a growth filter such as strong relative strength leads to a higher risk-adjusted return than the corresponding single factors. The value screen reduces the chance of paying too much for a growth stock, while the price momentum screen helps to highlight well-priced stocks with market recognized value. OShaughnessy tested a number of combinations and settled on two strategies superior on a risk-adjusted basis: a cornerstone value screen geared towards large cap stocks, and a cornerstone growth screen geared towards the allstocks universe. Cornerstone Value Testing revealed that the value approach was better suited for the large cap universe than the all-stocks universe; perhaps smaller-cap stocks with low valuation ratios do not have the resources to bounce back to glory. Large caps were also less volatile than the all-stocks universe, which fits nicely into the more conservative goal of the cornerstone value screen. OShaughnessy established a screen for large cap market leaders and tested a number of value factors to determine which factor produced consistent and strong performance over the long haul. AAIIs Stock Investor program was used to illustrate the screen. The large cap universe is defined as stocks whose market cap exceeds the average for the complete universe. Stock Investors database covers over 7,500 stocks with an average market capitalization of $1.3 billion. Establishing a minimum market capitalization of $1.3 billion reduced our universe to 1,024 companies. The next cornerstone value filter specifies that a company should have more common shares outstanding than the average stock in the databasea screen for adequate liquidity. We screened for companies with more than 38.2 million outstanding shares, reducing the number of passing companies to 858. The cornerstone value screen ultimately relies upon the dividend yield to highlight attractively-priced stocks. However, a high dividend yield may also signal the markets expectation of a dividend payout cut. To help screen out these potentially weak companies, OShaughnessy specified that the companies should have a cash flow per share

which exceeds the database average. One does not normally screen a single period per share item across a cross section of firms. Per share items are normally studied over time or converted into ratios that can be meaningfully compared across firms. OShaughnessy does not reveal if other tests of dividend safety were tested and discarded. An examination of the adequate coverage of dividend payouts from cash flow or earnings is a common divided strength requirement. We followed the OShaughnessy screen and looked for firms with cash flow per share greater then $1.60, which reduced the number of passing companies down to 646. OShaughnessy also specified that a firm must have total sales 1.5 times the database average. With sales averaging $930 million in Stock Investor, we screened for companies with sales levels greater than $1.4 billion. This screen cut the list of passing companies to 510. OShaughnessy excluded utilities to keep them from dominating the dividend yield screen, leaving us with 450 companies. OShaughnessy recommends the use of dividend yield to build a portfolio for the cornerstone value screen. The top yielding companies significantly outperformed the large cap universe while possessing a similar level of risk. Table 2 presents the 20 top yielding stocks of the cornerstone value screen. The 4.6% yield for this group is significantly above the 1.4% yield of the large cap universe. Cornerstone Growth With the exception of relative price strength, the growth strategies tested by OShaughnessy were not very promising. OShaughnessys single factor test screened for companies with extreme valuesfactors such as highest earnings growth, highest margins, and highest returns on equity. By reducing these extreme growth requirements and establishing moderate value requirements, OShaughnessy was able to construct a portfolio which had the desired combination of strong price growth and reasonable risk. The growth stock screen was based upon the all-stocks universe because smaller stocks have greater growth potential than their large cap counterparts. The all-stocks universe looks for stocks with a market capitalization above $150 million, providing a starting point of 3,476 companies. The cornerstone growth strategy focused on earnings consistency, rather than relying on high earnings growth levels. A screen for five years of consecutive earnings growth proves to be very restrictive and reduces the number of passing companies down to 455 when applied to the all-stocks universe. OShaughnessy balances the growth requirement by establishing a maximum price-to-sales ratio ceiling of 1.5. When used independently as a value screen, more restrictive ceilings of 0.75 or 1.0 are common. The price-to-sales ratio was loosened to allow more growth-oriented companies to pass, yet not allow them to have valuations that are too extreme. Applying the price-to-sales screen left 132

companies standing. OShaughnessy then screened for the 50 companies with the highest relative price strength over the last year. The top 20 stocks ranked by 52-week relative strength are presented in Table 2. With the exception of the price-to-sales ratio, the cornerstone value companies tend to have more attractive multiples than the cornerstone growth companies. The results of the screen also highlight that certain ratios can benefit from industry comparison. Brightpoint passes the cornerstone growth screen with a price-to-sales ratio of 0.9, yet it has relatively high price-to-book and price-earnings ratios. Retail and wholesale firms tend to naturally carry low price-tosales ratios. The cornerstone growth companies have much stronger earnings and sales growth rates than their value counterpoints. The cornerstone value companies are much larger

than their benchmark large cap growth, while the growth companies are smaller than the all-stocks median. Also, as expected, the relative strength of the cornerstone group is significantly higher than the value group. Only three of the cornerstone value stocks have positive relative strength, and their median is significantly below the large cap mediana common characteristic of value screens. Conclusion What Works on Wall Street provides an interesting examination of investment strategies. OShaughnessy argues that the market is far from random and that a sound, disciplined, emotion-free, investment approach is the only way to beat the market over the long term. (See AAIIs forum on America Online for a list of screening fields as used in AAIIs Stock Investor program.)

Definitions of Screens and Terms The following is a short description of the terms used in Table 2
Price-Earnings Ratio: Price per share divided by most recent 12 months earnings per share. Provides a measure of the markets expectations regarding the firms earnings growth and risk. Price-to-Book-Value Ratio: Current price per share divided by book value (common stockholders equity) per share. A measure of stock valuation relative to net assets. A high ratio might imply an overvalued situation; a low ratio might indicate an overlooked stock. Price-to-Sales Ratio: Current price divided by the sales per share for the most recent 12 months. A measure of stock valuation relative to sales. A high ratio might imply an overvalued situation; a low ratio might indicate an undervalued stock. Dividend Yield: Current annual dividend per share divided by share price. A measure of stock valuation relative to dividend payout. A high yield might imply an undervalued situation; a low yield might indicate an overvalued stock. EPS Growth Rate-Last Five Years: Annual growth in earnings per share from total operations over the last five fiscal years. Used as a measure of how successful the firm has been in generating the bottom line, net profit. Sales Growth Rate-Last Five Years: Annual growth in total sales over the last five fiscal years. Provides a confirmation of the quality of the historical earnings per share growth rate. Market Capitalization: Computed by multiplying the last share price by average number of shares of common stock outstanding during the latest quarter. 52-Week Relative Strength: Price performance of a stock relative to an index, in this instance, the S&P 500. A price momentum indicator, it confirms investor expectations and interest by comparing the performance of a stock relative to the market.

Screening Criteria For use with AAIIs Stock Investor program (Version 2.1)
Cornerstone Value Strategy Found in the Price & Share Data Group MKTCAP > 1322.9 Market capitalization is greater than the average market capitalization of the overall database; for example, the overall database average for market capitalization (2/28/

97dat)wa 1322. ( Note: Average values can be found on the screen after selecting a s, 9
the field or by running a statistical summary report for all companies.) SHR_AQ1 > 38.2 Average number of shares outstanding during the latest quarter is greater than the average number of shares outstanding of the overall database; for example, the overall database average for number of shares outstanding (2/28/97 data) was 38.2 (Note: Average values can be found on the screen after selecting the field or by running a statistical summary report for all companies.) Found in the Income Statement, Annual Group CFPS_12M > 1.60 Cash flow per share for the latest 12-month period is greater than the average cash flow per share of the overall database; for example, the overall database average for cash flow per share (2/28/97 data) was 1.60 (Note: Average values can be found on the screen after selecting the field or by running a statistical summary report for all companies.) SALES_12M > 1400 Total sales for the last 12-month period is 1.5 times greater than the average total sales of the overall database; for example, the overall database average (2/28/97 data) was 930.35, then multiplied by 1.5, was approximately 1,400 (Note: Average values can be found on the screen after selecting the field or by running a statistical summary report for all companies.) Found in the Company Information Group IND_2_DIG <> 12 Found in the Multiples Group Rank by YIELD Rank the resulting companies to seek out the highest yielding stocks Sector is not Utilities

Cornerstone Growth Strategy Found in the Price & Share Data Group MKTCAP > 150 Found in the Income Statement, Annual Group EPS_12M >= EPS_Y1 Total earnings per share for the latest 12-month period is greater than or equal to total earnings per share for the last complete fiscal year EPS_Y1 > EPS_Y2 Total earnings per share for the last complete fiscal year is greater than total earnings per share one year ago EPS_Y2 > EPS_Y3 Total earnings per share for one year ago is greater than total earnings per share two years ago Market capitalization is greater than $150 million

EPS_Y3 > EPS_Y4

Total earnings per share for two years ago is greater than total earnings per share three years ago

EPS_Y4 > EPS_Y5

Total earnings per share for three years ago is greater than total earnings per share four years ago

Found in the Multiples Group PSPS < 1.5 Found in the Price & Share Data Group Rank by RS_52W Rank the passing companies to seek out stocks with the highest relative strength Price to sales per share ratio less than 1.5

A Blue-Chip Value Investor: Seeking High-Quality, Out-of-Favor Stocks

By Maria Crawford Scott
A bird in the hand is worth two in the bush. Its an old saying, but its a sentiment felt by many conservative stock investors who prefer the stocks of stable and established companies that provide part of their return sooner, in the form of dividends, rather than later, in the form of capital gains. How does one choose among these kinds of stocks? One approach is followed by Geraldine Weiss, editor of the highly regarded Investment Quality Trends, a La Jolla, California-based newsletter that tracks and recommends stocks based on her approach. Weiss melds a conservative, blue-chip investment style with a value approach, using dividend yield as a guide to value. A high dividend yield signals out-of-favor stocks, but many such stocks are out-of-favor for good reasonthey are financially troubled. Weiss strategy attempts to weed out truly financially troubled firms by seeking out-of-favor stocks within a relatively safe sector of high-quality stocks. Weiss has outlined her approach in two books, Dividends Dont Lie, with Janet Lowe (Longman Publishing, 1988, out of print), and her more recent The Dividend Connection, written with son Gregory Weiss (Dearborn Financial Publishing, 1995, $24.95, 800/245-2665). These writings are the primary source for this article. The Philosophy Weiss can best be described as a blue-chip value investor buying quality stocks at a good value. Quality is Weiss first concerninvesting in companies that have withstood the test of time by surviving numerous economic cycles without lowering or canceling a dividend. These stocks tend to be more stable and are usually the last to fall when the economy is declining, making them less risky than lower-quality or unproved stocks. Weiss also notes that quality companies provide, through their dividend payments, a reliable source for steady and increasing income. These payments significantly contribute to an investors bottom line return, and in particular provide support during bear markets by supplying a source of income. Of course, significant profits come from price appreciation. Weiss maintains that all stocks go through cycles of undervaluation and overvaluation, and that investor profits can be achieved by taking advantage of these cycles buying stocks when they are undervalued and subsequently selling them when they are overvalued. But dividends are the star players in the approach. In Weiss view, dividends offer the best indication of both quality and value, besides providing a source of return. The quality of corporate management can be judged by examining a firms dividend payments and policies. Companies that provide steady dividend payments over the long term are generating sufficient earnings to first cover all expenses and debt payments; companies that increase cash dividends year-after-year are able to do so through increased earnings and thus are particularly well-managed. For Weiss, the most important measure of investment value is the dividend yielda companys current annual dividend per share divided by share price. Why? In the long run, the underlying value of the stream of dividend payments determines the price of a stock. As Weiss points out, the impact of dividends on price is reflected when changes occurif a dividend is increased, the stock becomes more valuable and more highly rated; if a dividend is decreased, stock values decrease. The dividend yield ratio relates dividends per share to share price, similar to other popular valuation measures such as priceearnings ratios (price divided by earnings per share) and price-to-book-value ratios (price divided by book value per share). Weiss does not discount these other ratios, but notes

Maria Crawford Scott is editor of the AAII Journal.

that distortions in reported earnings and book value more easily arise with them. Dividend payments, in contrast, tend to be more predictable and not subject to differing accounting interpretations; they are real, measurable dollars paid out to shareholders, and offer a more stable measure to relate to share price. On the other hand, Weiss believes that over the short term, prices go to extremes. This causes a companys dividend yield to fluctuate within a range that is unique to each company. When dividend yields are relatively high, the share price is low relative to dividends per share paid out, indicating that the stock may be undervalued; when dividend yields are relatively low, the share price is high relative to dividends per share, indicating that the stock may be overvalued. Weiss suggests buying and selling blue-chip stocks when they reach the extremes of their historical dividend yield range. The philosophy combines a high-quality strategy with a value approach, and has a goal of minimizing downside risk, maximizing the potential for capital gains, and maximizing the growth of dividend income. The Blue-Chip Universe Because the safety of dividend payments and their ability to rise are central to her approach, Weiss suggests that investors begin their selection process by narrowing their initial list down to a universe of blue-chip stocks. In this sense, the pre-selection of the universe of stocks is particularly important. Weiss seeks companies that are well-known, with good managers, good research and development efforts, good marketing skills, well-known products and services, and that are reluctant to cut a dividend even in times of cyclical stress. In particular, she lays out six criteria: 1) Dividend increases in five of the last 12 years: A measure of good long-term performance of the companys ability to increase net earnings, reflected by a trend of increasing dividends. Weiss terms this the most reliable measure of good management. 2) A minimum of five million shares outstanding: An assurance of liquidity, which in turn prevents manipulation of share price. Firms smaller than this may have trouble attracting institutional investors, which leads to illiquidity. 3) Shares must be held by at least 80 institutions: Another assurance of liquidity, but Weiss views this rule as the least rigid of her criteria. 4) Improved earnings in at least seven of the last 12 years: Another indication of a well-managed company, indicating that a company can survive the tough years and prosper in the good ones. Weiss notes that she also looks for sales increases, and profit margins that are under control. 5) It must have paid dividends, with no interruptions, for roughly the past 25 years: Consistent dividend payments are a sign of a profitable, well-managed company; a long record also provides the historical data necessary to evaluate the range of dividend yields indicating valuation extremes. Weiss

suggests that if an investor wants to relax the number of years, dividends should have been paid long enough for several cycles of overvaluation and undervaluation to be established. 6) The stock must carry a Standard & Poors quality ranking no lower than A. S&P ranks the quality of stocks on a scale of A+ to C (a D indicates reorganization) based on past growth and stability of earnings and dividends; Weiss finds the rankings a useful guide to investment quality. Although stocks must have a quality ranking of A to make the initial list, Weiss allows stocks to drop to B+ once on the list; however, if they drop to B, the stock is deleted from her blue-chip list. How many should be included in the universe? Weiss herself follows 350, a number she says is somewhat arbitrary but is a manageable size, while including a wide variety of industry groups. Dividend Yield Criteria Once a pre-selected list of blue-chip stocks is developed, Weiss suggests the purchase of these stocks based on a value approach, using historical dividend yields as a guide. Specifically, Weiss charts a firms dividend yield and its price over a decade or more, and looks for historical high and low dividend yield turning points, when stock prices change direction. Weiss maintains that most stocks turn at roughly the same dividend yield each cycle; averaging these dividend yields defines the boundaries. If a major rising price trend has ended in a 2% yield area many times, and a major declining price trend repeatedly has ended in a 5% yield area, a profile of value has been established for that stocka 2% dividend yield identifies a historically overvalued price where the stock should be sold to preserve capital and protect profits. Conversely, when that stock is priced to yield 5%, it is historically undervalued and a good buying opportunity is at hand. Weiss suggests that investors buy from their blue-chip stock list when the prices cause dividend yields to be within 10% of their historical high dividend yield. On the other hand, she does not suggest investors purchase an undervalued stock without first examining the reasons why a stocks price has fallenin particular, checking for the possibility of a dividend decrease, which would eliminate it from consideration. Other Factors Weiss does not discount the use of other value measures when analyzing stocks, and in fact suggests several that are useful in confirming valuations derived in the dividend yield approach. In addition, these valuations can help an investor more fully understand how the market perceives a stock. In particular, she suggests: 1) A price-earnings ratio that is historically low for that particular stock and other similar stocks, and that is below the market multiple. A low price-earnings ratio reflects the markets low

The Geraldine Weiss Approach in Brief

Universe of stocks High-quality blue-chip stocks. To get on this initial list, stocks should have the following characteristics: The dividend must have increased a minimum of five times in the past 12 years. Shares outstanding should number at least five million. Shares must be held by at least 80 institutions. In at least seven of the last 12 years, corporate earnings should have improved. It must have paid dividends, with no interruptions, for the past 25 years. The stock must carry an S&P quality ranking no lower than A. Criteria for initial consideration Buy from the blue-chip stock list when the prices cause dividend yields to be within 10% of their historical levels of high dividend yield, indicating it is historically undervalued. Other factors A price-earnings ratio that is historically low for that particular stock and other similar stocks, and that is below the market multiple. A price-to-book-value ratio that is no higher than 1.3, and the closer to 1.0, the better. A ratio of current assets to current liabilities of at least 2.0, and a debt-to-equity ratio of no more than 50% debt to equity (utility stocks are excluded because of their unique regulatory status). Conservative investors should look for a debt-to-equity ratio or no more than 20%. Also be wary of other signs that dividend payments may be in jeopardy: Payout ratios approaching 100%, although a rising earnings trend can support rising dividends; and an indicated dividend higher than reported annual earnings, although strong cash flow can help cover a dividend payment when earnings temporarily drop. In general, when evaluating a stock for potential purchase, examine: The companys financial performance, including its record of earnings, dividends, debt-to-equity ratio, dividend payout ratio, book value, and cash flow. The companys product performance, whether it is manufacturing goods or services that are in demand, its research and development efforts, and its ability to market its products or services. The companys investment performance in the form of capital gains and dividend growth. Stock monitoring and when to sell Aim for a portfolio of about 20 stocks selected from a variety of industry groups. Continually monitor the portfolio to weed out stocks that no longer satisfy the requirements of good value or quality. Sell stocks when they are within 10% of their historical low dividend yield, indicating overvaluation. If you tend to be reluctant to sell when prices are rising, consider placing a stop-loss order 12% to 15% below the overvalued price. If dividend yields rise among stocks you own, make sure you understand why, but in general view it as an opportunity to buy more. However, if rise occurs because a company omits a dividend, wait temporarily for prices to shore up, and then sell, since it no longer meets the blue-chip criteria.

growth-in-earnings outlook for the firm. 2) A price-to-book-value ratio that is no higher than 1.3, and the closer to 1.0, the better. This is a Benjamin Graham rule-of-thumb that seeks to buy stocks as close to the bare-bones worth of a company as possible. Weiss investment approach demands that the cash dividend be safe. A change in the dividend payment causes the dividend yield to change, so that a share price that was once regarded as undervalued may become fairly valued or overvalued, and vice versa. How can investors judge the safety of dividend payments for both prospective stocks and stocks that they own? Of

course, stocks on a blue-chip list should have relatively safe dividends. But Weiss also provides some guidelines: Seek stocks with a ratio of current assets to current liabilities of at least 2.0, and a debt-to-equity ratio of no more than 50% debt to equity (utility stocks are excluded because of their unique regulatory status); conservative investors should look for a debt-to-equity ratio of no more than 20%. Companies with high levels of debt can run into financial problems more quickly during a slowdown, putting the dividend in jeopardy. Payout ratios approaching 100% are a danger signal. Dividends are paid out of earnings, and are relatively safe and

can even be safely increased if the payout ratio (dividend as a percent of earnings) is 50% or less. The closer the payout ratio is to 100%, the more endangered the dividend and the less likely it is to be increased. A rising earnings trend, however, can support rising dividends. Similarly, an indicated dividend higher than reported annual earnings is a danger sign. Since firms pay dividends primarily from earnings, a company cannot sustain dividend payments above annual earnings. Although strong cash flow can help cover a dividend payment when earnings temporarily drop, an unprotected dividend is in greater danger than a protected dividend. Lastly, Weiss states that investors should examine all fundamental factors to fully understand the company before purchasing it, and when judging the merits of one prospective blue chip relative to another. She does not go into detail concerning what to look for, but she does provide a generalized guide of what to look at when judging the quality of a firm: 1) The companys financial performance, including its record of earnings, dividends, debt-to-equity ratio, dividend payout ratio, book value, and cash flow. 2) The companys product performance, whether it is manufacturing goods or services that are in demand, its research and development efforts, and its ability to market its products or services. 3) The companys investment performance in the form of capital gains and dividend growth. Portfolio Monitoring and When to Sell Weiss suggests that individuals aim for a portfolio of about 20 stocks, enough to assure that the portfolio is diversified but manageable. In addition, selected stocks should be in a variety of industry groups. On the other hand, Weiss does not believe that an investor should always be fully investedif, for example, few stocks are undervalued, or if the overall market appears to be overvalued (based on historical market dividend yields). Keeping money in cash during these times, she believes, allows an investor to take advantage when the opportunities eventually arise at the end of a bear market or during a major correction in a bull market. Weiss notes that these times offer investors the best opportunities to diversify their holdings because of the large selection of undervalued stocks. Portfolios must be continually monitored to weed out stocks that no longer satisfy the requirements of good value or quality. Within an investors portfolio, Weiss believes stocks should

be sold when prices cause them to be within 10% of their overvalued extreme range. She views historically low dividend yields as alarm bells, and although the stock price may continue to rise, the upside potential is outweighed by the downside risk. Of course, dividend yields tend to fall when prices are risingand Weiss notes that investors are often reluctant to sell these shares, particularly if they have held on to them for some time. Her suggestion: Place a stoploss order 12% to 15% below the overvalued price; the market will then dictate the sale. What happens when dividend yields riseindicating undervaluationfor stocks held within a portfolio? Dividend yields will rise if the price drops, and Weiss notes that investors should try to determine the cause of the price drop. In general, however, she views this as a buying opportunity to add shares. When bad things happen to good companies, it must be viewed as a buying opportunity rather than a bailout. As long as a stocks dividend is maintained, even an extremely undervalued stock merits investment consideration. Dividend yields may also rise, and prices drop, if the company omits a dividend. In this instance, she suggests that investors wait temporarily, since stock prices may move up shortly after, once the uncertainty has been eliminated. After the rebound, however, the stock should be sold because it no longer meets the blue-chip criteria. Conclusion Weiss strategy is an interesting derivative of a classic value approach that nonetheless reverses the process: Rather than finding undervalued companies first, and then analyzing for quality, Weiss first focuses on developing an initial list of quality companies in which you would be comfortable investing, and then purchasing them when they become undervalued. The approach is particularly useful for investors who seek stocks that pay a steady dividend and are likely to continue paying a steady dividend; it is less useful for investors primarily seeking growth and who are trying to limit annual taxable income. The approach is also well-suited for those who want to take advantage of dividend reinvestment plans. Weiss summarizes her own approach this way: Successful investing in the stock market is not brain surgery. Anyone can be a successful investor. The secret is no secret. It is simply that you confine your selections to blue-chip stocks, you buy them when they are undervalued, and you sell them when they become overvalued. This is the well-lit path of the enlightened investor.

Screening Criteria For use with AAIIs Stock Investor program (Version 2.1)
Found in the Income Statement Annual Group DPS_12M >= DPS_Y1 Dividends per share for the latest 12-month period is greater than or equal to dividends per share for the last complete fiscal year DPS_Y1 > DPS_Y2 DPS_Y2 > DPS_Y3 DPS_Y3 > DPS_Y4 DPS_Y4 > DPS_Y5 EPS_12M >= EPS_Y1 EPS_Y1 >= EPS_Y2 EPS_Y2 >= EPS_Y3 EPS_Y3 >= EPS_Y4 EPS_Y4 >= EPS_Y5 Dividends per share for the last complete fiscal year is greater than dividends per share one year ago Dividends per share for one year ago is greater than dividends per share two years ago Dividends per share for two years ago is greater than dividends per share three years ago Dividends per share for three years ago is greater than dividends per share four years ago Total earnings per share for the latest 12-month period is greater than or equal to total earnings per share for the last complete fiscal year Total earnings per share for the last complete fiscal year is greater than or equal to total earnings per share one year ago Total earnings per share for one year ago is greater than total earnings per share two years ago Total earnings per share for two years ago is greater than total earnings per share three years ago Total earnings per share for three years ago is greater than total earnings per share four years ago

Found in the Price & Share Data Group SHR_AQ1 >= 5 Average number of shares outstanding during the latest quarter is greater than or equal to 5 SHRINST >= 25.4 Percentage of shares outstanding held by institutional investors is greater than or equal to the median value for percentage of shares outstanding held by institutional investors (Note: The median value can be found on the screen after selecting the field or by running a statistical summary report for all companies.)

Found in the Earnings Estimates Group EPSN_EY0 >= 4.0 Number of analysts providing estimates for the current fiscal year is greater than or equal to median value for number of analysts providing estimates for the current fiscal year (Note: The median value can be found on the screen after selecting the field or by running a statistical summary report for all companies.) Found in the User Defined Group (see below) YIELD >= YIELD High A5Y Dividend yield is greater than or equal to the high 5-year average dividend yield

User Defined Field YIELD High A5Y =

((DPS_Y1/PRICEL_Y1) + (DPS_Y2/PRICEL_Y2) + (DPS_Y3/PRICEL_Y3) + (DPS_Y4/PRICEL_Y4) + (DPS_Y5/ PRICEL_Y5)) /0.5

Found in the Income Statement Annual Group DPS Dividends per share for the year Found in the Price & Share Data Group PRICEL Low price for the year

Screening for Value via Benjamin Graham

FEATURE

by John Bajkowski

In the May 1996 issue of the AAII Journal, Maria Crawford Scott analyzed the investment approach of Benjamin Graham. Grahams philosophy of trying to buy a dollars worth of stock for fifty cents has set the tone for the value investor. In this article we will develop and apply the stock screens formulated by Graham in his book, The Intelligent Investor. The Philosophy Grahams view of security analysis is founded upon the concept of intrinsic or central value justified by assets, earnings, dividends, financial strength and stability, definite company prospects, and quality of management. Without a basis for determining whether a security is undervalued or overvalued, the investor is at risk of being swept away by the tides of pessimism and euphoria which sweep the security market. For investors to have a reasonable chance of better than average results, they must follow policies that are inherently sound and promising, yet different from the policies followed by most investors or speculators. Graham warned that buying a neglected, and therefore undervalued, security for profit generally proves to be a protracted and patience-trying experience. However, the possibility of extraordinary gains only exists when the investor disagrees with the market. While our article covers the analysis and selection of stocks, it is important to keep in mind that Grahams analysis of stocks is framed by the construction and balance of a stock and bond portfolio. A neutral portfolio position would have half of the portfolio in stocks and half in bonds. This proportion could fluctuate from a minimum position of 25% to a maximum position of 75% depending upon the attractiveness of stocks relative to bonds. Types of Investors Graham felt that individual investors

fell into two campsdefensive investors and enterprising investors. These groups are distinguished by the amount of intelligent effort they are willing and able to bring to bear on the task. For the defensive, or passive, investor, his analysis was geared toward avoiding serious mistakes or losses. Graham tried to establish a procedure that provided freedom from great effort and the need for frequent decision. For the enterprising, or active and aggressive, investors, Graham established a policy for those willing to devote the time and care to the selection of securities that are both sound and more attractive than average. Table 1 summarizes the Graham investment approach. Screening: The Defensive Investor In establishing a course of action for the defensive investor, Graham laid out a set of criteria that would help the investor obtain securities which offered a minimum level of quality in terms of past performance and current financial position as well as a minimum level of quality in terms of earnings and assets per dollar of share price. Grahams analysis for the defensive investor is divided into primary industry sectors. Graham presented an investment approach specifically for utilities and industrials, but said additional sectors such as financials should also be selected using these criteria. Our analysis was therefore broken down into two segmentsutilities, and the rest of the stock universe. Tables 2 and 4 present the approach for these segments. AAIIs Stock Investor program was used to perform the screening for this article. As of April 30, its database included 6,970 companies, including 198 utilities. When screening, investors have the option of screening against relative factors, such as a profit margin higher than industry average, or absolute factors, such as a current ratio of 2.0 or higher. If you are planning on screening using criteria versus absolute factors, it

is important to break your analysis down into various market sectors. Factors such as debt levels, turnover, and margins, can be very industry-specific. Adequate Size of Enterprise Graham had a preference for large companies. He felt that large firms have the resources in capital and brain power to carry them through adversity and back to a level of satisfactory earnings. This concern came into play for Graham because he looked at stocks of firms that became unpopular due to unsatisfactory developments of a temporary nature. Graham also felt that the market responds more quickly with a price increase when an improvement is shown for a large firm than a small firm. When screening for company size, the three most popular criteria are market capitalization (number of shares outstanding times market price), sales, and total assets. Graham focused on sales for industrials and total assets for utilities because they reflect company activities and size directly, while market capitalization is tied to overall market levels. Graham specified that the defensive investor should exclude small companies with less than $100 million of annual sales for industrial companies and $50 million in total assets for public utilities. Graham specified these levels over 20 years ago. Assuming a 5% annual growth in prices over the last 25 years, our minimums would increase from $100 million in sales to $340 million for industrials and from $50 million in total assets to $170 million for utilities. This screen is much more restrictive for nonutilities than utilities. Except for small water and gas utilities, the capital requirements for an utility are significant, along with the benefits of economies of scale. Strong Financial Condition Graham used different measures of financial strength depending upon the

industry. As a test of short-term liquidity, Graham specified a current ratio (current assets divided by current liabilities) of 2.0 or higher for industrial firms. No current ratio requirement was specified for the utility sector. Graham stated that this working capital [current assets minus current liabilities] factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. To measure the use of long-term debt, Graham required that for industrial firms long-term debt not exceed net current assets, or working capital. This is not a common ratio for screening programs, but if your screening program allows you to create custom fields it should be easy to duplicate. Take care that when using this criteria you specify not only a upper limit, but a lower limit

as well. If a companys current liabilities exceed its current assets then it will have a working capital deficit and a negative ratio of long-term debt to net current assets. We specified that this ratio be positive and less than or equal to 1.0. If your screening program does not allow you to create custom fields you can use another measure of financial leverage such as debt-to-equity or debt to assets. Grahams criterion of debt to working capital screened out about half the companies when used by itself, so look for a similar pass rate. Financing is an important consideration for utilities, so Graham specified that investors look at the debt-to-equity ratio for this sector. He specified that debt should not exceed twice the stock equity (at book value, not market value). This turned out be a much less restric-

tive screen than the financial condition screens for non-utilities. Earnings Stability Graham liked to look at the historical company performance over an extended period of time. He had a preference for companies that avoided losses during recessionary periods. This would point to industries such as utilities, insurance, food processing, medical supply firms, and pharmaceuticals. Graham recommend 10 years of positive earnings in his screen for the defensive investors. Unfortunately, most screening programs on the market today only cover five years of income statement data. Our screen specified that earnings be positive for only the last five yearsa time period without a severe overall economic downturn. To be true to Grahams original criteria, an investor would want

Table 1. The Benjamin Graham Approach in Brief

Philosophy and style Investment in companies whose share prices are near their intrinsic value based on tangible assets, earnings, dividends, financial strength and stability, and quality of management. Buying at or below intrinsic value provides a margin of protection that can help absorb unfavorable developments, with subsequently less risk of a market overreaction on the downside. Universe of stocks For defensive investors: High-grade dividend-paying common stocks of leading companies; saw utilities as particularly fertile ground. For enterprising investors: No restrictions; stocks of unpopular large companies and secondary companies (ones that are not leaders in a fairly important industry) considered particularly promising. Criteria for initial consideration Exclude small companies with less than $100 million of annual sales for industrial companies and $50 million of total assets for public utilities in 1972 dollars. In todays market, this would roughly translate into sales of $340 million for industrial companies and total assets of $170 million for public utilities (assuming 5% annual growth). Strong financial conditionfor industrial companies, current assets (cash, accounts receivable and inventory) should be at least twice current liabilities (shortterm debt) and long-term debt should not exceed the net current assets (working capital, or current assets less current liabilities); for public utilities the debt should not exceed twice the stockholders equity (total assets less total liabilities). For enterprising investors, he relaxed some of this criteria: current assets should be at least 1 times current liabilities, and debt should not be more than 110% of net current assets. Positive earnings for at least the last five years. Uninterrupted dividend payments for at least past 20 years; for enterprising investors, some current dividend. Minimum increase of at least one-third in per share earnings in the past 10 years (2.9% average annual growth rate). Current price should not be more than 15 times average earnings for the past three years. Current price should not be more than 1 times book value last reported, but price-earnings ratio below 15 could justify higher multiplier of assets. [Rule of thumb: product of the multiplier times ratio of price to book value should not exceed 22.5]. For enterprising investors, he suggested trying to find firms selling at two-thirds or less of book value. Secondary factors Skeptical as to accuracy of subjective judgments concerning growth prospects and management; good management indicated by a good long-term track record. In terms of financial strength, surplus cash and no outstanding issues ahead of the common stock is preferable to firms with large bank loans and senior securities, but modest amount of bonds or preferred stock not necessarily a disadvantage, nor is moderate use of seasonal bank credit. Stock monitoring and when to sell Emphasized diversificationminimum of 10 different issues and maximum of 30. Buy and hold for the long term and try to ignore market vagaries. Review holdings at least annually in light of intrinsic value and if no shrinkage, continue to hold. Sell if issues rise excessively above their intrinsic value and can be replaced by issues much more reasonably priced.

Table 2. Translating Style Into Screening: The Defensive InvestorNon-Utilities

Primary Factors Market Sector The various market sectors have different characteristics in operations and financing. Ratio analysis is typically more meaningful when examined within industrial groups. The first filter excluded utilities. Adequate Size of the Enterprise Exclude smaller firms, which carry additional risks and tend to trade at a central value below their intrinsic value. Graham specified that industrials should have sales above $100 million back in the early 1970s. A rough inflation adjustment brings this level up to a minimum level of $340 million.

Number of Stocks Passing Screening Criteria Single Cumulatively Criterion* 6,970 6,772 6,772 6,772 1,684 1,684 535 2,705 408 3,287 244 2,233 127 1,646 98 3,342 21 3,371 13 1,480

Financial Condition Current assets should be at least twice current liabilitiestwo-to-one current ratio. *Of universe of non-utility companies. Long-term debt should not exceed working capital (current assets less current liabilities). This the type of ratio that is unique to Graham and will not typically be found in a screening program. If the program allows for custom fields, it should be easy to create. If you must work with a fixed set of fields, then look for a good measure of financial leverage, such as total debt to total assets or debt-to-equity. We created long-term debt to working capital, but were also careful to specify that the ratio not drop below zero or companies with negative working capital would pass the screen. Earnings Stability Graham specified some earnings for the common stock for the past 10 years. Most screening programs will not have data going back that far. Use the greatest number of years available and check the final results against a printed publication such as Value Line. We looked for positive earnings for each of the last five years and last 12-month period. Dividend Record Uninterrupted payments for at least the past 20 years. Most screening programs will not have data going back that far. S&P Stock Guide indicates how long the dividends have been paid. We screened for positive dividends in each of the last five years, along with a positive indicated dividend (most recent dividend multiplied by four). Earnings Growth Graham specified a 3% annual growth rate over a 10-year period using a three-year average at the beginning and ending periods. This type of growth rate calculation will not be found in most screening programs. We specified a minimum growth rate of 3% over five years using a more standard growth rate calculation which only looks at the beginning and ending years earnings. Moderate Price/Earnings Ratio Graham specified that the current price to the average of the last three years earnings per share should not exceed 15. You should be able to calculate this field with a screening program that allows you to create custom fields. The goal of this criterion is to create a portfolio with an average price-earnings ratio that does not exceed the inverse of the high-grade corporate bond yield. Moderate Ratio of Price to Assets Graham felt that current price should be less than or equal to 1 times book value. However, a low price-earnings ratio could justify a higher price-to-bookvalue ratio. So he multiplied the price-to-book-value ratio by the price-earnings ratio and came up with a value of 22.5. Most screening programs will not have the product of the price-earnings ratio and price-to-book ratio calculated, but will allow you to calculate this field. We screened for a value less than or equal to 22.5.

Complete Universe Market Sector Adequate Size of the Enterprise Financial Condition: Current Ratio Financial Condition: Long-Term Debt Earnings Stability Dividend Record Earnings Growth Moderate Price-Earnings Ratio Moderate Ratio of Price to Assets

to see how the company performed over at least a complete economic cycle when selecting the final candidates for the portfolio. Dividend Record A common test for financial strength over time is a long period of uninterrupted dividends. In the defensive investor screen, Graham recommended uninterrupted payments of at least the past 20 years. In screening for the divi-

dend record we came across the same time limitation that we encountered with the earnings screenonly five years of data. For the non-utilities, this criterion turn out to be a more restrictive screen than the earnings screen. But the reason is not due to companies cutting their dividends as much as it is a reflection that dividend payouts have become less important and are not demanded by investors as much. Today, companies are more inclined to use excess cash to

buy back their shares. To be faithful to Grahams original criterion, publications such as the S&P Stock Guide and Moodys Dividend Record report the record of uninterrupted dividends for a wide range of companies. Earnings Growth Graham recommended a minimum increase of at least one-third in per share earnings in the past 10 years, which translates into about a 3% annual growth

Table 3. Graham Defensive Growth, Non-Utilities Screen Results

Sales Last Current 12 Mos. Ratio ($ mil) (x) Total Debt to Total Assets (%) 5-Yr. Price-to EPS Price- Book- Return Growth Earnings Value on Relative Rate Ratio Ratio Equity Strength (%) (x) (x) (%) (%) Description

Company (Exchange: Ticker)

Bassett Furniture (M: BSET) Blair Corp. (A: BL) Bowne & Co. (A: BNE) Excel Industries (N: EXC) Haverty Furniture Cos. (M: HAVT) Hudson Foods (N: HFI) Justin Industries (M: JSTN) Oshkosh Truck Corp. (M: OTRKB) PACCAR Inc. (M: PCAR) Phelps Dodge Corp. (N: PD) Pitt-Des Moines (A: PDM) Thor Industries (N: THO)
Median Median for All Stocks

490.8 562.9 410.3 596.0 395.5 1,261.2 461.4 423.0 4,848.2 4,185.4 461.3 580.4
562.9 96.5

5.8 2.7 2.7 2.0 2.6 2.6 3.6 2.7 2.2 2.6 2.0 2.7 2.7
2.7 1.9

13.8 39.8 22.2 50.2 62.1 53.5 37.2 30.1 71.5 42.4 45.8 58.9 24.5
42.4 55.2

36.3 6.2 22.3 13.6 7.0 25.0 27.7 40.1 32.4 10.2 10.3 15.8 27.2
22.3 10.7

15.3 7.4 12.2 8.7 13.2 11.2 12.5 14.3 7.7 6.8 7.7 14.3 14.0
12.2 17.5

1.16 1.10 1.24 1.05 1.14 1.26 1.35 1.01 1.55 1.88 0.92 1.10 1.50
1.16 2.02

7.7 14.9 10.1 12.1 8.6 11.1 10.8 8.1 20.2 27.9 12.0 7.7 10.7
10.8 9.1

22 41 12 17 2 40 8 7 13 5 7 31 27
13 7

Mfrs furniture Mens & womens apparel, furnishings Document prep and distrib Vehicle window & door systems Specialty furniture retailer Produces poultry & meat prods Mfrs bldg materials, footwear; book pub Heavy-duty vehicles, transport equip Mfrs heavy-duty on- & off-road trucks Copper mining co. & engind prods mfr Custom-engineered prods, structures Mfrs replacement parts for auto systems Recreational vehicles & small buses

Standard Motor Products (N: SMP) 663.5

For Use With AAIIs Stock Investor (Version 2.1)

Found in Company Information Group IND_2_DIG <> 12 Sector is not utility Found in Income Statement, Annual Group EPS_12M > 0 Total earnings per share for the latest 12-month period is positive EPS_Y1 > 0 Total earnings per share last year is positive EPS_Y2 > 0 Total earnings per share one year ago is positive EPS_Y3 > 0 Total earnings per share two years ago is positive EPS_Y4 > 0 Total earnings per share three years ago is positive EPS_Y5 > 0 Total earnings per share four years ago is positive SALES_12M >= 340 Found in Ratios Group CURR_Q1 >= 2 INDCAT_DIV > 0 DPS_Y1 > 0 DPS_Y2 > 0 DPS_Y3 > 0 DPS_Y4 > 0 DPS_Y5 > 0 Indicated yearly dividend greater than $0.00 Dividend paid last year Dividend paid one year ago Dividend paid two years ago Dividend paid three years ago Dividend paid four years ago

Total sales for the latest 12-month period greater than or equal to $340 million

The current ratio greater than or equal to 2

Found in Growth Rates Group EPS_G5F > 3 Annual growth in earnings per share over the past five years greater than 3% Found in User Defined Fields (formulas below) Long-Term Debt to Wkg Cap <= 1 Long-term debt to working capital less than or equal to 1 Long-Term Debt to Wkg Cap >= 0 Long-term debt to working capital greater than or equal to 0 Price to Avg EPS <= 15 Price to three-year average earnings per share less than or equal to 15 P/E Times P/B <= 22.5 Price-earnings ratio times price-to-book-value ratio less than or equal to 22.5 User Defined Fields Long-Term Debt to Working Capital = LTDEBT_Q1 / ( CA_Q1 - CL_Q1) Found in Balance Sheet, Quarterly Group LTDEBT_Q1 Long-term debt at the end of the most recent fiscal quarter CA_Q1 Total current assets at the end the most recent fiscal quarter CL_Q1 Total current liabilities at the end the most recent fiscal quarter Price-Earnings Ratio Times Price-to-Book-Value Ratio = PE * PBVPS Found in Multiples Group PE Price-earnings ratio PBVPS Price-to-book-value ratio Price to Average Earnings per Share = PRICE / ( ( EPSCON_Y1 + EPSCON_Y2 + EPSCON_Y3) / 3 ) Found in Price & Share Data Group PRICE The closing market price of the common stock Found in Income Statement - Annual Group EPSCON_Y1-Y3 Earnings per share from continuing operations for the last three fiscal years

Table 4. Translating Style Into Screening: The Defensive InvestorUtilities

Number of Stocks Passing Screening Criteria Cumulatively 6,970 198 171 163 135 127 52 29 25 Single Criterion* 198 198 171 185 158 172 82 116 110 Primary Factors Market Sector The various market sectors have different characteristics in operations and financing. Ratio analysis is typically more meaningful when examined within industrial groups. The first filter included utilities. Adequate Size of the Enterprise Exclude smaller firms, which carry additional risks and tend to trade at a central value below their intrinsic value. Graham specified that utilties should have total assets above $50 million back in the early 1970s. A rough inflation adjustment brings this level up to a minimum level of $170 million. Financial Condition Debt should not exceed twice the stock equity at book value. We screened for a debt-to-equity ratio equal to or below 2.

Complete Universe Market Sector Adequate Size of the Enterprise Financial Condition Earnings Stability Dividend Record Earnings Growth Moderate Price-Earnings Ratio Moderate Ratio of Price to Assets
* Among utility stocks only.

Earnings Stability Graham specified some earnings for the common stock for the past 10 years Most screening programs will not have data going back that far. Use the greatest number of years available and check the final results against printed publication such as Value Line. We looked for positive earnings for each of the last five years and last 12-month period. Dividend Record Uninterrupted payments for at least the past 20 years. Most screening programs will not have data going back that far. S&P Stock Guide indicates how long the dividends have been paid. We screened for positive dividends in each of the last five years along with a positive indicated dividend (most recent dividend multiplied by four). Earnings Growth Graham specified a 3% annual growth rate over a 10-year period using a three-year average at the beginning and ending periods. This type of growth rate calculation will not be found in most screening programs. We specified a minimum growth rate of 3% over five years using a more standard growth rate calculation that only looks at the beginning and ending years earnings. Moderate Price/Earnings Ratio Graham specified that the current price to the average of the last three years earnings per share should not exceed 15. You should be able to calculate this field with a screening program that allows you to create custom fields. The goal of this criterion is to create a portfolio with an average price-earnings ratio that does not exceed the inverse of the high-grade corporate bond yield. Moderate Ratio of Price to Assets Graham felt that current price should be less than or equal to 1 times book value. However, a low price-earnings ratio could justify a higher price-to-book-value ratio. So he multiplied the price-to-book-value ratio by the price-earnings ratio for a value of 22.5. Most screening programs will not have the product of the price-earnings ratio and price-to-book ratio calculated, but will allow you to calculate this field. We screened for a value less than or equal to 22.5.

For Use With AAIIs Stock Investor (Version 2.1)

Found in Company Information Group IND_2_DIG = 12 Sector is utility Found in Income Statement, Annual Group EPS_12M > 0 Total earnings per share for the latest 12 month periods is positive EPS_Y1 > 0 Total earnings per share last year is positive EPS_Y2 > 0 Total earnings per share one year ago is positive EPS_Y3 > 0 Total earnings per share two years ago is positive EPS_Y4 > 0 Total earnings per share three years ago is positive EPS_Y5 > 0 Total earnings per share four years ago is positive Found in Balance Sheet, Quarterly Group Assets_Q1 >= 170 Total assets are greater than or equal to $170 million Found in Growth Rates Group EPS_G5F > 3 Annual growth in earnings per share over the last five years greater than 3%

INDCAT_DIV > 0 DPS_Y1 > 0 DPS_Y2 > 0 DPS_Y3 > 0 DPS_Y4 > 0 DPS_Y5 > 0

Indicated yearly dividend greater than $0.00 Dividend paid last year Dividend paid one year ago Dividend paid two years ago Dividend paid three years ago Dividend paid four years ago

Table 5. Graham Defensive Growth Utilities Screen Results

Sales Last Current 12 Mos. Ratio ($ mil) (x) Total Debt to Total Assets (%) 5-Yr. Price-to EPS Price- Book- Return Growth Earnings Value on Relative Rate Ratio Ratio Equity Strength (%) (x) (x) (%) (%) Description

Company (Exchange: Ticker)

Baltimore Gas & Electric (N: BGE) 2,934.8 Brooklyn Union Gas Co. (N: BU) Connecticut Water Serv (M: CTWS) Consolidated Edison Co. (N: ED) DQE, Inc. (N: DQE) ETown Corp. (N: ETW) Energen Corp. (N: EGN) Florida Progress Corp. (N: FPC) General Public Utilities (N: GPU) Houston Industries (N: HOU) IWC Resources Corp. (M: IWCR) Montana Power Co. (N: MTP) Nevada Power Co. (N: NVP) Northern States Power (N: NSP) Pacific Gas & Electric (N: PCG) PECO Energy Co. (N: PE) Public Service Co. of NC (N: PGS) SIGCORP, Inc. (N: SIG) SJW Corp. (A: SJW) UNITIL Corp. (A: UTL) Western Resources (N: WR) Median Median for All Utilities Median for All Stocks 1,256.0 39.4 6,536.9 1,231.3 108.4 327.2 3,055.6 3,804.7 3,680.3 147.1 974.8 750.0 2,568.6 9,621.8 4,186.2 256.0 338.7 97.4 156.7 1,572.1 974.8 806.9 96.5 Connecticut Energy Corp. (N: CNE) 236.3

1.0 1.5 1.0 0.6 1.1 0.7 1.0 0.5 0.9 1.1 0.7 0.3 0.6 0.9 1.0 1.0 0.7 1.0 0.5 0.4 0.8 0.8 2.0 0.9 0.8 0.9 0.9 1.9

60.0 61.5 66.1 70.2 55.8 75.2 68.5 68.2 62.8 61.7 64.2 61.7 74.0 57.9 60.6 59.3 63.6 66.0 65.7 64.3 64.3 63.8 61.2 67.9 66.7 64.2 66.5 55.2

7.6 5.9 3.8 10.8 4.6 43.3 8.0 4.5 9.0 3.1 8.6 27.1 8.1 6.7 15.1 5.6 6.6 7.4 35.5 6.6 7.3 4.7 3.4 8.3 3.7 7.3 2.1 10.7

12.9 13.2 12.2 12.0 10.1 13.2 12.0 12.9 13.2 13.0 8.4 4.7 12.5 12.2 12.7 12.7 11.9 7.6 9.4 13.3 9.7 11.7 10.9 11.9 11.0 12.0 13.2 17.5

1.40 1.45 1.30 1.46 1.25 1.41 1.54 1.14 1.42 1.50 1.25 1.26 1.41 1.04 1.37 1.70 1.58 1.11 1.23 1.66 1.19 1.67 1.15 1.51 1.21 1.40 1.51 2.02

10.6 10.8 10.5 12.2 12.5 10.6 12.9 8.6 10.8 11.5 14.8 9.6 11.5 10.0 9.6 13.4 13.0 14.8 12.9 12.3 12.2 12.2 10.6 12.7 10.8 11.5 11.0 9.1

13 16 20 14 16 15 7 19 20 15 13 15 17 24 20 11 17 34 24 15 26 13 13 4 24 16 13 7

Electricity & natural gas in MD Distribs natural gas at retail Holding co. for natural gas distrib Holding co. for water supplier Supplies electric serv to NYC Holding co. for water utilites Holding co. for electric prod & distrib Holding co. for water treat & real est Holding co. for prod & distrib of gas Diversified electric holding co. Holding co. for electric util in NJ & PA Holidng co for elec util & power gener Holding co. for water systems in Indy. Electric & natural gas systems in MT Electric serv for Las Vegas and area Distribs natural gas in NC Distribs electricity & natural gas Supplies electricity & gas in CA Electric & gas serv to southeast PA Distribs natural gas in NC Holding co. for electric & gas utilities Generates & distribs electricity & gas Holding co. for water util & real estate Holding co. for electric & gas in East Electric & natural gas utility

Consumers Water Co. (M: CONW) 101.8

North Carolina Nat. Gas (N: NCG) 158.1

Public Service Ent. Group (N: PEG) 6,164.2

Found in User Defined Fields (formulas below) Debt to equity <= 2 Debt to equity ratio less than or equal to 2 Debt to equity >= 0 Debt to equity ratio greater than or equal to 0 Price to Avg EPS <= 15 Price to three-year average earnings per share less than or equal to 15 P/E Times P/B <= 22.5 Price-earnings ratio times price-to-book-value ratio less than or equal to 22.5 User Defined Fields Debt to Equity = LTDEBT_Q1 / (Equity_Q1 + Pref_Q1) Found in Balance Sheet, Quarterly Group LTDEBT_Q1 Long-term debt at the end of the most recent fiscal quarter Equity_Q1 Common stock equity at the end the most recent fiscal quarter Pref_Q1 Preferred stock equity at the end the most recent fiscal quarter Price-Earnings Ratio Times Price-to-Book-Value Ratio = PE * PBVPS Found in Multiples Group PE Price-earnings ratio PBVPS Price-to-book-value ratio Price to Average Earnings per Share = PRICE / ( ( EPSCON_Y1 + EPSCON_Y2 + EPSCON_Y3) / 3 ) Found in Price & Share Data Group PRICE The closing market price of the common stock Found in Income Statement - Annual Group EPSCON_Y1-Y3 Earnings per share from continuing operations for the last three fiscal years

Table 6. Translating Style Into Screening: The Enterprising InvestorSecondary Companies

Number of Stocks Passing Screening Criteria Cumulatively Complete Universe 6,970 Low Price-Earnings Ratio 696 Financial Condition: Current Ratio 336 Financial Condition: Long-Term Debt 253 Earnings Stability 100 Dividend Record 46 Earnings Growth 38 Moderate Ratio of Price to Assets 16 Single Criterion* 6,970 696 3,708 3,366 2,391 2,599 4,150 1,477 Low Price-Earnings Ratio A primay factor to indicate that the stock is cheap on a relative basis is to look only at firms whose price-earnings ratios are in the lowest 10% of the overall market. We kept screening for a lower and lower price-earnings ratio until a maximum value of 10.2 filtered out all but 10% of the stocks.

Financial Condition Current assets should be at least 1 times current liabilitiescurrent ratio greater than or equal to 1.5. Long-term debt no more than 110% of net working capital (current assets less current liabilities). This is the type of ratio that is unique to Graham and will not typically be found in a screening program. If the program allows for custom fields, it should be easy to create. If you must work with a fixed set of fields, look for a good measure of financial leverage such as total-debt-to-total-assets or debt-to-equity. We created a long-term debt-to-working-capital ratio, but were also careful to specify that the ratio not drop below zero or companies with negative working capital would pass the screen. Earnings Stability Graham specified some earnings for the common stock for the past five years. Dividend Record Graham specified some current dividend payout. Earnings Growth Graham specified that last years earnings should be higher than that of five years ago. Moderate Ratio of Price to Assets Graham felt that current price should be less than or equal to 120% of tangible book value. Not all screening programs will provide a tangible book value measure and may provide book value that includes intangibles such as purchased goodwill.

ratea rate that roughly keeps pace with inflation over the long term. Without such a criterion, a screen looking for companies with low multiples may list companies with poor prospects. While Graham felt that even companies in a state of retrogression could be of interest if they could be purchased at a low enough price, this was not the domain of the defensive investor. Our filter specified a five-year growth rate in earnings greater than 3%. When examined as single screening criterion, this requirement turned out to be one of the most restrictive filters for both market groupsonly half the companies passed this filter. Moderate Price/Earnings Ratio Graham seemed to express frustration with the impact of special charges on the earnings per share calculation. He felt that managements discretion in establishing reserve accounts makes it difficult for the investor to determine whether they truly reflect the operation

of the firm for a specific time period. To help get around this problem and to smooth the impact of the business cycle, Graham often averaged earnings over a period of several years. In specifying the price-earnings filter, Graham required that the price to average earnings over the last three years be no more than 15. His goal in establishing the cutoff was to produce a portfolio with an average multiplier of 12 to 13. Graham wanted to establish a portfolio that was priced reasonably compared to the yield available to the AA bond yield. At the time he wrote the book, investmentgrade bonds were yielding 7.5%. The inverse of this yield (1 divided by 0.075), 13.3, determines the overall portfolio price-earnings ratio objective. With current investment-grade bond yields at 7.6%, there was no need to change the cut-off in todays market environment. But if bond yields were to go up, an investor would require that the priceearnings ratio be lower to consider purchase of stocks. Conversely, lower yields

result in a higher price-earnings cut-off, which makes more stocks available for consideration. Moderate Ratio of Price to Assets Graham was a believer in using low price-to-book-value ratios to select stocks and normally required a ratio below 1.5 for the defensive investor. However, he also felt that a low priceearnings ratio could justify a higher price-to-book-value ratio. Therefore, he recommended that investors multiply the price-earnings ratio by the price-tobook-value ratio and not let that value exceed 22.5the product of a current price-earnings ratio of 15 and a price-tobook-value ratio of 1.5. For our non-utility segment this filter turned out to be the most restrictive individual criterion. The securities passing all of the filters are presented in Tables 3 and 5. Screening: The Enterprising Investor Graham had a number of recommen-

Table 7. Graham Enterprising Growth Screen Results

Total Debt to Total Assets (%) 5-Yr. Price-to EPS Price- Book- Return Growth Earnings Value on Relative Rate Ratio Ratio Equity Strength (%) (x) (x) (%) (%) Description

Company (Exchange: Ticker)

Sales Last Current 12 Mos. Ratio ($ mil) (x)

Chicago Rivet & Machine (A: CVR) Excel Industries (N: EXC) Federal Screw Works (M: FSCR) Howard B. Wolf (A: HBW) Liberty Homes (M: LIBHA) Maine Public Service Co. (A: MAP) Martin Industries (M: MTIN) Pitt-Des Moines (A: PDM) Seaboard Corp. (A: SEB) The Smithfield Cos. (M: HAMS) The Somerset Group (M: SOMR) The Tranzonic Cos. (A: TNZ.A) Treadco, Inc. (M: TRED) Westwood Corp. (M: WNMP) Median Median for All Stocks
NA = not available

24.4 596.0 92.3 14.8 164.8 55.3 105.5 461.3 1,076.0 24.1 11.2 158.3 147.7 31.2 98.9 96.5

4.4 2.0 1.9 4.1 2.9 2.1 2.5 3.3 2.0 3.3 2.5 4.0 12.4 2.9 2.8 1.7 2.8 1.9

20.3 50.2 49.6 20.0 26.3 62.5 46.3 33.9 45.8 57.7 58.9 14.8 23.8 35.3 29.4 38.8 37.0 55.2

9.0 13.6 16.1 20.5 38.6 2.0 NA 10.7 10.3 13.5 31.2 77.9 5.1 2.4 29.2 35.4 13.6 10.7

8.2 8.7 6.1 7.8 7.7 7.3 6.3 9.0 7.7 9.7 6.8 5.7 9.3 8.4 7.8 6.6 7.7 17.5

1.11 1.05 0.82 0.99 0.97 0.59 1.15 1.04 0.92 0.86 0.46 1.01 1.07 0.68 0.56 0.92 0.95 2.02

13.5 12.1 13.3 12.6 12.5 8.0 15.1 11.8 12.0 8.9 6.8 6.1 11.4 8.0 7.1 13.9 11.9 9.1

9 17 4 21 10 27 NA 34 7 38 63 6 19 46 64 25 21 7

Rivets & rivet setting machinery Vehicle window & door systems Mfrs industrial component parts Womens fashion apparel Manufactured homes Prod & distrib electric in Maine Mfrs heating, office, & leisure prods Custom business & financial forms Custom-engineered prods, structures Meat processg; commodity merch Electronics & appliance retailer Produces branded food products Holds bank holding company Paper, cloth & vinyl products Tire retreader; truck tire dealer Marine elecrical distribution prods

Northstar Computer Forms (M: NSCF) 24.2

Sun Television & Applian (M: SNTV) 809.1

For Use With AAIIs Stock Investor (Version 2.1)

Found in the Multiples Group PE <= 10.2 Set maximum price-earnings ratio so that only 10% of the companies pass filter PBVPS <= 1.2 Price-to-book-value per share less than or equal to 1.2

Found in Ratios Group CURR_Q1 >= 1.5 The current ratio greater than or equal to 1.5 Found in Income Statement, Annual Group EPS_12M > 0 Total earnings per share for the latest 12-month periods is positive EPS_Y1 > 0 Total earnings per share last year is positive EPS_Y2 > 0 Total earnings per share one year ago is positive EPS_Y3 > 0 Total earnings per share two years ago is positive EPS_Y4 > 0 Total earnings per share three years ago is positive EPS_Y5 > 0 Total earnings per share four years ago is positive INDCAT_DIV > 0 EPS_Y1 > EPS_Y5 Indicated yearly dividend greater than $0.00 Earnings per share last year greater than earnings per share four year ago

Found in User Defined Field (formula below) Long-Term Debt to Wkg Cap <= 1.1 Long-term debt to working capital less than or equal to 1 Long-Term Debt to Wkg Cap >= 0 Long-term debt to working capital greater than or equal to 0 User Defined Field Long-Term Debt to Working Capital = LTDEBT_Q1 / ( CA_Q1 - CL_Q1) Found in Balance Sheet, Quarterly Group LTDEBT_Q1 Long-term debt at the end of the most recent fiscal quarter CA_Q1 Total current assets at the end of the most recent fiscal quarter CL_Q1 Total current liabilities at the end of the most recent fiscal quarter

dations for how the enterprising investor could hope to profit in the market. His procedure for developing a list of candidates among the secondary issues are of particular interest to the investor with a screening program. Graham would never recommend secondary issues for the passive, defensive investor, however, it is an area of interest for the aggressive investor with the time to carefully study the market and buy these securities at a significant discount. Graham defined a secondary company as a firm that is not a leader in a fairly important industryhowever, a firm with an established record of growth is not considered secondary. Table 6 describes Grahams approach for the enterprising investor. Low Price-Earnings Ratio One of the keys to selecting secondary issues is to purchase them at a significant discountGraham felt these stocks tended to almost always trade below their intrinsic value. It was only during

a bull market when little distinction was made between primary and secondary issues that the prices of these secondary issues approached or exceeded their intrinsic value. Grahams first screen for the enterprising investor was to look for companies trading with price-earnings ratios in the lower 10% of all stocks. Some programs may allow you to specify a percentile ranking for firms when establishing your criteria. If yours does not, simply specify a lower and lower price-earnings maximum until only 10% of the firms pass the filter. For our example, a maximum price-earnings ratio of 10.2 filtered exactly 10% of the firms in Stock Investor. One warning that Graham gave of the low price-earnings filter was for cyclical firms with widely fluctuating earnings. These firms often trade at high prices and low price-earnings ratios in good years when they should be sold, and low prices and high or non-existent price-earnings ratios in bad years when they should be considered for purchase. For these firms, Graham recommends a test of price low to past average earnings as suggested for the defensive investor. Strong Financial Condition For the enterprising investor, Graham relaxed his tests of the firms financial position. For the current ratio the minimum of 1.5 was specified, while longterm debt was not to be higher than 110% of net current assets. These requirements cut our list of 696 firms down to 253. Earnings Stability Graham also loosened the requirement of earnings stability, specifying that earnings be positive for each of the last five years; cutting the list further to only 100 companies. Dividend Record For the enterprising investor, Graham only specified that firms pay some level of current dividendsa simple filter that screens out nearly two thirds of the firms in Stock Investor when used as a stand-alone criterion. As a rule, only

more mature companies past their stage of strong, capital-intensive growth can afford to pay a cash dividend. This filter will also cut out some low price-earnings stocks that are troubled and under financial duress. Applying the dividend filter cut our list down to 46 stocks. Earnings Growth When it came to earnings growth, Graham again was less restrictive for the enterprising investor, requiring only that earnings for the latest year be higher than earnings five years ago. This filter cut our list down to 38 stocks. Ratio of Price to Assets The final criterion specified that the current price be less than or equal to 120% of tangible book value. This requirement is more restrictive than for the defensive investor and makes no adjustment for the level of the priceearnings ratio. Since Graham felt that secondary firms normally trade at a discount to their intrinsic value, it is not surprising that a tougher filter was specified. Applying this final criterion cuts our final list down to 16 firms which are listed in Table 7. We kept the comparative statistics the same for all three screens so that comparison between the results of the screens could be made. One of the most telling figures is the 52-week relative strength ratio, which compares the performance of this group to the performance of the S&P 500. A figure of zero would indicate performance equal to the S&P while a negative figure indicates relative underperformance. As a group, these stocks have fallen out of favor with the market. In structuring a portfolio of these contrarian stocks, Graham stressed the need for a broad diversified portfolio a minimum of 10 holdings, but preferably a larger group consisting of about 30 of the best prospects selling at significant discounts from their intrinsic value.

Graham developed a simple valuation technique based on his observations of the stock market and its relationship to the current earnings level, the expected earnings growth rate, and the earnings multiplier. The higher the current earnings multiplier, or growth rate, the higher the valuation. His original formulation was based on observation when the prevailing Aaa-rated corporate bond yield averaged 4.4%. As interest rates rise, price-earnings ratios fall because future earnings are worth less today when discount rates rise. The formula below adjusts for the current interest rates: Value = [EPS(8.5 + 2g)]4.4/Aaa Where g is the expected annual growth rate for the next seven to 10 years, EPS is the earnings per share for the most recent 12 months, and Aaa is the current rate on Aaarated corporate bonds. The formula (8.5 + 2g) (4.4/Aaa) could be broken out to form the adjusted earnings multiplier. The table to the right uses this valuation model to establish valuation levels for the stocks that passed the three Graham filters. The first three columns examine the priceearnings ratios, comparing the multiples based upon the last 12-month earnings per share, an average earnings per share of the last three fiscal years, and the Graham calculated multiple. In general, the Graham calculated multiples indicate that the stocks could support a much higher price than these stocks currently have. The primary factor affecting this formula is the growth rate assumed for the company. We used the historical five-year growth rate. While this is a reasonable starting point, the growth rate used in the formula should be a forecasted growth rate over the next seven to 10 years. A number of the companies have historical growth rates above 20%, which cannot be sustained for a long period. Graham was reluctant to use growth rates above 8% in his analysis and preferred to lower his estimate to provide a margin of safety. The Graham implied growth rate uses the current price and earnings to back out the growth rate implied by the market. The final two columns compare the current price to the valuation price using the historical growth rate. While the majority of these stocks would seem to be bargains, remember the analysis is only as good as the input. John Bajkowski

John Bajkowski is editor of Computerized Investing and senior financial analyst at AAII.

Putting a Value on a Stock

Price-Earnings Ratio (x) Trailing 3-Yr. 12-Mo. Average Grhm EPS EPS Adj Growth Rates (%) Last I/B/E/S Grhm Five Estd Impd Years Grth Grth Price ($) Current Grhms (4/30/96) Value

Description

The Defensive InvestorNon-Utilities Bassett Furniture (M: BSET) 15.3 Blair Corp. (A: BL) 7.4 Bowne & Co. (A: BNE) 12.2 Excel Industries (N: EXC) 8.7 Haverty Furniture Cos. (M: HAVT) 13.2 Hudson Foods (N: HFI) 11.2 Justin Industries (M: JSTN) 12.5 Oshkosh Truck Corp. (M: OTRKB) 14.3 PACCAR Inc. (M: PCAR) 7.7 Phelps Dodge Corp. (N: PD) 6.8 Pitt-Des Moines (A: PDM) 7.7 Standard Motor Products (N: SMP) 14.3 Thor Industries (N: THO) 14.0 Medlian 12.2 The Defensive InvestorUtilities Baltimore Gas & Electric (N: BGE) 12.9 Brooklyn Union Gas Co. (N: BU) 13.2 Connecticut Energy Corp. (N: CNE) 12.2 Connecticut Water Serv (M: CTWS) 12.0 Consolidated Edison Co. (N: ED) 10.1 Consumers Water Co. (M: CONW) 13.2 DQE, Inc. (N: DQE) 12.0 ETown Corp. (N: ETW) 12.9 Energen Corp. (N: EGN) 13.2 Florida Progress Corp. (N: FPC) 13.0 General Public Utilities (N: GPU) 8.4 Houston Industries (N: HOU) 4.7 IWC Resources Corp. (M: IWCR) 12.5 Montana Power Co. (N: MTP) 12.2 Nevada Power Co. (N: NVP) 12.7 North Carolina Nat. Gas (N: NCG) 12.7 Northern States Power (N: NSP) 11.9 Pacific Gas & Electric (N: PCG) 7.6 PECO Energy Co. (N: PE) 9.4 Public Service Co. of NC (N: PGS) 13.3 Public Service Ent. Group (N: PEG) 9.7 SIGCORP, Inc. (N: SIG) 11.7 SJW Corp. (A: SJW) 10.9 UNITIL Corp. (A: UTL) 11.9 Western Resources (N: WR) 11.0 Median 12.0 The Enterprising Investor Chicago Rivet & Machine (A: CVR) 8.2 Excel Industries (N: EXC) 8.7 Federal Screw Works (M: FSCR) 6.1 Howard B. Wolf (A: HBW) 7.8 Liberty Homes (M: LIBHA) 7.7 Maine Public Service Co. (A: MAP) 7.3 Martin Industries (M: MTIN) 6.3 Northstar Computer Forms (M: NSCF) 9.0 Pitt-Des Moines (A: PDM) 7.7 Seaboard Corp. (A: SEB) 9.7 Sun Television & Applian (M: SNTV) 6.8 The Smithfield Cos. (M: HAMS) 5.7 The Somerset Group (M: SOMR) 9.3 The Tranzonic Cos. (A: TNZ.A) 8.4 Treadco, Inc. (M: TRED) 7.8 Westwood Corp. (M: WNMP) 6.6 Median 7.7 Median for All Stocks 17.5

14.5 6.3 10.1 9.1 13.6 13.1 9.9 12.6 9.7 12.7 11.6 11.9 12.4 11.9 13.4 13.9 12.6 12.4 10.3 12.6 14.1 12.4 11.9 13.9 12.0 12.5 13.6 10.9 11.6 13.9 13.4 9.0 10.9 14.7 9.8 13.5 11.3 12.3 10.7 12.4 12.8 9.1 8.5 9.3 10.3 5.6 7.7 9.6 11.6 10.4 4.3 13.6 11.3 9.0 6.2 5.0 9.2 14.7

46.9 12.1 30.7 20.6 13.0 33.8 36.9 51.3 42.4 16.7 16.8 23.2 36.4 30.7 13.7 11.7 9.3 17.4 10.2 55.0 14.1 10.1 15.3 8.5 14.8 36.3 14.3 12.6 22.4 11.4 12.5 13.4 46.0 12.5 13.3 10.3 8.8 14.5 9.2 13.3 15.3 20.6 23.5 28.6 49.6 7.2 NA 17.3 16.8 20.5 41.0 95.1 10.8 7.7 38.7 45.9 20.6 17.3

36.3 6.2 22.3 13.6 7.0 25.0 27.7 40.1 32.4 10.2 10.3 15.8 27.2 22.3 7.6 5.9 3.8 10.8 4.6 43.3 8.0 4.5 9.0 3.1 8.6 27.1 8.1 6.7 15.1 5.6 6.6 7.4 35.5 6.6 7.3 4.7 3.4 8.3 3.7 7.3 9.0 13.6 16.1 20.5 38.6 2.0 NA 10.7 10.3 13.5 31.2 77.9 5.1 2.4 29.2 35.4 13.6 10.7

8.0 NA NA 10.0 15.0 12.5 10.5 NA 8.0 10.0 NA 8.5 NA 10.0

9.0 2.1 6.3 3.2 7.1 5.4 6.5 8.1 2.3 1.6 2.3 8.1 7.8 6.3

25.00 76.53 23.88 39.20 17.50 43.96 13.25 31.42 13.88 13.68 13.00 39.29 11.75 34.78 14.88 53.41 50.00 275.84 72.50 178.19 42.75 94.01 17.63 28.56 19.13 49.89 17.63 43.96 26.00 27.72 25.50 22.68 19.75 15.01 26.00 37.82 29.63 30.02 17.63 73.78 26.13 30.92 27.88 21.99 22.75 26.54 32.50 21.28 31.63 56.24 21.00 161.90 20.50 23.45 21.88 22.70 20.00 35.18 25.25 22.70 46.63 49.12 22.63 40.33 24.88 121.51 15.75 14.82 26.13 36.24 33.38 29.54 38.63 31.45 22.38 27.32 29.63 24.85 25.50 29.54 31.00 58.30 13.25 31.42 23.50 90.25 6.75 24.65 11.00 70.45 17.25 17.01 9.25 NA 7.00 13.50 42.75 94.01 213.00 453.39 4.00 24.22 11.13 187.39 15.00 17.43 10.50 9.55 7.25 36.02 1.63 11.48 11.07 31.42 14.25 16.80

Mfrs furniture Mens & womens apparel, furnishings Document prep and distrib Vehicle window & door systems Specialty furniture retailer Produces poultry & meat prods Mfrs bldg materials, footwear; book publr Mfrs heavy-duty vehicles, transport equip Mfrs heavy-duty on- & off-road trucks Operates copper mining co.& prods mfr Custom-engineered prods, structures Mfrs replacement parts for auto systems Recreational vehicles & small buses

3.4 6.8 4.0 7.1 3.5 6.3 3.0 6.1 1.0 4.4 3.0 7.1 4.8 6.1 2.0 6.8 6.0 7.1 3.0 6.9 3.0 2.9 3.5 0.1 3.5 6.5 3.0 6.3 3.5 6.7 6.5 6.7 3.0 6.0 1.0 2.2 4.0 3.8 7.0 7.2 2.0 4.0 3.0 5.8 NA 5.1 NA 6.0 3 5.2 3.0 6.1 NA 10.0 NA NA NA NA 15.0 NA NA NA 10.0 NA NA NA NA NA 10.0 15.0 2.8 3.2 1.0 2.5 2.4 2.0 1.2 3.5 2.3 4.0 1.6 0.6 3.8 3.0 2.4 1.3 2.4 6.8

Electricity & natural gas in MD Distribs natural gas at retail Holding co. for natural gas distrib Holding co. for water supplier Supplies electric serv to New York City Holding co. for water utilites Holding co. for electricity prod & distrib Holding co. for water treat & real estate Holding co. for prod & distrib of gas Diversified electric holding co. Holding co. for electric utilities in NJ & PA Holidng co for elec utility & power genrn Holding co. for water systems in Indy. Operates elec & gas systems in MT Electric serv for Las Vegas and area Distribs natural gas in NC Distribs electricity & natural gas Supplies electricity & natural gas in CA Electric & gas serv to southeast PA Distribs natural gas in NC Holding co. for electric & gas utilities Generates & distribs electricity & gas Holding co. for water utility & real estate Holding co. for electric & gas in East Electric & natural gas utility

Rivets & rivet setting machinery Vehicle window & door systems Mfrs industrial component parts Womens fashion apparel Manufactured homes Prod & distrib electric energy in Maine Mfrs heating, office, & leisure prods Custom business & financial forms Custom-engineered prods, structures Meat processg; commodity merchang Electronics and home appliance retailer Produces branded food products Holds bank holding company Paper, cloth & vinyl products Tire retreader; truck tire dealer Marine elecrical distribution prods

NA = not available

Screening on Growth: The T. Rowe Price Approach

FEATURE

by John Bajkowski
would never reveal. However, even with its quantitative focus, screening is an art as much as a science. Designing effective screens requires a clear objective, basic knowledge of finance, and a clear understanding of the strengths and weaknesses of the screening program. Defining a Clear Objective The first step in constructing a screen is establishing a clear, focused, narrowlydefined objective. Common objectives include seeking out small, emerging growth companies, out-of-favor contrarian plays, and high-yielding bluechip firms. On the surface, it would seem that a filter that combines a mix of unrelated objectives would be the ultimate screen. In reality, screens that look for extreme values defined by a combination of contrasting objectives typically turn up companies in odd situations, not necessarily Table 1. The T. Rowe Price Approach in Brief investment gems. The purpose of screening is to come up with a list of companies sharing a common characteristic that you believe makes them worthy of further analysis. Table 1 presents the summary of the T. Rowe Price investment approach. The objective of our screen can be found within the philosophy and style sectionlocate stocks of companies with long-term earnings growth prospects in the early growth stages of their life cycle. Primary Factors The primary screening criteria should flow naturally from your objective and should attempt to filter only those companies that meet your objective. In the case of the T. Rowe Price growth screen, our primary criteria should provide us with a list of companies that are in the growth stage of their life cycle, not mature cyclical firms. The criteria for initial consideration

In the January 1996 issue of the AAII Journal, Maria Crawford Scott analyzed the investment approach of T. Rowe Price. T. Rowe Price, who died in 1983, developed his long-term buy- and-hold growth philosophy in the 1930s when the prevailing approach was to try to time the market and greater emphasis was placed on investing in incomeproducing stocks. In this article, we will develop and apply the T. Rowe Price stock screen while discussing the overall process of developing screening filters. Screenings Appeal Stock screenings appeal to investors is the speed with which a well-designed filter can highlight stocks that merit further analysis. A screening system using a broad database can identify interesting companies that a haphazard system of relying on tips from friends and investment professionals

Philosophy and style Investment in stocks of companies with long-term earnings growth prospects, under the theory that growth in earnings will ultimately be reflected in growth of market values and dividends; and investment in stocks in the early, growth stages of their life cycle before they become glamorized. Universe of stocks No restrictions, but smaller capitalization stocks viewed as particularly fertile ground. Criteria for initial consideration Earnings per share increasing at the peak of each succeeding major business cycle, as well as increased projected earnings per share at peak of future business cycles. Earnings are examined relative to industry and overall market to find distortions caused by business cycles to determine the real trend in earnings, and to rule out non-growth cyclicals. To ensure long-term growth of earnings, companies should be in growing industries. Areas of possibility include: new industries, divisions of old industries experiencing vigorous growth as a result of new products or new uses for old products, and specialty industries with expanding products and markets. Long-term earnings per share growth greater than inflation. Price-earnings ratio not high relative to historical average.

Secondary factors: Management, which is key. Look for management with substantial interest in the firm and that appears to be planning intelligently for the future Strong finances: increase in capital from retained earnings; availability of additional financing Relatively high return on invested capital Favorable profit margins relative to industry; favorable trend in profit margins Absence of cut-throat competition in the industry Little government interference Good labor relations, but total payroll not large relative to gross revenue Stock monitoring and when to sell: Monitor for changes in trends of sales, profit margin and return on invested capital Monitor for changes in management, competitive stance, regulatory changes, and changes in industry Sell when company no longer fits definition of growth company, when the outlook does not continue to be favorable, when there is a break in trend of sales, profit margin, and return on invested capital Trim when prices reach excessively high levels, as measured by priceearnings ratios relative to historical levels

presented in Table 1 conceptually define our primary screening factors. Converting these concepts into quantitative screening criteria can be difficult due to the inherit limitations of screening programs. T. Rowe Price suggests identifying growth companies by looking for increasing earnings per share at the peak of each succeeding major business cycle, as well as increased projected earnings per share at the peak of future business cycles. I am not aware of any screening programs geared toward individual in-

vestors that provide data going back far enough in time to screen for this occurrence. We are currently in an economic expansion, which began in March of 1991. The peak of the previous expansion occurred in July of 1991, while you would have to go back nearly 15 years for the peak of a prior expansion, which occurred in July of 1981. (Note: The Survey of Current Business published by the U.S. Department of Commerce is a good source of data on measures of economic activity.) The filter make sense financiallyit

is trying to exclude cyclical companies that currently may look like growth stockshowever, it can not be reasonably applied automatically. After a prolonged economic expansion, the growth rates of cyclical companies may look extremely high because you are comparing earnings against a very low base level. Current five- and three-year growth rates are well into the double digits for many cyclical firms. Chryslers five-year annual growth rate in earnings from continuing operations is 48.7%, and its three-year annual growth

Translating Style Into Screening

Primary Factors: Earnings per share increasing at the peak of each succeeding major business cycle Few screening programs maintain enough data to establish such a perspective. This type of filter would be best applied manually after the computerized screening process. To ensure long-term growth of earnings, companies should be in growing industries In screening, you can include only perceived growth industries or exclude industries with few growth prospects. However, there are often segments of growth within a mature industry. Alternatively, companies with few growth opportunities can be excluded manually after the screen is performed. Long-term earnings per share growth greater than inflation. The current low inflationary environment (3%4%) makes this a rather loose filter in screening for growth stocks. A requirement of 8.1% in past growth in earnings per share, which was the mid-point for the companies in Stock Investor, is used. Price-earnings ratio not high relative to historical average Use a filter in which the price-earnings ratio based upon trailing 12 months earnings is below the average price-earnings ratio over the last five years. The hidden screen behind this filter is positive earnings for each of the last five years and a requirement that the company have five years of price history. The calculation of the five-year price-earnings average required positive earnings over each of the last five years (price-earnings ratios are not meaningful for negative numbers) as well as price data for each of those years. The historical average can be skewed upward by one year of weak earnings, so a screen excluding companies whose price-earnings ratio was above 40 for any of the last five years was added. Secondary Factors: Substantial management interest in the firm Screen for companies with insiders holding at least 20% of outstanding shares. Strong financesincrease in capital from retained earnings Given the other filters, not a very restrictive screen. However add a requirement for payout ratio to be below 100%. Modern interpretations may call for positive cash flow or free cash flow, which would be more restrictive. Strong financesavailability of additional financing More of a qualitative examination than a quantitative screen. No screen added; however, if you are interested in considering the type of factors a lender would require, a focus on financial leverage, cash positions, cash flow, and coverage ratios would be appropriate. Relatively high return on invested capital T. Rowe price examined return on invested capital (earnings before interest, taxes and dividends divided by equity and long-term debt). A screen for company return on assets higher than industry norms is substituted. Favorable profit margins relative to industry Screen for gross and net profit margins to exceed industry norms. Favorable trend in profit margins Screen for gross and net profit margins below levels last year and five years ago. Absence of cut-throat competition in the industry Screen for above-industry average margins and improving profit margins. Little government interference Difficult screen to implement except by excluding industries with known regulatory issues such as the utility group. Good labor relations, but total payroll not large relative to gross revenues More of a qualitative evaluation than a quantitative analysis. Reference to payroll relative to revenues may also be better suited toward industrial firms versus those in the service sector.

rate comes in even higher at 87.2%. Sales growth over the same time periods clocks in at 8.2% annually over five years and 21.1% over three years. Industries that make heavy use of fixed assets and financial leverage can show tremendous earnings growth once they get past their breakeven point. Growth firms represent companies growing well beyond the level of the overall economy. A mature firm such as Chrysler, in a cyclical industry such as autos, will roughly grow and contract at the rate of the overall economy. While it may be possible to expand market share and grow at a slightly higher rate than the industry, there are still severe restraints on the firms longterm growth potential. In screening for growth stocks, it may be possible to focus on industries in the early stages of their life cycle, which can be fairly easy to accomplish with screening programs. Alternatively, you can explicitly exclude industries known to be at their mature stage; however, T.

Rowe Price also expressed interest in looking at divisions of old industries experiencing vigorous growth as a result of new products or new uses for old products. In the end, when applying this screen it may be better to screen for reasonable levels of growth and manually exclude firms that do not have strong long-term growth potential. Growth Greater Than Inflation T. Rowe Price was an early proponent of buying a good company at reasonable price and holding it for a long time. He recognized the potential for inflation to erode the value of his holdings and specified that earnings per share should be increasing faster than the rate of inflation. In the last five years, inflation as measured by the consumer price index has grown at about 3.5% per yearroughly in line with the long-term inflation rate. Specifying a minimum historical growth rate of 3.5% or 4.0% would lead to a very unrestrictive screening filter. The me-

dian five-year earnings per share growth rate for the 6,600 companies in AAIIs Stock Investor program is 8.1%. Since we are trying to identify companies with above-average growth rates and have not specified any other minimum growth levels, a minimum growth rate of 8.1% was specified. This filter, when applied to AAIIs Stock Investor database, reduced the number of companies to 2,693 from 6,636. More than half the number of companies were excluded by this filter because not all firms have been around long enough to calculate the growth rate. Growth at a Reasonable Price While T. Rowe Price concentrated on growth, he would not pay any price for that growth. When looking at price-earnings ratios, he would prefer not to buy stocks selling at levels high relative to their historical average. A current priceearnings ratio lower than its historical average would be a potential sign that a stock is undervalued, while a current

Definitions of Screens and Terms

EPS Growth RateLast Five Years: Annual growth in earnings per share from total operations over the last five fiscal years. A measure of how successful the firm has been in generating the bottom line, net profit. Sales Growth RateLast Five Years: Annual growth in total sales over the last five fiscal years. Provides a confirmation of the quality of the historical earnings per share growth rate. Current Price-Earnings Ratio: Market price per share divided by the most recent 12 months earnings per share from total operations. A measure of the markets expectation regarding the firms earnings growth potential and risk. Firms with very high price-earnings ratios are being valued by the market on the basis of high expected growth potential. Price-Earnings RatioFive-Year Average: An average of the high and low price-earnings ratio for the past five years. Provides a base from which to compare the current level of the price-earnings ratio. Trailing 12-month ratios below the five-year average may point to an undervalued stock. % of Shares Held by Insiders: The percent of common stock held by all the officers and directors as a group plus beneficial owners who own more than 5% of companys stock as disclosed in the most recent proxy statement. A high percentage should indicate that management is as concerned about the performance of the stock as are other shareholders. % of Shares Held by Institutions: The percent of common stock held by all reporting institutions. Provides an indication of the institutional interest in the company. Return on AssetsTrailing 12 Months: Net income for the most recent 12 months divided by the total assets reported last quarter. Provides a measure of the managements efficient use of assets. Net Profit MarginTrailing 12 Months: Net income divided by total sales over the last 12 months. When compared against industry norms and over time provides a indication of the competitive nature of the industry and the companys competitive position. Gross Profit MarginTrailing 12 Months: Gross income divide by total sales for the last 12 months. When compared against industry norms and over time provides a indication of the competitive nature of the industry and the companys competitive position.

price-earnings ratio that is high compared to its historical average might indicate an overvalued firm. This assumes that the growth prospects of the firm have not changed fundamentally over the period of study and that based upon the historical relationship of price to earnings, the market is not correctly discounting the future earnings potential of the firm.

Applying the filter with a requirement that the current price-earnings ratio be below the average price-earnings ratio reduced the number of passing companies from 2,693 to 595. This is a restrictive screen for a number of reasons. With the market at record highs, many firms are trading with price-earnings ratios well above their normal levels.

Many firms also do not have a fiveyear average price-earnings ratio. To calculate this figure a company needs five years of price data and five years of positive earnings. Negative earnings lead to non-meaningful price-earnings ratios, so positive earnings for each of the last five years are required. This illustrates that a seemingly simple single filter can in fact have many built-in hid-

Table 2. T. Rowe Price Screen Results

5-Year Growth Rate in in EPS Sales (%) (%) 96.1 77.9 39.9 35.1 34.9 31.1 29.9 29.7 24.1 22.6 21.4 20.5 19.4 19.0 18.0 16.6 15.3 14.5 14.1 14.0 13.1 12.5 10.8 9.1 9.0 8.3 5.3 27.7 11.3 29.5 11.5 20.2 23.9 5.5 16.2 2.4 7.7 0.7 2.1 19.3 9.9 18.0 7.7 11.0 8.5 8.2 13.8 8.6 6.6 4.7 5-Year % of % of Trailing 12 Months Avg. Shares Shares Return Net Gross P/E Held by Held by on Profit Profit Ratio Insiders Institutions Assets Margin Margin (X) (%) (%) (%) (%) (%) Description 14.5 10.9 12.6 14.1 17.3 23.5 25.0 13.7 21.5 18.8 13.2 11.5 11.1 12.9 20.7 22.6 18.5 20.6 15.8 16.5 21.8 18.3 23.6 18.2 13.7 22.1 64.9 60.3 41.2 30.1 44.4 46.0 21.2 21.0 53.9 30.0 43.2 72.0 41.5 47.1 28.0 26.0 25.0 80.0 44.5 43.0 32.7 25.0 45.7 31.9 94.1 14.7 16.9 na 37.4 95.0 83.7 33.6 58.3 18.5 5.4 na 21.3 20.7 36.3 46.1 55.5 62.8 na 81.1 37.8 19.9 54.3 55.0 19.8 9.4 6.5 8.6 3.8 6.7 6.8 6.6 20.3 10.2 4.4 7.4 10.1 16.8 26.7 9.1 11.4 10.9 17.9 6.7 8.3 10.3 8.2 16.6 26.0 10.8 20.1 3.9 5.2 15.2 7.7 10.1 20.1 11.6 7.7 3.3 6.0 6.1 10.3 7.5 10.0 3.7 10.4 10.9 8.5 4.9 6.7 5.6 17.6 29.6 9.1 56.3 37.0 32.7 76.8 28.8 49.0 50.9 40.0 47.7 74.0 30.8 35.2 24.1 27.1 32.7 25.6 62.6 29.8 41.2 24.6 29.3 24.3 48.5 70.9 35.6 Operates railroad track Brand food products Mfrs vacuum cleaners Transport equip leasing serv Seismic data for locating oil & gas Intl House of Pancake restaurants Regional telecomm company Closed circuit TV cameras and sys Fast-food restaurants Family restaurants Prods/process in electro sys Womens fashion apparel Mfrs welded steel tubing Aluminum & vinyl windows & doors Mfrs industrial prods Superstores & supermarkets combo Scheduled air transport Power transmission prods Casual apparel Engineered industrial prods Electric motors & drives Prods for protective pkg Mfrs flavors & fragrances Analyzes hazard exposure Rivets & rivet setting machines

Company Illinois Central Corp. The Smithfield Cos. HMI Industries Xtra Corporation Dawson Geophysical Co. IHOP Corp. Century Telephone Ent. Cohu Wendys International Max & Ermas Restaurants Astronics Corp. Howard B. Wolf UNR Industries Drew Industries TriMas Corp. Albertsons Comair Holdings Regal-Beloit Corp. Benetton Group S.P.A. Varlen Corp. Baldor Electric Tuscarora Incorporated Intl Flavors & Fragrance Landauer Chicago Rivet & Machine
na= not available

Current P/E Ratio (X) 13.7 5.3 8.0 12.6 15.0 12.9 15.9 11.6 19.1 11.4 9.6 7.9 10.7 9.3 12.3 18.9 17.1 12.0 13.8 6.9 18.7 14.2 22.1 17.5 7.9

Note: We compared the actual holdings of T. Rowe Price funds with the stocks that appear on this list. Only five of the stocks in this list are held in T. Rowe Price mutual funds. Three stocks are held in T. Rowe Price Equity Index, which attempts to emulate the S&P 500. TriMas Corp. was the most widely held stock in the list, appearing in five T. Rowe Price mutual fund portfolios. It should be noted that the founder sold his mutual fund company prior to his death, so there may be no actual correspondence between his original investment practices and the manner in which the funds are managed today.

den requirements. Beyond negative earnings, unusually low earnings may also throw off standard price-earnings ratio screens. Shortterm drops in earnings due to events such as special charges, extraordinary events, or even general slowdowns can lead to unusually high price-earnings ratios. As long as the market perceives the earnings decline as temporary, the high price-earnings ratio will be supported. Because the average price-earnings screen relies on a normal situation, these outlier ratios must be excluded. When performing a hands-on evaluation you can manually exclude years with negative or unusually low earnings. However, when screening a large universe of stocks, it is best to establish conditioning criteria that eliminate companies with extreme price-earnings ratios. Five filters were added that excluded companies whose price-earnings ratio exceeded 40 for any of the last five years. This reduced the number of passing companies to 300 from 595. Secondary Factors: Management T. Rowe Price felt that good management was an important consideration when selecting firms, believing that managers should have substantial interest in the firm and not receive compensation primarily from big salaries and pensions. A filter requiring that insiders own at least 20% of outstanding shares dropped the number of companies down to 211 from 300. The primary weakness with this filter is that the SEC defines an insider as a beneficial owner who maintains at least a 5% position in the firm. Under this definition, an investment adviser who owns at least 5% of a firms shares will be included as an insider. To make the best use of this screen, it would be a good idea to look at the proxy statements of the companies that pass the complete screen and see how many shares the officers and directors own. Much is made out of owning companies with good management. Certainly, a good management team is essential for the long-term viability and growth of the firm. However, many investors

in effect double count the benefit of good management. With a good management team the company should have aboveaverage growth, profitability better than other firms in the industry, improving profit margins, etc. In other words, the effect of good management should be apparent in the results. Strong Finances T. Rowe Price thought that a company should have strong finances to be considered for purchase. The failing of many growth firms is the inability to obtain further capital for future expansion. T. Rowe Price focused in on the ability to increase capital from retained earnings and on the ability to obtain further financing. These two criteria deal with the primary sources of company fundsinternal cash flow from operations and additional outside sources of capital. At its most basic level, an increase in capital from retained earnings simply means the company is profitable and is not paying out all of its earnings in the form of dividends. Since we have already screened for positive earnings, we simply need to screen for a payout ratio (dividend per share divided by earnings per share) below 100%. Applying this filter had no effect on the overall screen. Since earnings can be reduced by non-cash charges such as depreciation, an alternative screen could look at actual cash flow measures and require that this be positive. Availability of additional external financing is more of a qualitative examination than a quantitative screen. It would consider the ability of the company to raise capital from the equity markets by floating additional stock. Here the market environment for initial public offerings would play a role. Many technology firms had to scrap or delay plans for floating common stock late last year when the technology stocks as a whole retreated. Beyond equity financing, companies can try to float debt or look toward bank lending. If you were interested in considering the type of factors a lender would require, you could add filters that look at the current levels of debt (financial leverage), cash positions, cash flow, and coverage ratios.

Return on Invested Capital T. Rowe Price looked for high and expanding return on invested capital (earnings before interest, taxes and dividends divided by common equity, preferred stock and long-term debt) when selecting stocks. He was trying to capture firms that made effective use of their capital by keeping a lid on production costs and expanding into new markets. Stock Investor does not include this calculation, so return on assets was substituted. Return on assets is calculated by dividing net income by total assets, and using it represents the type of adjustments often required when applying a computer screen. Return on assets was used instead of return on equity because it includes preferred stock, longterm debt, common equity, and shortterm liabilities, which more closely match the return on invested capital calculation. Our screen looked for company return on assets higher than industry norms, cutting the number of companies down to 174 from 211. Favorable Profit Margins Favorable profit margins may provide an indication that a company has a competitive advantage over its peers. However, because profit margins are very industry specific, they must be compared against industry norms. Two screens, one that looked for gross margins above industry medians and another that compared net profit margins against industry medians, were included. Beyond margins that are currently high, it is important that the company be able to maintain its profit margins. A declining profit margin can point to increased competition and lower prices or weak cost control. Therefore, screens were added that looked for current net and gross margins above levels five years ago. These screens reduced the number of companies down to the 25 firms displayed in Table 2. Absence of Cut-Throat Competition The screens above that compared gross and net profit margins against industry norms and required improving margins should help to pinpoint the level of

competition. There really is no need to add additional screens for this factor. After the screen, however, it would be a good idea to study the industries of the passing companies to gain a feel for how competitive the industry might be and whether there are any changes on the horizon that might effect the firm down the line. For example, Wendys, which passed all of the filters and is operating in the fast-food industry, would seem to be operating in a rather competitive field. Little Government Interference The level of government interference is also a difficult screen to implement. The best mechanical approach would be to exclude industries with known regulatory issues, such as the utility group. Alternatively, companies that pass the screen can be examined one by one and the impact of government interference could be assessed individu-

ally. This is the type of discussion that would be covered in the companys annual 10-K filings with the SEC. These can be obtained directly from the company or can be downloaded from the Internet for a large number of public companies at the SEC Web site (http:// www.sec.gov). Good Labor Relations Much of T. Rowe Prices work was written when industrial companies were the strength and growth of our economy. With the shift toward the service sector in the U.S., some of the rules tend to deal more with the analysis of the typical union-based work forcealthough even today major league baseball has its share of labor problems. This screen is also more of a qualitative evaluation than a quantitative analysis. While it is an important concern, it would be best addressed when analyzing the passing companies individually.

The Results Table 2 presents the results of our interpretation of the T. Rowe Price screen. The companies are ranked by growth in earnings per share. While the T. Rowe Price style is associated with growth, many of the rules we used also focused on value. Many of the final companies appear to be industrial firms in cyclical industries. Further analysis would be required to see if they possess qualities that provide the potential for long-term growth. Screening can be a very rewarding process, but looking at the results of a screen such as this highlights that screening is the first stage in the investment process. In-depth analysis of the company and its industry must be performed before your money is invested.

John Bajkowski is editor of Computerized Investing and senior financial analyst at AAII.

For the Computerized Investor Using AAIIs Stock Investor

Screening Criteria: Found in Growth Rates Group EPS_G5F > 8.10 Five-year earnings per share growth rate is greater than the median growth rate for all stocks

Found in Multiples Group PE < PE_A5Y Found in User Defined Fields (formulas below) PE Y1 < 40 PE Y2 < 40 PE Y3 < 40 PE Y4 < 40 PE Y5 < 40 Found in Price & Share Data Group SHRINSD > 20 Found in Ratios Group PAYOUT_12M < 100 ROA_12M > INDUSTRY.ROA_12M (N) NPM_12M > INDUSTRY.NPM_12M (N) NPM_12M >= NPM_Y1 NPM_12M > NPM_Y5 GPM_12M > INDUSTRY.GPM_12M (N) GPM_12M >= GPM_Y1 GPM_12M > GPM_Y5 User Defined Fields: PE Y1 = PRICE_Y1/EPS_Y1 PE Y2 = PRICE_Y2/EPS_Y2 PE Y3 = PRICE_Y3/EPS_Y3 PE Y4 = PRICE_Y4/EPS_Y4 PE Y5 = PRICE_Y5/EPS_Y5

Price-earnings ratio is greater than five-year average price-earnings ratio

Price-earnings ratio last year is less than 40 Price-earnings ratio one year ago is less than 40 Price-earnings ratio two years ago is less than 40 Price-earnings ratio three years ago is less than 40 Price-earnings ratio four years ago is less than 40

Percentage of insider ownership is greater than 20%

12-month payout ratio is less than 100% 12-month return on assets is greater than that of narrow industry group 12-month net margin is greater than that of narrow industry group 12-month net margin is greater than that of net margin last year 12-month net margin is greater than that of net margin four years ago 12-month gross margin is greater than that of narrow industry group 12-month gross margin is greater than that of gross margin last year 12-month gross margin is greater than that of gross margin four years ago

Price fields found in Price & Share Data Group EPS fields found in Income Statement, Annual Group

Screening for Cash-Rich Firms That Will Put Their Money to Good Use
By John Bajkowski
Investors may be tempted to scan for defensive securities considering the recent market volatility and rich valuation levels of the market compared to historical benchmarks (a current price-earnings ratio of 18.9 and dividend yield of 2.2% versus a 15.1 average price-earnings ratio and 3.7% average dividend yield since the 1960s). Many consider the ultimate safety net for a firm to be a high cash position. With a large cash hoard, a firm should be able to weather an economic storm, or so the reasoning goes. However, there are difficulties in identifying firms that have truly strong financial positions and gaining a feel for the long-term prospects of these cash-rich firms. Strengths and Drawbacks of a High Cash Position A healthy cash position provides important flexibility and safety to a firm. Cash-rich firms should be able to more easily meet their debt obligations, decreasing the probability of a creditor weakening the position of the equity investors or even gaining control of the firm. During an economic slow-down, cash allows a cyclical firm to continue its research and development efforts, as well as undertake capital expansion or productivity improvements, in anticipation of an economic rebound. Firms with excess cash positions can also elect to distribute the cash to shareholders in the form of dividendsalthough double taxation is a weakness to the high payout strategy. The firms pay corporate taxes when they earn the money and shareholders must pay taxes at their marginal tax rate when they receive the dividend. To avoid the double tax, many firms have chosen to use excess cash to repurchase shares on the open market. This helps to boost the share price in the short term by providing demand for shares. And with fewer outstanding shares, the same level of net income boosts earnings per share. Firms with excess cash can also attempt to use the cash strategically to broaden their product lines or diversify into new areas. This can be accomplished either through direct capital investment or the outright purchase of another firm. Cash-rich firms can also be attractive acquisition candidates. While much more common in the leveraged buyout craze of the 1980s, the cash prize reduces the actual purchase price of the firm and the cash flow that allowed the cash hoard to be built helps to service the debt incurred acquiring the firm. A high cash position can also be a disadvantage. Cash is generally defined as cash plus marketable securities that are readily convertible into cash. This would consist of bank deposits and short-term instruments such as Treasury bills. The cash position may reduce profitability if it earns a lower rate of return than other assets in the company. One would expect any corporate investment to earn more than the money market rate in the long run. When finding firms with large cash balances, the critical question becomes: Why are they holding on to the cash? Often it points to a firm in a mature industry with little growth prospects. The firm may have reasonable profit margins, but little need for additional capital. For such a firm, the need for a good management team is especially important. Unlike a start-up, which must pass the tests of the capital markets to raise cash in an effort to expand into a new market, management has carte blanche to spend the firms cash as it sees fit. Wall Street is filled with stories of firms divesting or spinning off unprofitable divisions that were acquired a few years back at rich premiums. Measuring Cash Levels The amount of cash per share to the market price per share provides a useful indication of the cash level of the firm. General Electric may have $3 billion in cash, but this works out to a cash level equal to about 2.5% of the stock value (cash divided by market capitalization). Screening for firms with high proportions of cash to share price represents a reasonable starting point in tracking down cash-

John Bajkowski is AAIIs senior financial analyst and editor of Computerized Investing.

Table 1. Cash-Rich Firms

Net Cash Cash to to Price Price (%) (%) Free Cash Flow to Price (%) Dividend Yield (%) Growth Rate 52PriceI/B/E/S Est. Week Earnings Historical Long- Historical Relative Ratio EPS Term Sales Strength (X) (%) (%) (%) (%)

Description

Large-Cap Stocks (above $1.5 billion) Temple-Inland (N) 179.2 na UAL Corp. (N) Northwest Airlines (M) Delta Air Lines (N) General Motors Corp. (N) King World Producns (N) Foster Wheeler Corp. (N) Apple Computer (M) PACCAR (M) Moore Corporation Ltd. (N) Canon (M) Novell (M) National Semiconductor (N) General Dynamics (N) Liz Claiborne (N) 75.4 52.1 34.7 33.9 33.1 32.5 32.4 32.0 31.5 29.8 28.9 28.3 26.3 26.2 152.3 55.8 48.9 na 25.7 35.6 47.3 54.9 5.4 21.3 18.8 4.8 3.6 3.0

5.6 19.2 21.5 3.5 9.3 9.0 9.3 21.6 8.5 0.6 0.6 8.0 7.9 9.6 5.0

3.0 0.0 0.0 0.3 3.1 0.0 1.8 1.7 2.1 4.8 0.6 0.0 0.0 2.5 1.4

8.6 7.4 11.5 9.5 7.3 11.8 21.7 20.4 7.5 7.1 49.0 13.5 7.0 13.0 26.2

9.0 44.7 na 6.8 0.5 7.9 13.9 1.8 2.6 10.7 6.5 21.5 48.7 1.8 10.8

9.0 10.0 9.0 9.0 6.0 11.0 15.0 15.0 8.0 12.0 15.0 15.0 12.0 8.0 12.0

8.6 7.3 na 7.3 4.1 4.8 12.4 14.8 5.0 2.4 7.4 32.6 7.3 20.2 8.9

35 49 60 1 1 11 6 50 17 19 9 56 33 2 57

Holding co. in paper, pkg, & buildg prod Holding co. of United Airlines Holding co. of Northwest Airlines Inc. Air transport for passengers, mail, freight Autos, trucks, & related parts; defense prods Distribs TV programs, feature films Design, engineerg, constructn, mfg operations Personal computers & related products Multinational design, mfr heavy-duty trucks Manufactures business forms Electronics; fine chemicals; & engineerg Networking and application software Designs, manufactures semiconductor prods Armored vehicles; submarines; coal mining Designs & mkts apparel, fragrances, & cosmetics

Mid-Cap Stocks ($250 million to $1.5 billion) Chris-Craft Indus. (N) WHX Corporation (N) Amdahl Corp. (A) VLSI Technology (M) BHC Communications (A) LTV Corporation (N) National Presto Indus (N) Seaboard Corp. (A) Navistar International (N) Alaska Air Group (N) Mercer International (M) Silicon Valley Group (M) Continental Airlines (N) FSI International (M) Farmer Brothers Co. (M) 121.2 105.9 77.6 76.4 66.0 65.9 65.3 61.9 57.6 48.2 47.8 45.9 45.4 41.0 38.3 101.5 32.7 22.2 43.8 56.8 9.7 51.3 20.1 na 100.3 7.1 22.3 75.1 19.2 30.5 14.4 16.4 9.5 3.5 6.8 37.1 2.4 44.7 33.1 13.1 3.9 3.7 16.2 8.9 8.4 0.0 0.0 0.0 0.0 0.0 0.0 4.8 0.4 0.0 0.0 0.0 0.0 0.0 0.0 1.6 40.5 5.4 9.4 13.4 44.3 7.2 13.7 10.8 5.5 23.7 4.7 13.4 7.2 10.4 12.6 33.1 36.0 14.7 109.4 32.8 8.9 5.6 13.5 25.8 9.1 43.1 30.5 16.2 48.3 0.3 na 10.0 5.0 21.0 na 7.5 6.0 na 5.5 9.0 20.0 22.0 10.0 25.0 na 12.5 0.8 4.9 15.3 13.1 6.6 0.1 13.7 10.5 7.5 55.3 20.2 1.3 28.5 3.5 5 16 39 40 5 35 26 10 46 13 0 31 338 43 14 TV broadcasting; polyvinyl alcohol film Integrated steel manufacturer High-perform general-purpose computer systems Custom & semi-custom integrated circuits Holding co. in TV broadcasting Steel & energy industries Electrical appliances and housewares Poultry & pork processg; Holding co. of diesel truck manfacturer Holding co. for Alaska Airlines & Horizon Air Pulp & paper indus; financial services Automated wafer processg equip Air transport of passengers, cargo, mail Equip used in fabrication of integrated circuits Coffee, spices, & allied food prod for food serv

Shadow Stocks (small-cap firms with low institutional interest) Astrosystems (M) Daxor Corp. (A) Wilshire Oil Co. of Texas (N) Salem Corp. (A) Sevenson Environmental (M) Intrav (M) Thermo Voltek Corp. (A) National Beverage Corp. (A) Detroit & Canada Tunnel (M) Align-Rite International (M) Lynch Corp. (A) American Filtrona Corp. (M) FDP Corporation (M) Industrial Scientific (M) 97.9 97.5 62.4 48.8 47.6 45.4 42.5 39.3 32.3 32.2 32.0 27.5 25.9 24.7 93.0 80.2 51.1 36.8 30.5 50.3 29.7 46.6 25.4 17.9 57.3 8.5 23.8 16.7 18.6 14.6 1.4 7.7 7.7 4.3 4.8 0.1 5.4 10.4 0.8 8.8 2.6 7.1 0.9 5.7 0.0 0.0 1.2 2.6 1.3 6.3 0.0 0.0 1.6 0.0 0.0 3.0 0.0 0.0 0.0 55.8 27.2 19.0 13.1 9.7 9.6 38.6 8.0 10.4 11.4 19.1 13.2 6.3 23.6 15.6 33.4 43.8 73.3 13.8 5.3 na 19.8 72.6 0.1 na 8.2 0.0 21.9 52.7 29.3 na na na na 15.0 na 20.0 na na na na na na na 11.0 4.1 17.4 9.9 1.2 8.3 na 27.7 3.0 8.7 na 16.4 0.4 15.9 5.0 24.9 5 13 29 21 22 na 49 22 8 na 20 7 49 8 26 Electronic measure & control devices Cryopreservation tech for human semen & blood Explore & prod oil & gas in U.S. and Canada Industrial equip for furnaces, metal processg Field serv for remediation of hazard materials Escorted international travel programs Instruments to test electronic & elecl systems Holding co. for branded soft drinks Operates tunnel connecting Detriot & Windsor Manufactures photomasks for integrated circuits Holding co. for multimedia, serv & manufacg Fiber filters for tobacco prods Real estate sales, exchanges, & devlp Application software for life insurance indus Portable instruments for measuring gases

New Mexico & Arizona Land (A) 26.6

Source: AAII's Stock Investor and Market Guide. Data as of 2/29/96.

Definitions of Screens and Terms

The following is a short description of the screens and terms used for this months Shadow Stock listing.
Cash to Price per Share: Cash and cash equivalents per share divided by the market price per share. Indicates what percentage of the stock price is equal to cash per share. The higher the percentage, the more cash on hand relative to share price. Net Cash to Price per Share: Cash and cash equivalents per share less current liabilities per share divided by market price. Indicates percentage of stock price equal to net cash per share, a more conservative measure than cash to price per share. A higher percentage indicates a higher level of cash per share relative to share price. Free Cash Flow to Price per Share: Free cash flow per share divided by price per share. Free cash flow per share is defined as cash from operations minus capital expenditures and dividends paid. Positive ratios indicate that the firm has positive free cash flow and is able to meet the needs of its capital expenditures and dividend payouts from internal operations. The higher the percentage, the greater the free cash flow relative to share price. Dividend Yield: Annual dividends per share divided by price per share. An indication of the income generated by a share of stock. Price-Earnings Ratio: Market price per share divided by the firms earnings per share. A measure of how the market currently values the firms earnings growth and risk prospects. High price-earnings ratios indicate high expectations of future earnings growth. Historical EPS Growth Rate: Annual growth in earnings per share over the last five years. A measure of how successful the firm has been in generating the bottom line, net profit. I/B/E/S Est. Long-Term Growth Rate: The median growth rate in earnings per share in continuing operations expected over the next five years that is being forecasted by analysts tracked by I/B/E/S. An indication of the growth expectations for the firm. Historical Sales Growth Rate: Annual growth in sales over the last five fiscal years. Used to provide a confirmation of the quality of historical earnings per share growth rate. 52-Week Relative Strength: Price performance of the stock during the last year relative to the price performance of the S&P 500 index. A figure of 0 indicates the stock had the same percentage price performance as the market. A figure of 5 indicates that the stock outperformed the market by 5%.

rich firms. When performing such a screen, it is important to exclude financials, because by the nature of their business they are required to hold large cash positions. Utilities were also excluded because of their regulated nature and overall low growth potential. To perform this screen, AAIIs Stock Investor program was used. In addition to excluding financials and utilities, a filter requiring positive earnings from continuing operations for the last 12 months was specified as a minimum current profitability requirement, along with a minimum share price requirement of five dollars. Without the minimum share price requirements, bankrupt firms with a share price of a few pennies would dominate. The securities were broken into three groupslarge-capitalization, mid-cap, and Shadow Stocks. (Shadow Stocks are defined by AAII as stocks of small nonfinancial companies with low institutional interest, and that have had positive earnings for the last two years.) The 15 stocks with the highest percentage of cash to price are listed for each group in Table 1. As important as it is to look at cash, it is equally important to look at the financial obligations of the firm. In the mid-cap group, WHX Corporations cash position is equal to 105.9% of its share price, com-

pared to 121.2% for Chris-Craft Industries. A quick look at balance sheets of the firms reveals large differences. WHX is the ninth largest domestic integrated steel manufacturer and has emerged from a chapter 11 reorganization. Its $12.32 per share in cash is quickly reduced when one considers the firms short-term liabilities and long-term debt. Some firms build up a cash reserve to ensure that they can meet the required payments of their short-term debt and current portion of long-term debt. When borrowing money, they may be required to hold compensating balances as terms of the loan. In the case of WHX, its annual 10K filing indicates that it intends to retain any future earnings for working capital needs and to finance capital improvements, and it does not intend to pay cash dividends on the common stock for the foreseeable future. In addition, the terms of the companys senior debt places certain limitations on WHXs ability to pay cash dividends. A useful modification to the gross cash to price per share ratio is to subtract the short-term liabilities from cash to establish a net cash per share figure, which provides a better measure of the excess cash on hand. Dividing the net cash per share by the share price indicates how

much of this excess cash is available on a per share basis. In the case of WHX, considering short-term liabilities drops the ratio of cash to price from 105.9% to 32.7%. While this is still a significant number, it paints a different picture than that for Chris-Craft Industries, which manages to maintain a net cash to share price per share ratio of 101.5%. While the mention of the name ChrisCraft may bring the image of boats to mind, the company has reinvented itself into primarily a television broadcaster through its majority owned subsidiary, BHC Communications, which also made the screen as a separate entityhighlighting the problem of double counting when screening. Many of the firms with positive ratios of cash to price per share have negative ratios once short-term liabilities are considered. The effect is especially pronounced with the many airline stocks that passed the initial screen. These firms have heavy capital expenditure requirements and are heavy users of cash in operations. While these companies have made a recent turnaround and the industry is turning profitable after a number of years of running in the red, the high gross cash positions are not significant when screening for cash-rich firms.

Three firms, Temple-Inland, General Motors, and Navistar, do not show a net cash to price per share ratio calculation because they do not maintain clear-cut divisions between current and long-term assets and liabilities. Beyond looking at the static cash positions of these firms, an examination of the actual cash the firm is providing is even more important for a long-term investor. Free cash flow is calculated by taking the cash flow from operations as reported on the firms statement of cash flow and subtracting capital expenditures and dividends. This measure attempts to capture whether the firm is generating enough cash to help fund any necessary internal capital expenditures. Apple, which has a positive cash to price ratio, has a negative ratio of free cash flow per share to market price. It is not generating enough cash from its operations to cover its currently required capital expenditures. Its current position points out the need for the company to determine whether it should jettison some of its product development ideas and focus on those that show the greatest potential. In contrast, another technology firm, Novell, has a lower cash to price ratio, yet has positive net cash to price per share and positive free cash flow to price per share. Novell dominates the network operating systems marketplace for personal computers, but is facing increased competition from vendors such as Microsoft. In the past, Novell has used its built-up cash hoard and excess cash flow to acquire products in an attempt to diversify its product line. It acquired UNIX System Laboratories in 1993, merged with WordPerfect in 1994 and purchased Quattro Pro from Borland in 1994. As is too often the case, things did not go as well as planned. Novell just sold off its WordPerfect and Quattro product lines to Corel and its UnixWare product line to the Santa Cruz Operation, so that it could focus on its primary business unit. The price-earnings ratio is the traditional measure of value and market expectations. The price-earnings ratio is computed by dividing a stocks price by its most recent 12 months earnings per share. The price-earnings ratio is closely followed because it embodies the

markets expectation of future company performance; companies with high price earnings ratios have greater expectation of future performance than those with low ratios. A value investor would typically search for stocks with low price-earnings, with the belief that the market has mispriced the stock. The price-earnings ratios for this group ranges from a low of 4.7 for Mercer International to a high of 55.8 for Astrosystems. Many of the cyclical companies such as Navistar are currently carrying low priceearnings ratios because the market feels that the economys growth potential is limited and these firms would suffer if the economy topped out. So while Navistar currently has a positive free cash flow per share and has a very high earnings growth rate of 25.8% annually over the past five years, its growth potential is limited. The I/B/E/S consensus long-term earnings growth estimate of 5.5% confirms this market view. It is common for cyclicals to carry low price-earnings ratios late into the economic cycle. Many of the companies that passed our initial screen are capital-intensive firms that benefited from operating le-

verage, in which a small boost in sales translates to a larger boost in earnings. Sales growth rates are often used to confirm the strength of earnings per share. The final data element presented in Table 1 shows the 52-week relative strength versus the S&P 500 index; positive figures indicate the percentage that the stock outperformed the S&P 500, and negative numbers indicate the percentage that the stock underperformed the S&P 500. As a whole, this group has performed poorly on a relative basis, with the airline group being the notable exception. The few firms with an na designation have gone public in the last year. Conclusion Screening for cash-rich stocks is not a simple process. Preliminary filters should screen for companies that have not only a high level of cash per share, but also a strong balance sheet, the potential for future earnings growth, and positive free cash flow per share. Much of the final analysis rests on your belief in managements ability to use any cash hoard wisely.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)
Found in the Company Information Group: IND_2_DIG <> 07 IND_2_DIG <> 12 IND_3_DIG <> 0933 Found in the Price and Share Data Group: MKTCAP > 20 PRICE > 5 Found in the Income StatementAnnual Group: EPSCON_12M > 0 Earnings per share from continuing operations for the last 12 months is greater than 0. User Defined Cash to Price per Share or Net Cash to Price per Share is Greater than 20% Cash per Share: Cash_Q1 / Shr_AQ1 Cash to Price per Share: ((Cash_Q1 / Shr_AQ1) / Price) * 100 Net Cash per Share: (Cash_Q1 - CL_Q1)/SHR_AQ1 Net Cash to Price per Share: (((Cash_Q1 - CL_Q1)/SHR_AQ1) / Price) * 100 Found in Balance SheetQuarterly: Cash Q1 Current libilities Q1 Found in Price & Share Data: Shares average Q1 Price Market capitalization in the last quarter is greater than $20 million Price is greater than $5 per share Sector is not equal to Financial Sector is not equal to Utility Industry is not equal to Real Estate Operations

Finding a good company is only half the battle. Buying at a reasonable price is the other.

Investment Techniques: Stock Screening la Peter Lynch

By John Bajkowski
Examining the investment techniques of successful money managers can prove insightful when trying to establish or refine your personal techniques. For this issues Analysts Corner, we explore the techniques of investment manager Peter Lynch and apply a basic stock screen using some of his principles. In his two books, One Up on Wall Street and Beating the Street, Peter Lynch describes the analytical process that led to his success at the helm of Fidelitys Magellan fund. Lynchs Laws Stick with industries and companies you know and understand. Getting ideas is a critical starting point for a bottom-up stockpicker like Peter Lynch. He advocates looking around at companies and products for stock ideas and then performing in-depth analysis to determine if the stock is a buy. This would be contrasted with a top-down approach that starts the analysis with an overall economic forecast that leads to sectors, industries, and finally companies expected to perform well. In looking for ideas, Lynch favors areas that you understand and where your intimate knowledge is a competitive advantage. For example, if you are a pharmacist, use your knowledge to analyze the drug industry. Also notice trends around youis a new store in the mall a hit? If so, investigate it. Leverage your knowledge as a consumer, hobbyist, and professional in your investments. Do your research before investing. Lynch observes that many people follow a hunch or a tip and invest in a company without doing any research. Very often these are the same individuals who spend many hours researching which coffee maker is the best on the market and scouring the papers to discover which store offers the best price. Is it a buy? Finding a good company is only half of the battle in making a successful investment. Buying at a reasonable price is the other. Lynch looks toward both earnings and assets when it comes to valuing stocks. An earnings

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

examination focuses on the ability of the company to earn future income. The greater the earnings prospects, the more valuable the company. Increasing earnings will translate to increasing prices. Assets are important in determining the base value of a company should it be split up and sold off in pieces. Carefully consider the price-earnings ratio. The earnings potential of a company is a primary determinant of company value. At times, the market may get ahead of itself and overprice even a stock with great prospects. The priceearnings ratio helps to keep your perspective in check. The ratio compares the current price to the most recently reported earnings. Stocks with good prospects should sell with higher priceearnings ratios than stocks with poor prospects. How does the price-earnings ratio compare to its historical average? By studying the pattern of price-earnings ratios over a period of several years, you can develop a sense of the normal level for the company. This knowledge should help you avoid buying into a stock if the price gets ahead of the earnings or send an early warning that it may be time to take some profits in a stock you own. If a company does everything well, you may not make any money on the stock if you paid too much for it. How does the price-earnings ratio compare to the industry average? Comparing a companys price-earnings ratio to that of the industry may help reveal if the company is a bargain. At a minimum, it leads to questions as to why the company is priced differently. Is it a poor performer in the industry, or is it just neglected? Lynchs ideal investment is a neglected niche company, controlling a market segment, in an unglamorous industry that would be difficult and time-consuming for a competitor to break into. How does the price-earnings ratio compare to its earnings growth rate? Companies with better prospects should sell with higher price-earnings ratios. A useful valuation technique is to compare the price-earnings ratio to the earnings growth rate. A price-earnings ratio of

Table 1. Low P/E to Earnings Growth Stocks

Modified P/E to EPS Growth () EPS Growth Rate (%) LongTerm Debt to Capital (%) Shares Net Held by Cash per Institutions Share Price (%) ($) ($) Price as % of 52Wk. High (%)

Company (Exchange)

P/E Ratio ()

Dividend Yield (%)

Description

Large Cap (above $1.5 billion)

Intel Corp (NM) General Dynamics (NY) Sun Co (NY) NFC Plc ADR (AM) Magna Intl A (NY) 0.22 0.25 0.37 0.43 0.47 11.1 11.2 13.7 14.8 12.3 49.5 41.3 30.3 31.1 23.9 0.4 3.2 6.3 3.6 2.0 5.4 14.6 26.8 36.6 10.1 73.7 55.9 53.6 0.2 75.3 4.88 12.63 (5.73) (0.24) 0.20 61.50 43.75 28.75 15.38 36.88 83 88 82 72 68 Semicond components & systems Military marine & aircraft Energy resources integrated petro coal Transport, logistics, home delivery serv Automotive components & systems

Medium Cap ($250 million to $1.5 billion)

IP Timberlands (NY) Bowne & Co (AM) Family Dollar Stores (NY) Scitex Corp (NM) Briggs & Stratton (NY) Standard Microsystems (NM) Lattice Semicon (NM) Clarcor Inc (NY) Instrument Systems (NY) Rayonier Timberlands (NY) Ballard Medical Prods (NY) XTRA Corp (NY) Lancaster Colony (NM) Church & Dwight (NY) Weatherford Intl (AM) Champion Enterprises (AM) 0.14 0.16 0.28 0.28 0.30 0.30 0.32 0.33 0.35 0.35 0.37 0.37 0.43 0.47 0.47 0.48 4.1 7.8 9.6 14.0 9.9 11.8 15.3 15.2 10.6 6.5 15.3 17.8 17.8 18.0 20.0 14.1 18.1 45.3 31.0 48.0 30.4 38.8 47.2 42.7 30.4 4.3 41.4 46.4 40.2 36.5 42.8 29.1 11.6 2.0 3.0 2.3 2.6 0.0 0.0 3.1 0.0 14.3 0.5 1.1 1.4 1.9 0.0 0.0 0.2 4.3 0.0 0.1 15.7 6.0 0.0 19.0 12.6 32.8 0.0 51.1 12.2 4.3 6.3 5.7 1.2 53.3 64.7 29.7 71.6 40.6 68.2 52.2 45.7 0.2 38.1 63.1 73.1 47.0 65.0 36.7 0.20 0.53 0.11 6.39 10.09 1.96 5.65 (1.18) 0.77 0.00 0.94 na (0.07) (0.04) (0.83) 1.07 24.88 18.00 11.38 22.50 70.25 19.88 18.50 20.25 7.88 35.25 10.38 51.25 35.00 23.00 12.38 39.25 80 63 62 84 78 74 75 90 81 88 56 96 89 79 84 99.04 Forest resource management Finance & corporation printing Operates discount stores Computer imaging systems Mfrs air cooled engines & auto locks Mfrs semiconductor circuits Programmable logic devices Mobile & environl filtration prods Mfrs diversified instruments Marketing, sale of timber Disposable medical products Tractor-trailer, cargo contain leasing Mfrs food and auto products Mfrs, mkts soap & cleaning prods Equip for petroleum industry Holding co, Champion Home Builders

Shadow Stocks (small firms with lower institutional interest)

Norex America (AM) Huffman Koos (NM) SBE Inc (NM) Diodes Inc (AM) CCA Industries (NM) Shelter Components (AM) Genovese Drug (AM) Prima Energy (NM) Comcoa Inc (NM) Craftmade Intl Inc (NM) Jennifer Convertible (NM) Methode Electronics B (NM) Refac Technology Devlp (AM) Xscribe Corp (NM) Western Beef (NM) Jones Medical Indus (NM) Prime Medical Corp (NM)
na = not available

0.08 0.17 0.22 0.26 0.27 0.28 0.35 0.35 0.37 0.42 0.42 0.48 0.48 0.48 0.49 0.50 0.50

1.8 6.4 9.1 11.7 11.0 9.2 11.6 11.8 12.0 15.1 13.6 20.0 9.9 10.7 10.6 11.6 12.0

21.7 37.2 40.8 45.1 41.4 32.2 30.9 33.8 32.8 36.1 32.5 41.0 20.5 22.1 21.6 22.1 24.1

0.0 0.0 0.0 0.0 0.0 0.4 2.2 0.0 0.0 0.2 0.0 0.5 0.0 0.0 0.0 1.3 0.0

14.6 18.7 0.0 3.6 7.1 28.4 0.0 6.0 0.0 0.0 0.4 0.0 0.0 7.2 17.4 1.6 7.4

1.4 12.8 15.9 5.4 11.2 58.4 14.2 8.3 6.4 22.7 7.2 11.6 17.6 8.0 9.4 27.6 6.9

(6.41) na na 0.22 0.84 (2.14) (3.44) na 0.28 0.03 2.19 1.13 2.75 na (0.80) (0.08) na

9.25 7.75 7.50 5.50 4.38 12.00 11.00 13.75 14.00 10.44 7.75 20.00 7.13 2.56 7.50 7.75 3.13

82 86 60 55 48 73 79 81 89 84 48 100 60 44 52 44 86

Mkts, provides leisure cruises Specialty furniture retailer Designs, sells computer hardware Semiconductor devices Makes specialty cosmetic products Mfrs, sells, distrib prods for houses Drug store chain in NYC Explor, devlp, prod oil & gas Rent-A-Center Designs, distrib, mkts ceiling fans Sells sofabeds Mfrs electronic component devices Administers intl technology licenses Hard-, software for computer-aided systems Wholesale meat and poultry Prod branded & generic ethical drugs Estab & mgmt of cardiac rehab centers

Exchanges: NY= New York Stock Exchange AM= American Stock Exchange NM= Nasdaq National Market NS= Nasdaq Small Cap Sources: Stock Investor/Media General; S&P Stock Guide. All data as of September 30, 1994.

Definitions of Screens and Terms

The following is a short description of the screens and terms used in the table.
Modified P/E to EPS Growth: Current price-earnings ratio divided by the sum of the historical earnings growth rate and dividend yield. Ratios below 0.5 are considered attractive. Ratios above 1 are considered poor. P/E Ratio: Market price per share divided by most recent 12 months earnings per share. A measure of the markets expectations regarding the firms earnings growth and risk. EPS Growth Rate: Annual growth in earnings per share from total operations over the last five fiscal years. A measure of how successful the firm has been in generating the bottom line, net profit. Dividend Yield: Indicated annual dividend divided by market price. Long-Term Debt to Capital: Long-term debt divided by the total of long-term debt and preferred and common equity. Provides a measure of the financial strength of the company. The lower the figure, the stronger the balance sheet. Shares Held by Institutions: Percentage of shares outstanding that are held by institutions. Provides an indication of the level of Wall Street interest in the stock. Net Cash per Share: The total of all cash and cash equivalents less longterm debt, divided by the number of shares outstanding. Provides an indication of the financial strength of the company and a support for the stock price. Price: Most recent market price as of September 30, 1994. Price as % of 52-Wk. High: Most recent market price divided by highest market price over the last 52 weeks.

half the level of historical earnings growth is considered attractive, while ratios above two are considered unattractive. Lynch refines this measure by adding the dividend yield to the earnings growth. This adjustment acknowledges the contribution that dividends make to an investors return. The ratio is calculated by dividing the price-earnings ratio by the sum of the earnings growth rate and the dividend yield. With this modified technique, ratios above one are considered poor, while ratios below 0.5 are considered attractive. How stable and consistent are the earnings? It is important to examine the historical record of earnings. Stock prices cannot deviate very long from the level of earnings, so the pattern of earnings growth will help to reveal the stability and strength of the company. Ideally, earnings should move up consistently. Avoid hot companies in hot industries. Lynch prefers to invest in companies with earnings expanding at moderately fast rates (20% to 25%) in non-growth industries. Extremely high levels of earnings growth rates are not sustainable, but continued high growth may be factored into the price. A high level of growth for a company and industry will attract a great deal of attention from both investors, who bid up the stock price,

and competitors, who provide a more difficult business environment. What is the level of institutional holdings? Lynch feels that the bargains are located among the stocks neglected by Wall Street. The lower the percentage of shares held by institutions and the lower the number of analysts following the stock, the better. How large is the firm? Small firms have more upside potential than large firms. Small firms can easily expand in size while large firms are limited. A small firm like Starbucks can double in size much more easily than a large firm such as General Electric. How strong is the balance sheet? A strong balance sheet provides maneuvering room as the company expands or experiences trouble. Lynch is especially wary of bank debt, which can usually be called in by the bank on demand. What is the level of net cash per share? Lynch likes to look at the net cash per share to help discover both a support for the stock price and the financial strength of the company. The net cash per share is calculated by adding the level of cash and cash equivalents, subtracting the long-term debt, and dividing the result by the number of shares outstanding. Are insiders buying the stock? Insider buying of shares is a positive sign,

especially if it is spread among a number of individuals. While insiders may have many reasons for selling holdings, they generally buy stock when they feel it is an attractive investment. Is the company buying back shares? Lynch favors companies that buy back their shares over companies that choose to expand into unrelated businesses. Share buybacks become an issue once companies start to mature and have cash flow that exceeds their capital needs. The share buyback will help to support the stock price and is usually performed when management feels that the current stock price is favorable. Applying the Lynch Screen While Peter Lynch is a bottom-up, kick-the-tires type of stockpicker, some of his principles are useful screening criteria. Our first screen excluded financial firms. Peter Lynch is a big fan of financial stocks and presents a series of screens he uses to help select banks and savings and loans in Beating the Street. We had to exclude them from the general screen, however, because their financial statements cannot be directly compared to other firms. AAIIs Stock Investor program was used to perform the screen and we were left with 5,751 non-financial companies out of a

Stock-Picking Checklist
Invest only in industries and companies you understand and know the specific reason that you are buying the stock How does the price-earnings ratio compare to the growth rate in earnings and dividends? How does the price-earnings ratio compare to its historical average? How does the price-earnings ratio compare to the industry? How stable and consistent are the earnings?

Rules

Your analysis should center on the factors that will move the stock price. Look for low P/Es compared to earnings growth and dividend yield Look for P/E in lower range of historical average Look for P/E below industry average Study the pattern of earnings, especially how they reacted during a recession. Look for a low level of debt, especially bank debt Net cash per share should be high relative to stock price Be wary of earnings growth rates above 50% Small companies should be favored in your search, they have more upside potential Look for low percentage of shares held by institutions and number of analysts following stocks Insider buying by a number of insiders is a positive sign If so, this will support the stock price and probably indicates the company has been ignored, but management is confident

How strong is the balance sheet? What is the cash position? Avoid hot companies in hot industries Big companies have small moves, small companies have big moves. What is the level of institutional holdings?

Are insiders buying stock? Is the company buying back shares?

total of 8,123 stocks. Price-earnings ratios are an important aspect to Lynchs analysis and make an excellent primary screen. Our screen used the ratio of price-earnings to the earnings growth rate plus the dividend yield. A ratio less than or equal to 0.50 was specified as a cut-off, leaving 441 companies. Lynch is wary of companies growing too quickly, so the next filter specified a maximum earnings per share growth rate of 50%. The number of firms passing this filter was 258. The final filter required that the longterm debt-to-capital ratio for each company be less than its industry average, leaving 125 firms. The screens we applied seemed to favor smaller firms. Of the 125 firms that passed the screen, only five were large-cap stocks16 were mediumcap, and 104 were small-cap. All of the large- and medium-cap firms that passed the filter are shown in Table 1, ranked in ascending order by the modified price-earnings to growth ratio. Within the small-cap area, 17 of the stocks passing the screens were

Shadow Stocks, and these are presented in Table 1. Most of the companies passing the screens had relatively low price-earnings ratios when compared to the current market level of 18.0. The historical growth rates, however, were well above average, with many ranging between 30% and 40% per year. These are historical growth rates and are not sustainable for a long period of time; some are due to special situations. General Dynamics growth rate of 41.3% was due to a one-time earnings boost in 1993. Looking only at earnings from continuing operations and the yearby-year earnings figures would present a better picture of earnings growth and consistency. The dividend yield for two of the securitiesIP Timberlands and Rayonier Timberlandsshould clue an investor in to a special situation. Both of the securities are limited partnerships created to manage the lumber resources of International Paper and Rayonier, respectively. These are partnerships structured with finite lives and they highlight the importance of in-

depth analysis after any basic screen. The ratio of long-term debt to capital is generally lower for the Shadow Stocks than for the medium- and large-cap stocks. Small-cap stocks have a more difficult time raising capital through the bond market than larger stocks and often turn to banks for capital. A close examination of the financial statements, especially in the notes to the financial statement, should help to reveal the use of bank debt. A large number of the listed companies in Table 1 have very high percentage of shares held by institutions, a negative in Lynchs opinion. Net cash per share highlights a potential hidden asset for a number of companies and is of greater interest for companies that are distressed, turnaround potentials, or asset plays. Only a basic level of screening was performed when presenting the Lynchbased screens. Much of the analysis advocated by Peter Lynch is subjective in nature, requiring hands-on analysis. As Peter Lynch stresses, it is possible to succeed at investing, but you must be willing to do your work.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)

Exclude financial stocks Found in the Company Information Group Ind_2_Dig <> 07 Ind_3_Dig <> 0933 Sector is not equal to Financial Industry is not equal to Real Estate Operations

Low price-earnings ratio in comparison to the growth rate in earnings plus the dividend yield Found in User-Defined Group Yield Adjusted PE to Growth Ratio < 0.5 Yield Adjusted PE to Growth Ratio > 0.0 PE / (EPSCon_G5F + Yield) Be wary of earnings growth rates above 50% Found in Growth Rates Group EPSCon_G5F < 50 Five-year earnings per share growth from continuing operations is less than 50% Look for a low level of debt, especially bank debt Found in Ratios Group LTD_TC_Q1 < INDUSTRY.LTD_TC_Q1 (N) or TL_TA_Q1 < INDUSTRY.TL_TA_Q1 (N) Tot Liab / Assets Q1 is less than that of the narrow industry group median LT Debt / Tot Cap Q1 is less than that of the narrow industry group median Yield Adjusted PE to Growth Ratio between 0.0 and 0.5 Calculation of the Yield Adjusted PE to Growth Ratio PE divided by the sum of EPS Cont-Growth 5yr and the current Dividend Yield

Optional Criteria Not Used in Screen Look for PE in lower range of historical average Found in Multiples Group PE < PE_A5Y Look for PE below industry average Found in Multiples Group PE < INDUSTRY.PE (N) Look for low percentage of shares held by institutions Found in Price & Share Data Group ShrInst < 28.3 Instl Ownership is low compared to average or median displayed when selecting field PE is less than that of the narrow industry group median PE less than PE-Avg 5yr

Using all the rules can be very restrictive and sometimes contradictory. But it is hard to argue with screens that try to find neglected stocks on the verge of a turnaround.

Stock Market Winners: Applying the Rules in Todays Environment

By John Bajkowski
In September 1989 the AAII Journal published an article by Marc Reinganum, titled Investment Characteristics of Stock Market Winners, which examined the common traits of a group of winning stocks. These types of examinations can be noteworthy if they help to establish financial relationships likely to hold true over time. The study examined 222 stocks highlighted as winners in a publication by William ONeil & Co. titled The Greatest Stock Market Winners: 1970-1983. The goal was to establish the characteristics common to these stocks prior to their rise to super stock status. Nine trading rules were developed that helped to identify the winners: Price-to-book-value ratio less than 1.00; Accelerating quarterly earnings; Positive five-year growth rate; Positive pretax profit margin; Relative strength rank of at least 70; Relative strength rank of the stock in the current quarter is greater than the rank in the previous quarter; ONeil Datagraph rating of at least 70; Stock selling within 15% of its maximum price during the previous two years; and Fewer than 20 million common shares outstanding. The use of these rules or screening criteria produced returns significantly higher than the market. While the group of stocks passing the filter were slightly more risky than the market, the additional risk did not account for the extraordinary returns of the winners. There can be problems encountered when trying to apply trading rules determined during a specific point in time with a specific group of stocks. This article discusses some of the difficulties in trying to interpret and apply these rules in the real market environment. Low Price-to-Book-Value When examined independently, the first screen requiring that the price-tobook-value ratio be below one produced the highest rate of return. This finding coincides with many studies that

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

show that buying into neglected, out of favor stocks leads to investment success. While the market does a good job of valuing securities in the long-run, in the short-run it can overreact to information and push the prices away from their true value. Measures such as priceto-book-value ratio, price-earnings ratio, and dividend yield help to identify which stocks may be truly undervalued. The price-to-book value ratio is determined by dividing market price per share by book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represents the value of the owners equity based upon the historical accounting activities. If accounting truly captured the current values of the firm, then one would expect the current stock price to sell near this accounting book value. Over the history of a firm, many events occur which can distort the book value figure. For example, inflation may leave the replacement cost of capital goods within the firm way above their stated book value, or the purchase of a firm may lead to the establishment of goodwill, which is an intangible asset boosting the level of book value. Some services are more conservative in reporting book value and may subtract out the value of intangibles such as patents, copyrights, trademarks, or goodwill. Of course it makes these values incomparable with services that include intangibles. Different accounting policies among industries may also come into play when screening for low price-to-book stocks. AAIIs Stock Investor program was used to screen for the potential stock market winners. The first screen specified a price-to-book ratio below 1.5, leaving 2,501 companies out of a complete database of 8,145 NYSE, Amex, Nasdaq National Market, and Nasdaq Small Cap stocks. The maximum price-to-book ratio level is higher than the original study so that a slightly larger group of companies would pass the complete set of filters. As a primary screen, specifying a price-to-book ratio below 1.0 led to about 14% of the companies pass-

Table 1. Stock Market Winners Screen

Price-to BookValue Ratio () Quarterly Earnings Per Share Second Quarter* First Quarter* 1994 1993 1994 1993 ($) ($) ($) ($) Annual EPS Relative Price as No. of Growth Strength % of 52Shares Rate Rank Wk High Outstanding (%) (%) (%) (mil)

Company (Exchange)

Description

Concord Fabrics A (AM) Canandaigua Wine B (NM) Dynamics Corp of Amer (NY) TSR Inc (NM) Bindley Western (NM) Oglebay Norton (NM) Kings Road Entertainment (NS) FDP Corp (NM) Schultz Sav-O-Stores (NM) FRP Properties (NM) Elmers Restaurants (NS) Bell Industries (NY) Windmere Corp (NY) Nortek Inc (NY) Ropak Corp (NM) Univ Health Services B (NY)

0.47 0.53 0.76 0.78 0.90 0.99 1.05 1.18 1.18 1.20 1.21 1.33 1.35 1.36 1.37 1.44

0.55 0.41 0.45 0.10 0.34 2.75 0.07 0.04 0.54 0.35 0.05 0.57 0.57 0.44 0.53 0.57

0.36 0.29 0.18 0.04 0.30 1.12 0.03 0.01 0.45 0.17 0.01 0.33 0.08 0.12 0.41 0.46

0.60 0.35 0.24 0.07 0.33 (0.06) 0.03 0.03 0.41 0.16 0.02 0.33 0.03 0.06 (0.06) 0.72

0.48 0.25 0.16 0.00 0.30 (0.83) (0.05) (0.03) 0.35 0.12 (0.01) 0.22 0.02 (0.11) (0.11) 0.60

6.5 54.2 4.1 39.6 15.8 10.5 20.8 35.1 12.6 8.4 12.5 3.0 5.2 24.6 39.3 28.9

89 86 83 87 86 90 81 92 77 90 93 83 76 93 92 92

87 98 99 89 97 100 86 94 100 89 94 98 94 87 93 97

2.1 3.4 3.9 1.5 10.8 2.5 5.3 3.4 2.6 4.0 1.8 6.3 17.9 12.5 4.3 13.1

Devlps, designs fabrics Makes dessert, table, & sparkling wines Mfgs & sells electronic devices Operates IBM computer systems Wholesales ethical pharmaceuticals Lakes shipping: mining & manufacturing Devlp, produc, finance motion pictures Software to market life insurance prods Regional food retailer and wholesaler Regulated carrier, real estate Owns, operates, sells restaurant franchises Distribs, mfrs electronic components Imports & markets personal care prods Mfrs commercial & residential bldg prods Prod plastic shipping containers Owns, operates acute care hospitals

*calendar quarters Exchanges: NY = New York Stock Exchange; AM = American Stock Exchange; NM = Nasdaq National Market; NS = Nasdaq Small Cap

Source: Stock Investor/Media General. All data as of August 31, 1994.

ing the filter, versus about 30% passing the 1.5 price-to-book-value limit. Valuation levels of stocks vary over time, often dramatically from bear market bottoms to bull market tops. During the depths of a bear market, many firms can be found selling for a priceto-book ratio less than one. In the latter stages of a bull market, few companies other than troubled firms sell for less than book value per share. Earnings Momentum The low price-to-book screen is very good at identifying neglected firms, but secondary, or conditioning, screens are also needed to help identify which stocks may be poised for a turnaround. Quarterly earnings per share for winners rose on average 46% in the original study and exhibited an increase from the previous quarters growth rate. Accelerating earnings attract attention, and may be one of the first signs that a company is poised for an upturn. The earnings measure used in the original study was somewhat crude in

that it did not consider the seasonality of quarterly earnings. A more useful technique is to compare one quarter to the same quarter last yeari.e., this years second quarter is compared to last years second quarter. Many firms have annual seasonal cycles, either in production or sales. Comparing similar quarters is one way of taking these seasonal changes into consideration. In our screen, earnings from continuing operations for the most recent two quarters were required to be above their respective quarters last year. This dropped the number of companies down to 824 from the 2,501 passing the low price-to-book-value screen. To emphasize momentum or acceleration in quarterly earnings, the next criterion specified that the rate of change between the recent quarter and its counterpart last year be greater than the increase between the previous quarter and its counterpart. This momentum screen dropped the number of passing companies down to 383. Table 1 presents the quarterly earnings per share figures used for the

screening. Looking at the raw data can assist in judging the significance of any decisions based upon percentage changes. For example, very small earnings figures can lead to distorted growth rates. Elmers Restaurant experienced a 400% increase in its latest quarter over the same quarter a year ago, but this increase was based upon a change in earnings per share from one cent to five cents. Minimum Fundamentals As further proof that a companys fortunes have turned around, the next two criteria specified a minimum level of company fundamental performance. The first criterion required that the five-year annual growth rate in earnings per share be positive. Applying this criterion cut the number of firms down to 140. In the original study, the five-year growth rate was based upon the most recent five years of quarterly data. The growth rates used in the screening are based upon the firms fiscal-year data, which will not show

Definitions of Screens and Terms

The following is a short description of the screens and terms used in the table. Price-to-Book-Value Ratio: Market price per share divided by book value (assets less liabilities) per share. A measure of stock valuation relative to net assets. A high ratio might imply an overvalued situation; a low ratio might indicate an overlooked stock. Quarterly Earnings per Share: Net income from continuing operations of a firm divided by the number of common stock shares outstanding. Second Quarter 1994: Earnings per share for the most recent quarter. Second Quarter 1993: Earnings per share four quarters ago. Provides a comparison for the latest quarters earnings per share. First Quarter 1994: Earnings per share one quarter ago. First Quarter 1993: Earnings per share five quarters ago. Provides a comparison figure for this years first quarter earnings per share. Comparison of quarterly earnings helps to provide an indication of accelerating earnings. Annual EPS Growth Rate: Annual growth in earnings per share from continuing operations over the last five fiscal years. A measure of how successful the firm has been in generating the bottom line, net profit. Relative Strength Rank: Relative price change, computed here with the most recent quarterly price change given a weight of 40% and the three previous quarters each weighted 20%. The weighted price change is then compared to other stocks over the same time period. Price as % of 52-Wk High: Most recent market price divided by highest market price over the last 52 weeks. No. of Shares Outstanding: Total number of shares of stock held by shareholders. Provides an indication of the trading liquidity of the firm.

intra-year turnaround as quickly as the trailing quarterly data. The second criterion required that the pretax profit margin be positive. This is determined by taking sales and subtracting cost of goods sold, operating expenses, interest expenses, and depreciation and amortization, and dividing the result by sales. The gross profit margin was substituted and is calculated by subtracting cost of goods and operating expenses from sales and dividing the result by sales. The gross operating margin is not as stringent as the pretax profit margin used in the original study, but it captures much of the same effect. It represents the type of compromise often necessary when implementing a screening strategy. Requiring a positive gross profit margin brought the number of companies down to 87. Requiring a positive five-year earnings growth rate or a positive gross operating profit margin by themselves are not very restrictive criteria. However, they help to screen out some of the very weak firms that have some time to go before turning around, if ever. It is interesting to note that fundamental measures such as profit margins rose substantially during the major

price moves. Requiring a high profit margin as a screening criterion would mean missing at least part of this major price advancement. Price Momentum The next set of criteria help to identify stocks that have already shown upward price movement. Patience is required when selecting stocks using purely contrarian rules. It often takes time for the market to recognize value in the firm. The study indicated that technical measures such as strong and improving relative strength, a current stock price near its high, and a high Datagraphs ranking, point to stocks likely to advance further. The weighted relative strength ranking was the primary price momentum indicator used in the study. The weighting required that the most recent quarterly price change be given a weight of 40% and the previous three quarters each weighted 20%. The weighted price changes were then ranked for all the stocks and the relative position indicated via percentage rank. Stocks with a 90% relative strength rank had a weighted price change better than 90% of all the firms.

The study indicated that the winners had relative strength rank of 70% or better before their main price move. When this criterion was applied it reduced the number of companies to 33. The study also indicated that it is best if relative strength rank also increased from the previous quarter. While this further screen was not applied to narrow the data set, this is the type of variable that could be investigated after the screening process. The other price-based screening criterion developed in the study required that the current price be within 15% of the high price for the last two years. This rule reinforces the requirement of price strength. In applying this screen, the 52-week high was used in place of the two-year high. The 52-week high screen is not as strict but the 52-week high is more readily available for most stocks. When applied to our list of stocks it cut the number of firms down to 16, as shown in Table 1. The original study was performed using the Datagraph books (published by William ONeil and sold primarily to institutional investors), which include both fundamental and technical data. It was found that the winners usually had a high Datagraph rating in the buy quar

ter. The Datagraph rating uses a proprietary weighting mix for reported earnings, capitalization, sponsorship, relative strength, price-volume characteristics, group rank and other factors. Since most individuals will not have access to this charting and data service, it was not used in the screen. It is worth noting, however, that the other rules seem to reflect much of the information contained within the Datagraph rating. Limited Float This criterion examines the number of shares outstanding, often termed the float. The study found that 90% of the firms had fewer than 20 million shares outstanding before their main price rise.

The midpoint or median figure was 5.7 million shares, which doubled during the two years that each winning stock was held. This probably indicates many of the firms split their shares during their big price increase. Some investors look for a stock to have a limited float with the belief that the price move on positive information will be magnified by a limited number of shares available. Applying this screening criterion did not cause any firms to drop out. It seems that in todays market the other screening criteria did a good job of filtering out the larger firms that have more shares outstanding. The list of stocks passing all the screens is presented in Table 1. They are ranked on the price-to-book-value

ratio. The list represents a diverse set of relatively small firms. Like all screens, this list provides a beginning point for further in-depth analysis. Conclusion Examining the characteristics of past stock market winners might prove interesting. But using all of the rules may lead to a very restrictive screen in the present. Screens can also be in some ways contradictory. In this case, there is a strong price-to-book neglect screen tied to look-at-me earnings and stock price movements. But it is hard to argue with screens that try to find neglected stocks on the verge of a fundamental and technical turnaround.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)
Weighted relative strength rank of at least 70 Found in User-Defined Group Weighted Rel Strenth > X Weighted Relative Strength greater than value which returns only 30% of companies

Note: Try different values for X until 30% of companies pass. For example with a database size of 7,000 companies X should be varied until about 2,100 companies pass screen. Calculation of the Weighted Relative Strength Weighted Relative Strength = (Price Change Q1 * 40%) + (Price Change Q2 * 20%) + (Price Change Q3 * 20%) + (Price Change Q4 * 20%) ((Price/Price_Q2 - 1)*40) + ((Price_Q2/Price_Q3 - 1)*20) + ((Price_Q3/Price_Q4 - 1)*20) + ((Price_Q4/Price_Q5 - 1)*20) Low price-to-book-value ratio Found in Multiples Group PBVPS < 1.5 Accelerating quarterly earnings Found in Income Statement - Quarterly Group: EPSCon_Q1 > EPSCon_Q5 EPSCon _Q2 > EPSCon _Q6 Found in User-Defined Group Percent change between the recent quarter and its counterpart last year be greater than the percent change between the previous quarter and its counterpart Q1/Q5 EPS Change > Q2/Q6 EPS Change EPS Change greater than Q2/Q6 EPS Change Q1/Q5 EPS Change = (EPS Cont Q1 / EPS Cont Q5 - 1) * 100 (EPSCon_Q1/EPSCon_Q5 - 1)*100 Calculation of the User-Defined FieldQ1/Q5 EPS Change EPS Cont Q1 greater than EPS Cont Q5 EPS Cont Q2 greater than EPS Cont Q6 Price/Book is less than 1.5 (Note: original study required a more restrictive 1.0)

Q2/Q6 EPS Change = (EPS Cont Q2 / EPS Cont Q6 - 1) * 100 (EPSCon_Q2/EPSCon_Q6 - 1)*100 Positive five-year growth rate Found in Growth Rates Group EPSCon_G5F > 0 Five-year earnings per share growth from continuing operations is greater than 0% Calculation of the User-Defined FieldQ2/Q6 EPS Change

Positive profit margins (Note: This was changed from the pre-tax margin in the original study) Found in Ratios Group NPM_12M > 0 or GPM_12M > 0 Stock Selling within 15% of its maximum price Found in User-Defined Group Price as % of 52wk high => 85 Calculation of the Price as % of 52wk high (Price/PriceH_52W)*100 Fewer than 20 million common shares outstanding Found in Price & Share Data Group Shr_AQ1 <= 20 Shares Average Q1 less than or equal to 20 million Price as % of 52wk high = (Price / Price high 52W) * 100 Price as % of 52wk high greater than or equal to 85% Gross Margin 12m greater than zero Net Margin 12m greater than zero

Earnings estimates embody the expectations that are built into a stock price. Tracking these expectations and their changes can be a rewarding strategy.

Analyzing the Analysts: Stock Valuation and Earnings Revisions

By John Bajkowski
Investors quickly learn that the market is forward-looking. Security prices are established through expectations, and prices change as these expectations change or are proven incorrect. In the last 10 years, we have seen a significant increase in the services that track and analyze expected earnings per share estimates. Services such as I/B/E/S, Nelsons, Standard & Poors, and Zacks provide consensus earnings estimates by tracking the estimates of thousands of investment analysts. Tracking these expectations and their changes is an important and rewarding strategy for stock investors. [See the Stock Investing Basics column starting on page 27 for sources of earnings estimates.] In using earnings estimates, the first rule to keep in mind is that the current price usually reflects the consensus earnings estimate. It is common to see price declines for stocks that report earnings increases from the previous reporting period because in many cases, while the actual earnings represent an increase, the increase is not as great as the market had expected. Earnings surprises occur when a company reports actual earnings that differ from consensus earnings estimates. During the earnings reporting season, financial newspapers such as the Wall Street Journal provide daily reports on earnings announcements. Firms with significant earnings surprises are often highlighted. Positive earnings surprises occur when actual reported earnings are significantly above the forecasted earnings per share. Negative earnings surprises occur when reported earnings per share are significantly below the earnings expectations. The stock prices of firms with significant positive earnings surprises show above average performance, while those with negative surprises have below average performance. Changes in stock price resulting from an earnings surprise can be felt immediately, and the surprise also has a long-term effect. Studies indicate that the effect can persist for as long as a year after the announcement. This

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

means that it does not make sense to buy a stock after the initial price decline of a negative earnings surprise. There is a good chance that the stock will continue to underperform the market for some time. It also indicates that it may not be too late to buy into an attractive company after a better than expected earnings report is released. Not surprisingly, large firms tend to adjust to surprises more quickly than small firms. Larger firms are tracked by more analysts and portfolio managers, who tend to act quickly. Firms with a significant quarterly earnings surprise also often have earnings surprises in subsequent quarters. When a firm has a surprise, it often is a sign that other similar surprises will follow. This is sometimes referred to as the cockroach effectlike cockroaches, you rarely see just one earnings surprise. Revisions to earnings estimates lead to price adjustments similar to earnings surprises. When earnings estimates are revised significantly upward5% or morestocks tend to show above average performance. Stock prices of firms with downward revisions show below average performance. Changes in estimates reflect changes in expectations of future performance. Perhaps the economic outlook is better than previously expected, or maybe a new product is selling better than anticipated. Revisions are often precursors to earnings surprises. As the reporting period approaches, estimates normally converge toward the consensus. A flurry of revisions near the reporting period can indicate that analysts missed the mark and are scrambling to improve their estimates. Table 1 represents the results of a screen for firms with significant earnings estimate revisions. AAIIs Stock Investor, which contains earnings estimates from I/B/E/S, was used to perform the screening. About half of the 8,000 securities in Stock Investor include earnings estimates. The first screen filtered out those firms with less than four estimates for the current fiscal year. This filter helps to ensure that revisions actually reflect a change in general con-

Table 1. Firms with Upward Revisions in Earnings Estimates

I/B/E/S EPS Estimate 7/1 7/29 Change ($) ($) (%) No. of Estimates No. of Revisions Up in Mo. EPS Estimate Range High Low ($) ($) Price Change Last Qtr. Last Yr. (%) (%)

Company (Exchange)

Description

Large Cap (above $1.5 billion)

Alcan Aluminum Ltd (NY) U.S. Cellular (NY) Intl Business Machines (NY) Southern Pacific Rail (NY) Tandem Computer (NY) General Instrument (NY) Inland Steel (NY) Coca Cola Enterprises (NY) Georgia Gulf (NY) Apple Computer (NM) Dana Corp (NY) Aluminum Co of Amer (NY) Genentech Inc (NY) Lyondell Petroch (NY) Eastman Chemical (NY) 0.05 0.08 3.03 0.85 1.00 2.61 1.60 0.31 1.70 1.45 2.00 1.37 1.00 1.13 2.78 0.08 0.12 4.00 1.00 1.15 3.00 1.82 0.35 1.90 1.60 2.20 1.50 1.09 1.23 3.00 60 50 32 18 15 15 14 13 12 10 10 9 9 9 8 31 9 23 9 15 13 20 13 15 33 13 24 16 12 13 5 2 20 5 7 7 8 5 9 15 9 4 6 4 4 0.55 0.30 4.80 1.15 1.33 3.20 2.25 0.42 2.50 1.80 2.30 2.10 1.18 1.62 3.30 (0.35) (0.28) 3.45 0.80 0.95 2.50 1.19 0.20 1.50 1.11 1.55 1.00 0.90 0.45 2.55 17 9 8 (10) 17 12 13 (6) 24 12 6 15 1 2 16 24 (0) 39 na 34 45 48 15 95 21 4 10 16 38 na Produces aluminum Own, oper cellular phone systems Mfrs business machines & computers Oper freight railroad network in the West Disk drive & microcomputer system Systems, equip to cable & satellite TV indus Integ steel & steel serv Soft drink distributer Prod commodity chemicals Computer systems, tech application Manufactures parts for auto industry Aluminum production; finished aluminum prod Devlp health care prods using gene splicing Integrated petrochemical & petroleum processor Chemical co spin-off of Eastman Kodak

Medium Cap ($250 million to $1.5 billion)

ASARCO Inc (NY) Read-Rite Corp (NM) Amdahl Corp (AM) Cobra Golf (NM) Tencor Instruments (NM) NACCO Industries (NY) Cyrix Corp (NM) VLSI Technology (NM) Novellus Systems (NM) Quantum Corp (NM) Magma Copper (NY) Modine Mfg (NM) Oak Industries (NY) Robert Half (NY) Regal-Beloit Corp (AM) 0.05 0.07 0.30 1.48 1.10 3.55 1.50 0.89 2.00 2.73 0.75 1.65 1.48 1.50 1.83 0.15 0.12 0.40 1.80 1.33 4.23 1.78 1.04 2.33 3.18 0.87 1.90 1.70 1.70 2.06 200 71 33 22 21 19 19 17 17 16 16 15 15 13 13 13 5 15 4 4 4 7 15 12 12 16 8 5 4 4 3 2 2 4 2 2 5 10 8 6 3 5 4 3 4 1.30 0.15 0.65 1.85 1.60 4.60 1.85 1.10 2.35 4.00 1.45 1.95 1.79 1.73 2.10 (1.50) 0.06 0.00 1.52 1.00 3.50 1.50 0.88 2.00 2.60 (0.28) 1.55 1.50 1.60 2.05 21 10 2 23 21 10 44 3 1 (7) 13 5 18 22 2 53 38 31 na 108 8 43 23 44 47 44 36 (5) 84 35 Prod silver, copper, lead Magnetic recording head for disk drive Computers, software, communicn systems Designs, mfrs, mkts golf clubs Water defect inspection systems Mines/mkts lignite & bituminous coal IBM-comp microprocess/coprocess Designs, mkts integrated circuits Chemical vapor deposition equip Rigid disk drives Owns/oper copper mines Mfrs, sells heat transfer equip Mfrs electronic controls & circuits Personnel placement services Makes cutting tools, taps, dies, reamers

Small Cap (below $250 million)

Coho Energy (NM) Arkansas Best (NM) Alaska Air Group (NY) Network Equip (NY) Tultex Corp (NY) Redman Industries (NM) Hauser Chemical Research (NM) Dura Pharmaceuticals (NM) Conmed Corp (NM) SPX Corp (NY) Nuevo Energy (NY) Loyola Capital (NM) Sullivan Dental Products (NM) Foothill Group A (NY) Transmedia Network (NM)
na = not available

0.07 0.50 0.85 0.40 0.25 2.05 0.20 0.11 1.02 1.10 0.70 1.53 0.80 1.56 0.43

0.10 0.60 1.00 0.45 0.28 2.28 0.22 0.12 1.10 1.18 0.75 1.63 0.85 1.64 0.45

43 20 18 13 12 11 10 9 8 7 7 7 6 5 5

4 5 16 7 9 4 4 4 5 10 9 4 5 4 4

1 2 6 3 1 2 1 2 2 4 1 2 2 4 1

0.18 0.68 1.85 0.65 0.40 2.50 0.25 0.14 1.20 1.60 1.25 1.70 0.93 1.69 0.48

0.03 0.40 0.47 0.40 0.25 2.02 0.03 0.10 0.75 1.05 0.57 1.55 0.80 1.60 0.36

22 (4) 4 14 (5) 8 (12) 29 0 15 6 12 10 5 (11)

(28) 39 28 25 (41) na (56) 121 10 5 (16) 59 (23) 17 78

Explor, devlp oil & natural gas Ship general commodities U.S. & Alaska airline service Advanced communications prods Mfrs sportswear & yarn Producer of manufactured homes Petrochemical analytical serv Specialty pharmaceutical concern Mfg of disposable medical devices Automotive components & serv prods Explor, mkt oil & gas Federal stock savings & loan assoc Distrib dental prods & equip Financial co specializing in lending Restaurant charge cards
Sources: Stock Investor/Media General; I/B/E/S; and S&P Stock Guide. Data as of July 29, 1994.

Exchanges: NY= New York Stock Exchange; AM= American Stock Exchange; NM= Nasdaq National Market; NS= Nasdaq Small Cap

Table 2. Using Consensus Earnings Estimates Earnings Estimates Firms with high expected earnings growth tend to underperform the market because it is difficult to meet the markets high expectations. Companies with low earnings expectations tend to do better than expected. Prices embody current earnings estimates. Earnings Estimate Revisions Stock prices of firms with significant upward revisions (5% or more) generally outperform the market. Firms with significant downward revisions underperform the market. Earnings revisions are often a precursor to earnings surprises. Stock prices react positively to upward revisions. Earnings Surprise Stock prices of firms that significantly exceed their earnings expectations (positive earnings surprise) outperform the market, while those with negative earnings surprises underperform. The earnings surprise effect is long-lasting. The greatest effect of the surprise can be felt immediately, but the effect of the earnings surprise can be seen for as long as a year. The effect of the surprise tends to be longer lasting for negative earnings surprises. The stock prices of large firms adjust to surprises more quickly than those of small firms. Earnings surprises often follow in groupsthe cockroach effect. The chance of an earnings surprise is greater if the range of estimates for a company is wide. The price move can be more dramatic, however, if an earnings surprise occurs for a firm with a very tight range of earnings estimates.

sensus, not just a change by one or two analysts. However, requiring that a stock have at least four analysts reporting earnings estimates will knock out most of the very small-capitalization stocks. The next filter required that the firm have a change in its current fiscal-year estimate over the course of the last month, leaving about 400 firms. The stocks were divided into three market capitalization groups. The percentage change in the estimate from one month to the next was calculated. The 15 firms within each group with the greatest percentage increase in estimate are listed in Table 1. The screen includes a number of cyclical firms experiencing better than expected demand for their products. For example, producers of metals such as Alcan Aluminum, Inland Steel, Aluminum Company of America, and ASARCO are seeing strong enough demand for products that they are able to raise their prices for the first time in years. Whenever your filter involves the percentage change of a variable, there is a

risk that firms with very small base numbers will dominate. With an increase of 200%, ASARCO had the highest percentage revision in the medium-cap group. This jump in percentage change is caused by an increase in earnings estimate from $0.05 to $0.15. When working with percentage changes, it is helpful to use an additional screen to confirm the significance of the change. The number of estimates for each firm is provided to help gauge the interest in the firm and the meaningfulness of the overall estimates. The larger the firm, the greater the number of analysts that will track it. The number of revisions upward indicates how many analysts have revised their estimates upward in the last month. When compared to the number of analysts making estimates, this is a confirmation of the significance of the percentage change in estimates. You can put more faith in a revision if a large percentage of the analysts tracking a firm have revised their estimates. VLSI Technology, located in the medium-cap group, had

10 of the 15 analysts tracking the firm revise their estimates upward. This compares with Amdahl, which had only two of its 15 estimates revised upward. Some investors screen for earnings estimate revisions by looking at the number of revisions. Stock prices of firms with more upward revisions than downward revisions have shown above average returns, while those with more downward revisions tend to underperform. Examining the range of estimates provides an indication of the consensus within the group of estimates. A wide range of estimates would point to great disagreement among analysts, indicating greater uncertainty and greater chance for an earnings surprise. The 13 estimates for ASARCO range from a low of $1.50 to a high of $1.30 a range of $2.80. This is a wide range compared to the Novellus Systems earnings estimates, which range from $2.00 to $2.35. The price move can be more dramatic, however, if an earnings surprise occurs for a firm with a very tight range of earnings estimates.

Definitions of Screens and Terms

The following is a short description of the screens and terms used in the table. I/B/E/S EPS Estimate: The consensus of analysts estimates for earning per share. Reflects the earnings level built into the stock price. EPS Estimate % Change: The percentage change in the consensus earnings estimate over a one-month period. Prices of firms with positive revisions tend to perform better than average. No. of Estimates: Number of analysts providing earnings per share estimates. Indicates how widely a firm is followed. Widely followed firms tend to react more quickly to estimate revisions. No. of Revisions Up in Mo.: The number of analysts who revised their earnings per share estimate for the stock upward during the month. Provides an indication of strength of the earnings revision. EPS Estimate Range: The highest and lowest earnings per share estimates given by analysts for most recent month-end. Indicates the level of consensus among analysts. The wider the range, the greater the divergence in opinion and the greater the chance for an earnings surprise. Price Change: The percentage change in the stock price for the last quarter and the last year.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)
Significant analyst following Found in Earnings Estimates Group EPSN_EY0 > 4 EPS Est Y0-Est no is greater than 4

Increase in earnings estimate over the course of the last month Found in Earnings Estimates Group EPS_EY0 > EPSPM_EY0 and/or EPS_EY1 > EPSPM_EY EPS Est Y1 is greater than EPS Est Y1-Last Month EPS Est Y0 is greater than EPS Est Y0-Last Month

Upward revisions in last month with no downward revisions in last month Found in Earnings Estimates Group EPSUM_EY0 > 0 EPSDM_EY0 = 0 and/or EPSUM_EY1 > 0 EPSDM_EY1 = 0 EPS Est Y1-Rev Up is greater than zero EPS Est Y1-Rev Down is zero EPS Est Y0-Rev Up is greater than zero EPS Est Y0-Rev Down is zero

The last two columns of data help to illustrate the recent price moves as the market has adjusted to changes in expectations. Most of these stocks have experienced fairly strong price moves on both a short-term (three-month) and

intermediate-term (one-year) basis. A larger price change for the last quarter than for the last year would indicate a positive change in price trend. NACCO Industries and Oak Industries are two such examples.

Earnings estimates are important. They embody the expectations built into a stock price. Table 2 summarizes the main points to keep in mind when dealing with consensus earnings estimates.

While price-earnings ratios are indicators of value, an approach that simply looks for low ratios can be misleading.

The Basic Techniques for Using Low P/Es to Find Undervalued Stocks
By John Bajkowski
The price-earnings ratio is one of the most basic measures of value for investors. The price-earnings ratio, or multiple, is computed by dividing a stocks price by its most recent 12 months earnings per share. The price-earnings ratio is followed so closely because it embodies the markets expectations of future company performance through the price component of the ratio and relates it to historical company performance as measured by earnings per share. This article will explore some of the basic price-earnings ratio techniques employed in searching for undervalued stocks. Many studies point to profitability of investing in out-of-favor stocks. Value investors seek out firms with low priceearnings ratios with the belief that the market may have overreacted to negative news and is not correctly discounting their future earnings potential. A simple search for low price-earnings ratios, however, can be misleading as a guide to undervalued stocks. Typically, firms with high growth potential trade with correspondingly high price-earnings ratios while those with low priceearnings ratios are expected to have low growth. Screening just for stocks with a low price-earnings ratio may leave you with a list of companies with little or no growth prospects. Table 1 illustrates the problems associated in screening for low price-earnings stocks. AAIIs Stock Investor database of 8,000 stocks was used to perform the screening. The first screening filter excluded financial firms because their non-standard financial statements do not allow for direct comparison with firms in other industries. The next set of filters required that the firms have five years of data and that earnings per share must be positive for the last 12 months. Table 1 presents the 20 securities with the lowest price-earnings ratio that passed the screens. The priceearnings ratios for the these securities range from 1.3 to 4.2 compared with the S&P 500s current price-earnings ratio of 19.2. Any screen requires that detailed analysis be performed on the resulting list of companies, and for good reason.

This list is loaded with troubled firms. Studies indicating the advantages of investing in low price-earnings stocks use large portfolios of stocks to reduce the higher risk of investing in any single stock. Littlefield, Adams, for example, is burdened by the uncertainty of an SEC investigation examining a wide range of corporate activities. Raytech Corp. has been operating under Chapter 11 bankruptcy protection since 1989 and has a cloud of over 3,000 asbestosrelated lawsuits hanging over its head. Also, some of the securities that passed the screen are not corporations. For example, Samson Energy is a master limited partnership involved in the production, development, and acquisition of oil and gas drilling operations, a relatively high-risk and uncertain activity that often leads to lower price multiples. In looking at Table 1 you may notice that only a few of the securities have information entered for the average and relative price-earnings valuation models. A weakness of using the price-earnings ratio for analysis is that dividing price by a negative earnings per share figure produces a meaningless number. Using Historical Averages One useful way to use price-earnings ratios is to compare current multiples against historical averages. A current price-earnings ratio lower than its historical average would be a potential sign that a stock is undervalued, while a current price-earnings ratio that is high compared to its historical average might indicate an overvalued firm. Models that examine historical averages assume that the growth prospects of the firm have not changed fundamentally over time and, based on historical relationships of price to earnings, the market is not correctly discounting the future earnings potential of the firm. To help illustrate the valuation aspect of the average price-earnings model, it is common to multiply the five-year average price-earnings ratio by the most recent 12 months earnings

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

Table 1. Low Price-Earnings Ratio Screen Ranked by Price-Earnings Ratio

Price as of 6/3094 ($) EPS Last 12 Mo. ($) 5-Year Average P/E Ratio (x) Average P/E Share Valuation ($) Ratio of Avg. P/E Valuation to Price (x) 5-Year P/E Relative (x) P/E Ratio of Relative P/E Rel. Share Valuation Valuation to Price ($) (x) Description

Company (Exchange)

P/E Ratio (x)

Littlefield, Adams (AM) Advanced Semicon (NM) Samson Energy LP (AM) Raytech Corp. (NY) Castle Energy (NM) Norex America (AM) America West Airlines (NM) Audiovox Corp. (AM) WPP Group PLC (NM) LVI Group Inc. (NY) Fairchild Corp. A (NY) Buffton Corp. (AM) Highwood Restaurant (NM) Hathaway Corp. (NM) Salant Corp. (NY) Allied Research Corp. (AM) Instrumentarium (NS) IP Timberlands LP (NY) Maxco Inc. (NM) Flanigan Enterprises (AM)

4.81 2.63 8.63 4.50 14.50 9.00 3.75 6.88 2.94 0.63 3.88 1.19 0.75 4.00 7.00 4.19 11.25 24.13 8.25 4.00

3.58 1.60 5.26 2.67 8.00 5.11 1.88 3.47 1.45 0.29 1.58 0.42 0.26 1.19 1.89 1.09 2.89 6.02 2.06 0.96

1.3 1.6 1.6 1.7 1.8 1.8 2.0 2.0 2.0 2.2 2.5 2.8 2.9 3.4 3.7 3.8 3.9 4.0 4.0 4.2

nmf nmf nmf 4.5 nmf nmf nmf nmf 10.5 nmf nmf nmf nmf nmf nmf nmf nmf 6.1 12.1 nmf

nmf nmf nmf 12.02 nmf nmf nmf nmf 15.23 nmf nmf nmf nmf nmf nmf nmf nmf 36.72 24.93 nmf

nmf nmf nmf 2.67 nmf nmf nmf nmf 5.18 nmf nmf nmf nmf nmf nmf nmf nmf 1.52 3.02 nmf

nmf nmf nmf 0.22 nmf nmf nmf nmf 0.57 nmf nmf nmf nmf nmf nmf nmf nmf 0.35 0.75 nmf

nmf nmf nmf 11.51 nmf nmf nmf nmf 16.20 nmf nmf nmf nmf nmf nmf nmf nmf 41.30 30.28 nmf

nmf nmf nmf 2.56 nmf nmf nmf nmf 5.51 nmf nmf nmf nmf nmf nmf nmf nmf 1.71 3.67 nmf

Engages in the imprinting of athletic wear Mfrs equipment to produce semiconductor devices Prod, devlp, acquisition of oil & gas prop Mfrs asbestos & other friction prods Explorn, devlp, producn oil & gas Mkts, provides leisure cruises Regional airline service Mkts, distribs automotive aftermarket prods Multi-national marketing services Electrical equipment distributors Motor freight carrier & aircraft replacement parts Mfrs avionic, electronic, plastic products Explores for strategic, rare-earths, precious metals Mfrs, sells elec power record equip & elec motors Mfrs, mkts apparel prods for entire family Devlps, prods weapons systems, ammo Distribs hospital equip and supplies Forest resource management Engineers, fabricates special machine for welding Pkg liquor stores, cocktail liquor

Table 2. Price-Earnings Average Screen Ranked by the Ratio of Valuation Based on Average P/E to Current Price
Price as of 6/3094 ($) EPS Last 12 Mo. ($) 5-Year Average P/E Ratio (x) Average P/E Share Valuation ($) Ratio of Avg. P/E Valuation to Price (x) 5-Year P/E Relative (x) P/E Ratio of Relative P/E Rel. Share Valuation Valuation to Price ($) (x) Description

Company (Exchange)

P/E Ratio (x)

Georgia Bonded (NM) 5.00 WPP Group PLC (NM) 2.94 Adac Laboratories (NM) 8.38 LaBarge Inc. (AM) 1.19 Merisel Inc. (NM) 8.75 Holly Corp. (AM) 28.50 Research Indus (NM) 8.00 Dresser Indus (NY) 20.50 ACC Corp. (NM) 13.75 Teltronics Inc. (NS) 9.00 Anacomp Inc. (NY) 3.00 Times Mirror (NY) 30.13 USA Waste Service (NY) 11.63 Raytech Corp. (NY) 4.50 Dorchester Hugoton (NM) 13.25 Providence & Worchester Rail (NM) 7.50 General Microwave (AM) 7.88 Pennzoil Co. (NY) 51.25 Pacific Telecom (NM) 21.75 Surgical Care (NY) 13.25
nmf = no meaningful figure

1.04 1.45 1.23 0.16 1.07 3.87 0.60 2.17 1.70 0.75 0.22 2.41 0.79 2.67 0.94 0.54 0.76 3.38 3.06 0.95

4.8 2.0 6.8 7.4 8.2 7.4 13.3 9.4 8.1 12.0 13.6 12.5 14.7 1.7 14.1 13.9 10.4 15.2 7.1 13.9

32.5 10.5 34.4 35.8 37.0 25.8 44.4 31.3 26.7 36.5 38.1 34.5 39.8 4.5 36.8 35.6 26.4 37.8 17.7 34.2

33.80 15.23 42.31 5.73 39.59 99.85 26.64 67.92 45.39 27.38 8.38 83.15 31.44 12.02 34.59 19.22 20.06 127.76 54.16 32.49

6.76 5.18 5.05 4.82 4.52 3.50 3.33 3.31 3.30 3.04 2.79 2.76 2.70 2.67 2.61 2.56 2.55 2.49 2.49 2.45

1.88 0.57 1.71 2.18 2.15 1.35 2.41 1.68 1.37 1.92 2.38 1.83 2.34 0.22 2.04 2.15 1.43 2.10 0.96 1.80

38.32 16.20 41.23 6.84 45.09 102.40 28.34 71.46 45.65 28.22 10.26 86.45 36.23 11.51 37.58 22.76 21.30 139.12 57.59 33.52

7.66 5.51 4.92 5.75 5.15 3.59 3.54 3.49 3.32 3.14 3.42 2.87 3.12 2.56 2.84 3.03 2.70 2.71 2.65 2.53

Mfrs elastomeric impregnated paper prods Multi-national marketing services Nuclear medicine computer systems Mfrs tubular, modular, electrical prods Wholesale microcomputer hardware & software Refining, explorg, producg petroleum Sales health care prods & real estate development Supplier of prods & serv to oil & gas cos Diversified telecommunications company Mfrs telecommun equip Provides computer & micrograph serv News & book publish, info serv, TV Provides solid waste management and serv Mfrs asbestos & other friction prods Partnership in oil & gas properties Operates interstate freight system Electronic measurement and control equip Explor, produc oil & gas; mfrs refined petro prods Telephone communication serv Devlps, owns outpatient surgical care facilities
Sources: Stock Investor/Media General; I/B/E/S; and S&P Stock Guide. All data as of June 30, 1994.

Exchanges: NY= New York Stock Exchange; AM= American Stock Exchange; NM= Nasdaq National Market; NS= Nasdaq Small Cap

Table 3. Price-Earnings Relative Screen Ranked by the Ratio of Valuation Based on P/E Relative to Current Price
Price as of 6/3094 ($) EPS Last 12 Mo. ($) 5-Year Average P/E Ratio (x) Average P/E Share Valuation ($) Ratio of Avg. P/E Valuation to Price (x) 5-Year P/E Relative (x) P/E Ratio of Relative P/E Rel. Share Valuation Valuation to Price ($) (x) Description

Company (Exchange)

P/E Ratio (x)

WPP Group PLC (NM) Seneca Foods (NM) Raytech Corp. (NY) Merrimac Indus (AM) Bowne & Co. (AM) Lynch Corp. (AM) Boston Celtic s NY) Napco Security Sys (NM) Park Electrochemical (NY) Robinson Nugent (NM) Sun Microsystems (NM) PSICOR Inc. (NM) B.A.T. Indus PLC (AM) REFAC Tech Devlp (AM) Plasti-Line (NM) GTI Corp. (NM) Top Air Mfg (NS) Bridgford Foods (NM) Utah Medical Prods (NM) United Stationers (NM)

2.94 22.50 4.50 8.38 20.75 26.38 20.00 3.13 28.75 5.75 20.63 9.25 12.31 7.00 7.50 10.25 0.88 8.31 6.88 9.75

1.45 3.01 2.67 1.16 2.39 3.56 2.81 0.47 2.58 0.47 1.94 1.01 1.19 0.79 0.72 1.15 0.07 0.62 0.60 1.15

2.0 7.5 1.7 7.2 8.7 7.4 7.1 6.7 11.1 12.2 10.6 9.2 10.3 8.9 10.4 8.9 12.6 13.4 11.5 8.5

10.5 18.0 4.5 15.5 17.0 14.9 14.8 13.7 22.0 24.3 19.9 17.1 19.3 15.5 19.0 16.9 24.9 25.0 20.6 15.0

15.23 54.18 12.02 17.98 40.63 53.04 41.59 6.44 56.76 11.42 38.61 17.27 22.97 12.25 13.68 19.44 1.74 15.50 12.36 17.25

5.18 2.41 2.67 2.15 1.96 2.01 2.08 2.06 1.97 1.99 1.87 1.87 1.87 1.75 1.82 1.90 1.98 1.87 1.80 1.77

0.57 1.00 0.22 0.86 1.01 0.85 0.81 0.74 1.23 1.33 1.12 0.96 1.07 0.91 1.06 0.90 1.26 1.33 1.11 0.82

16.20 59.00 11.51 19.56 47.32 59.31 44.62 6.82 62.20 12.25 42.58 19.01 24.95 14.09 14.96 20.29 1.73 16.16 13.06 18.48

5.51 2.62 2.56 2.33 2.28 2.25 2.23 2.18 2.16 2.13 2.06 2.06 2.03 2.01 1.99 1.98 1.97 1.94 1.90 1.90

Multi-national marketing services Food processing; distrib services Mfrs asbestos & other friction prods Component/subsystem in signal process Finance & corporation printing Diversified manufg activities Professional basketball team Mfrs security alarm prods Prints circuit materials Sockets & custom electromechanl prods Supplies network-based computing systems Provides perfusionist equip to hospitals Mfrs tobacco prods Admins internal technology licenses Designs, mkts illuminated outdoor signs Mfrs electronic sealer components Designs, mfrs, sells agricultural equip Makes, distributes frozen foods Dev/mfrs/mkts medical devices Distribs wholesale office prods

Table 4. Sample Calculations Using Boston Celtics LP as an Example

S&P 500 Index Value High Low ($) ($) 1989 1990 1991 1992 1993 $359.80 $368.95 $417.09 $441.28 $470.94 $275.31 $295.46 $311.49 $394.50 $429.05 EPS ($) $22.87 $21.34 $15.97 $21.95 $21.88 Price-Earnings Ratio High Low () () 15.7 17.3 26.1 20.1 21.5 20.1 12.0 13.9 19.5 18.0 19.6 16.6 Stock Price High Low ($) ($) $19.500 $19.125 $20.875 $23.875 $21.625 $13.500 $14.500 $16.125 $16.250 $16.375 EPS ($) $1.88 $1.23 $1.69 $1.19 $0.80 Boston Celtics Price-Earnings Ratio P/E Relative to Market High Low High Low () () () () 10.4 15.6 12.4 20.1 27.0 17.1 14.8 7.2 11.8 9.5 13.7 20.5 12.5 0.66 0.90 0.47 1.00 1.26 0.86 0.81 0.60 0.85 0.49 0.76 1.04 0.75

5-year average 5-year average (combined high & low) Recent S&P Price-Earnings Ratio Recent Stock Price Earnings per Share (last 12 mos.) Price-Earnings Ratio 19.6 $20.00 $2.81 7.1

18.4

P/E Relative Model Adjusted P/E = Current Market P/E Average P/E Relative = 19.6 0.81 = 15.9 Share Valuation = Adjusted P/E EPS = 15.9 $2.81 = $44.68

Average P/E Model Share Valuation = Average P/E Ratio EPS = 14.8 $2.81 = $41.59 Ratio of Share Valuation to Current Price = Valuation Current Price = $41.59 $20.00 = 2.08

Ratio of Share Valuation to Current Price = Valuation Current Price = $44.68 $20.00 = 2.23

per share to arrive at a price estimate. Comparing this valuation price to the stocks current price provides a useful ratio for screening stocks. Table 2 provides the results of a stock screen based upon the average price-earnings ratio. The information pertaining to the average price-earnings model is highlighted. Because the screen relies on the fiveyear average price-earnings ratio, this screening required that the firms have five years of positive earnings per share. This is why so many of the firms listed in Table 1 did not make it into Table 2. Beyond negative earnings, which lead to meaningless price-earnings ratios, unusually low earnings may also throw off standard price-earnings ratio screens. Short-term drops in earnings due to events such as special charges, extraordinary events, or in some cases even recessions may lead to unusually high price-earnings ratios. As long as the market interprets the earnings decrease as temporary, the high priceearnings ratio will be supported. Because the average price-earnings model relies on a normal situation, these outlier price-earnings ratios must be excluded. When performing a hands-on evaluation you can manually exclude years with negative earnings or unusually high price-earnings ratios. However, when screening a large universe of stocks, it is best to establish criteria that eliminate companies with extreme price-earnings ratios. For the average price-earnings screen, companies with ratios above 100 for any of the last five fiscal years were excluded. If you want to be more conservative, a tighter requirement, such as ratios above 40 or 50, might be specified. The top 20 firms ranked on the ratio of average price-earnings valuation to current price are shown in Table 2. To arrive at the valuation, the earnings per share for the last 12 months was multiplied by average price-earnings ratio. Table 4 illustrates the calculations involved in the average price-earnings model. The Boston Celtics Limited Partnership owns and operates the Boston Celtics as well as a Boston radio and television station. Over the last five years, the price-earnings ratio of Bos-

ton Celtics has trended up as the price largely stayed flat and earnings have decreased. The average price-earnings ratio over the last five years is 14.8. Multiplying the earnings per share for the last 12 months by the average priceearnings ratio leads to a valuation of $41.59. This is 2.08 times the current price. Boston Celtics just missed making the listing in Table 2, but made the listing in Table 3, which is based upon the price-earnings relative model. One weakness with average priceearnings approach is that it looks purely at historical relationships, while the current market price is driven by future expectations. The trailing 12-month earnings per share figure may be unusually high or low due to a one-time event, or the historical average may not reflect a change in the company, industry, or economic environment. For the Boston Celtics Limited Partnership the trailing earnings per share figure of $2.81 represents a tremendous increase over the $0.80 for the last fiscal year. Much of this earnings increase can be attributed to the selling of an option to Fox Television providing the right to purchase a 26% ownership interest in the television station owned by the partnership. The earnings figure also includes an insurance settlement involving the death of a Celtics basketball player. To get around the limitation of historical earnings per share, estimated earnings can be used. Consensus earnings estimates, however, are usually only available for larger, more actively followed companies. A screen requiring consensus earnings estimates will exclude a number of interesting neglected stocks. Price-Earnings Relative Models Another way to use price-earnings ratios is to compare them with the industry price-earnings ratio, or even the overall market ratio. Based upon economic conditions and factors, the fair value of the market can change. For example, the market can support higher price-earnings ratios under the condition of low interest rates than it can

under high interest rate conditions. The price-earnings relative is determined by dividing a companys price-earnings ratio by that of the market. Based on relative growth and risk expectations, companies trade at market multiples greater or smaller than that of the market. One would expect a company with prospects better than the market or with lower risk to have a higher price-earnings ratio than the market. Comparing a firm to its industry is an equally useful technique that has the benefit of isolating interesting candidates within a specific industry. A price-earnings relative above 1.00 would indicate that a companys priceearnings ratio is typically above the markets price-earnings ratio, while a price-earnings relative below 1.00 would indicate that a companys priceearnings ratios tends to be lower than the markets. By averaging the priceearnings relative over time, you can estimate a price-earnings relative that a stock tends to follow. Table 4 also illustrates the calculations used to determine the price-earnings relative. Over the last five years the Boston Celtics have averaged a price-earnings multiple below that of the S&P 500 leading to an average priceearnings relative of 0.81. Multiplying the price-earnings relative by the markets current price-earnings ratio provides an adjusted stock price-earnings ratio. The assumption is that the market is fairly valued and that the companys relationship to the market has not changed. A stock price valuation can be determined by multiplying this adjusted stock price-earnings ratio by the earnings per share figure. The ratio of the valuation to the current price provides a useful screening measure. Table 3 is based upon this ratio of valuation determined by the priceearnings relative valuation divided by the current price. To eliminate outliers, the high limit for the price-earnings ratio was tied to the markets price-earnings level. Companies whose price-earnings ratios were more than double the markets in any year were excluded. This filter was more stringent than the one used with the

Definitions of Screens and Terms

The following is a short description of the screens and terms used in the tables. EPS Last 12 Mo.: Earnings from continuing operations for the most recent 12 months divided by the number of common shares outstanding. P/E Ratio: Market price per share divided by most recent 12 months earnings per share. A measure of the markets expectations regarding the firms earnings growth and risk. 5-Year Average P/E Ratio: An average of the high and low price-earnings ratios for the past five years. Provides a base level from which to compare the current price-earnings ratio. Average P/E Share Valuation: Five-year average priceearnings ratio multiplied by earnings per share for the most recent 12 months. Gives an estimate of price supported by historical price-earnings average. Can also be computed with expected future earnings per share. Ratio of Avg. P/E Valuation to Current Price: Estimated average price-earnings share valuation divided by current price. A ratio of 1.00 indicates that the valuation estimate is equal to the current price. A ratio above 1.00 indicates an undervalued security while a ratio below 1.00 indicates an overvalued security. 5-Year P/E Relative: Ratio of historical company price-earnings levels relative to those of the S&P 500 index. Provides an indication as to whether the company traditionally trades at a premium or discount to the market. P/E Relative Share Valuation: Price-earnings relative multiplied by the company earnings per share. Gives an estimate of stock price value supported by the historical relationship of the price-earnings ratio to the markets, and the current market and company situation. Can also be computed with expected company earnings per share. Ratio of P/E Rel. Valuation to Current Price: Estimated price-earnings relative share valuation divided by current price. A ratio of 1.00 indicates that the valuation estimate is equal to the current price. A ratio above 1.00 indicates an undervalued security; a ratio below 1.00 indicates an overvalued security.

average price-earnings ratio screen, creating a more conservative screen and leading to a largely different list of companies in Table 3 than in Table 2. The companies passing these screens were sorted based upon their ratio of price-earnings relative share valuation to current price, with the top 20 firms listed in Table 3. The fields pertaining to the price-earnings relative model are highlighted. As with the previous screens, the list is made up of companies that have fallen out-of favor, such as B.A.T. Industries and Sun Microsystems. B.A.T. is a tobacco company caught in the midst of a storm surrounding the tobacco industry. Sun Microsystem, once a high-flying computer workstation manufacturer , has seen its earnings decline in recent years. Both firms find their current price-earnings ratios hovering at about half the market level of 19.6, not at their historical slight premium to the market. Conclusion Screening for stocks by looking at

price-earnings ratios can help highlight firms that have fallen out of favor. As in any technique, there are many ways to take a simple rule and expand upon it to meet your objectives. Looking at just low price-earnings stocks will highlight companies the market is neglecting, but this screen also tends to highlight the most troubled issues that require very detailed analysis. It is also common for low price-earnings screens to be dominated by a few industries that are currently out of favor. Screening based upon an examination of the average price-earnings ratio allows you to seek out companies that have fallen out of favor, but may not be as troubled as firms from the pure low price-earnings screen. The average price-earnings model looks to past earnings valuation to help set a benchmark comparison. It identifies firms that have deviated from their normal valuation level, with the expectation that they will move back toward their typical levels. This model also has its weaknesses: It assumes that nothing fundamental to the company, industry, or

market has significantly changed. The primary benefit of the price-earnings relative model over the average price-earnings ratio is that it allows for adjustments to broad economic changes affecting the market. It identifies those stocks that have deviated from their long-term relationships to a benchmark index, while still assuming a stable company relationship to the market over time. As with all of the techniques presented, industries that have fallen out of favor may dominate the analysis. This article has focused purely on identifying primary screening criteria. Screening for low price-earnings firms turns up companies that have fallen out of favor, some for good reasons. In constructing screening criteria, you may wish to include a number of conditioning criteria that help indicate items such as the future earnings potential of the firm, the financial strength of the firm, as well as the strength of the firm within its industry. Investing in low price-earnings stocks can be rewarding, but caution is required.

Screening Criteria Price Earnings Average Screen Ranked by Ratio of Valuation Based on Average P/E to Current Price For use with AAII's Stock Investor program (version 2.1)
Low PE Versus Historical Average PE Ratio Found in Company Information Group: IND_2_DIG <> 07 IND_3_DIG <> 0933 Found in User Defined Group: PE Y1 < 50 PE Y2 < 50 PE Y3 < 50 PE Y4 < 50 PE Y5 < 50 User Defined PE Y1 = Price_Y1 / EPS_Y1 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y2 = Price_Y2 / EPS_Y2 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y3 = Price_Y3 / EPS_Y3 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y4 = Price_Y4 / EPS_Y4 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y5 = Price_Y5 / EPS_Y5 (Note: This can be varied to make screen more or less restrictive) Found in the Income Statement - Annual Group: EPS_Y1 > 0 EPS_Y2 > 0 EPS_Y3 > 0 EPS_Y4 > 0 EPS_Y5 > 0 Found in the Multiples Group PE < PE_A5Y Found in the Growth Rates Group Sales_G5F > 5 EPS_G5F > 5 Sales-Growth 5yr is greater than 5% (Note: This can be varied to make screen more restrictive) EPS-Growth 5yr is greater than 5% (Note: This can be varied to make screen more restrictive) Found in the Ratios Group TL_TA_Q1 < Industry.TL_TA_Q1 (N) Found in User-Defined Group Price PE Avg Val / Price > 1.5 PE Avg Val / Price = (EPS_12M * PE_A5Y)/Price Ratio of PE Average Valuation to Current Price greater than 1.5 times (Note: This number can be varied to make screen more or less restrictive) Note: To see calculated PE Average Valuation create the following User-Defined Field: PE Avg Valuation = EPS_12M * PE_A5Y Tot Liab/assets Q1 greater than narrow industry median PE less than PE-Avg 5y EPS Y1 greater than 0 EPS Y2 greater than 0 EPS Y3 greater than 0 EPS Y4 greater than 0 EPS Y5 greater than 0 Sector is not equal to Financial Industry is not equal to Real Estate Operations

Screening Criteria Price-Earnings Relative Screen Ranked by the Ratio of Valuation Based on P/E Relative to Current Price For use with AAII's Stock Investor program (version 2.1)
Found in Company Information Group: IND_2_DIG <> 07 IND_3_DIG <> 0933 Found in User Defined Group: PE Y1 < 50 PE Y2 < 50 PE Y3 < 50 PE Y4 < 50 PE Y5 < 50 User Defined PE Y1 = Price_Y1 / EPS_Y1 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y2 = Price_Y2 / EPS_Y2 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y3 = Price_Y3 / EPS_Y3 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y4 = Price_Y4 / EPS_Y4 (Note: This can be varied to make screen more or less restrictive) User Defined PE Y5 = Price_Y5 / EPS_Y5 (Note: This can be varied to make screen more or less restrictive) Found in the Income Statement - Annual Group: EPS_Y1 > 0 EPS_Y2 > 0 EPS_Y3 > 0 EPS_Y4 > 0 EPS_Y5 > 0 Found in the Multiples Group PE < PE_A5Y Found in the Growth Rates Group Sales_G5F > 5 EPS_G5F > 5 Sales-Growth 5yr is greater than 5% (Note: This can be varied to make screen more restrictive) EPS-Growth 5yr is greater than 5% (Note: This can be varied to make screen more restrictive) Found in the Ratios Group TL_TA_Q1 < Industry.TL_TA_Q1 (N) Found in User-Defined Group Ratio of PE Relative Valuation to Current Price greater than 1.5 times (Note: This number can be varied to make screen more or less restrictive) To perform this screen the PE relative, PE relative valuation, and the ratio of PE relative valuation to Price must be calculated To calculate PE relative S&P 500: First, calculate PE RelHigh (UDEF10) as ((PriceHigh Y1/EPS Y1)/ S&P High PE Y1 + (PriceHigh Y2/EPS Y2) / S&P High PE Y2 + (PriceHigh Y3/EPS Y3) / S&P High PE Y3 + (PriceHigh Y4/EPS Y4) / S&P High PE Y4 + (PriceHigh Y5/EPS Y5) / S&P High PE Y5) / 5 Where S&P PE High is 18.3 for 95, 15.7 for 94, 21.5 for 93, 20.1 for 92, and 26.1 for 91 Tot Liab/assets Q1 greater than narrow industry median PE less than PE-Avg 5y EPS Y1 greater than 0 EPS Y2 greater than 0 EPS Y3 greater than 0 EPS Y4 greater than 0 EPS Y5 greater than 0 Sector is not equal to Financial Industry is not equal to Real Estate Operations

Screening criteria continued on next page

Screening Criteria contin. UDEF10 = (PriceH_Y1/EPS_Y1)/18.3 + (PriceH_Y2/EPS_Y2)/15.7 + (PriceH_Y3/EPS_Y3)/21.5 + (PriceH_Y4/EPS_Y4)/20.1 + (PriceH_Y5/EPS_Y5)/26.1 Second, calculate PE RelLow (UDEF11) as (PriceLow Y1/EPS Y1)/ S&P Low PE Y1 + (Price Low Y2/EPS Y2) / S&P Low PE Y2 + (Price Low Y3/EPS Y3) / S&P Low PE Y3 + (Price Low Y4/EPS Y4) / S&P Low PE Y4 + (Price Low Y5/EPS Y5) / S&P Low PE Y5) / 5 Where S&P PE Low is 13.5 for 95, 14.3 for 94, 19.6 for 93, 18.0 for 92, and 19.5 for 91 UDEF11 = (PriceL_Y1/EPS_Y1)/13.5 + (PriceL_Y2/EPS_Y2)/14.3 + (PriceL_Y3/EPS_Y3)/19.6 + (PriceL_Y4/EPS_Y4)/18.0 + (PriceL_Y5/EPS_Y5)/19.5 Third, calculate PE Relative S&P 500 (UDEF12) as average of PE RelHigh and PE RelLow UDEF12 = (UDEF10 + UDEF11) / 2 Fourth, calculate ratio of PE Rel Val to Price (UDEF14) as (PE Relative S&P 500 * Current S&P PE *EPS_12M)/Price UDEF14 = (UDEF12 * 19.0 * EPS_12M)/Price In the screen you can then use the user-defined PE Rel Val/Price ratio and specify a value greater than 1.5 times (Note: This number can be varied to make screen more or less restrictive) UDEF14 > 1.5 PE Avg Val / Price > 1.5

Note: To see calculated PE Relative Valuation create the following User-Defined Field (UDEF13): UDEF13 = UDEF12 * 19.0 * EPS_12M PE Rel Valuation = PE Relative S&P 500 * Current S&P PE *EPS_12M

on earnings? How are same store sales? To help buffer the impact of extraordinary items on earnings, earnings from continuing operations were used throughout this article. Looking at sales growth will also provide a confirmation of how earnings were achieved.

Growth stock investing has appeal because of the potential for high returns, but it comes at the price of high risk.

Secondary Growth Screens The next filter applied examined year-to-year earnings per share changes from continuing operations. In screening for growth companies it is important to examine the year-to-year figures for steady and increasing earnings. A screen requiring increased earnings for each of the last five years was specified. If you wish to be more stringent in your screening, you might require an increase in the year-to-year growth rate for each of the last five years. This more stringent screen focuses on the momentum of earnings. Investors examining growth stocks look toward any signs that a trend in growth may be broken. Quarterly earnings are closely examined and deviations from the expected norm are quickly rewarded or punished. The seasonality of sales and earnings for most firms, however, do not allow investors to compare one quarter to the preceding quarter in a meaningful manner. To deal with seasonality, it is best to compare one quarterly figure to the same quarter one year prior. A decrease from the same quarter one year ago is a warning flag that merits investigation. In our screening process, higher quarterly earnings than the same quarter one year ago for each of the last four quarters was required. Beyond examining overall growth or momentum, many investors examine how a company compares to its industry peers. The ability to expand within an industry group may point to a firm that has a competitive edge.Therefore, our final growth screen specified the companys earnings growth to be above that of its industrys average. One other screen we applied excluded financial firms because of the non-compatibility of the financial statements.

A Screening Strategy for Investing in Stocks With High Growth Potential

By John Bajkowski
The mention of growth investing brings a sparkle to many an investors eye. Looking for rapidly growing firms in hot industries seems much sexier than picking through the value plays that other investors have cast off. But searching for growth stocks is like all investment techniquesit has its ups and downs. The allure of buying into a stock with the potential for a 10-fold increase in price must be balanced with the potential for substantial price declines if the firm fails to meet the markets growth expectations. Screening for Growth Screening can be used as a first step in identifying growth stock prospects. Screening is the process of applying a set of criteria to a set of stocks to filter out those companies that merit more detailed examination. The table on page 29 of this issue lists a few publications that provide preliminary screens of growth companies. Readers with access to computers can use a number of software programs or dial-up services to screen for growth stocks. AAIIs Stock Investor program was used to perform the screening for this article. While there are many ways to measure company growth, most investors focus on earnings growth, with an emphasis on a high and expanding rate of growth. A common first screen for growth stocks is to specify an absolute minimum growth level. A minimum annual growth rate of 15% in earnings from continuous operations over the last five years was the first screen applied in our example. While 15% may not seem very restrictive, it will knock out most of the cyclical firms just coming out of the recession. In selecting a time period for historical analysis, the economic environment should be kept in mind. True growth companies are expanding throughout the economic cycle. Screening based upon earnings requires a careful analysis of a firms reports, which can highlight how the growth was achieved. Was the growth due to acquisition or internal expansion? Did currency translation impact

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

Stocks With High Earnings Growth

EPS Growth Historical Average (%) Rate I/B/E/S Est. (%) EPS Last 12 Mo. ($) EPS Current Fiscal Yr. Forecast ($) P/E Ratio Trailing Fiscal 12 Mo. Yr. Est. (X) (X) Historical Sales 52-Week Growth Relative Rate Strength (%) (%)

Company (Exchange)

Description

Large Cap (above $1.5 billion)

U.S. Healthcare (NM) Cisco Systems (NM) Parametric Technology (NM) United Healthcare (NY) EMC Corp. (NY) Amer Power Conversion (NM) Cabletron Systems (NY) CUC International (NY) Intel Corp (NM) BMC Software (NM) Microsoft Corp (NM) Blockbuster Entertain (NY) Linear Technology (NM) Sysco Corp (NY) Home Depot (NY)
S&P 500

180.0 140.6 96.8 67.2 62.7 57.8 57.7 52.1 49.5 47.4 47.3 39.9 38.4 37.7 37.4
1.1

17.5 35.0 40.0 28.0 30.0 35.0 25.0 28.0 18.0 25.0 25.0 25.0 25.0 16.5 30.0
8.0

2.00 0.92 0.95 1.25 0.77 0.60 4.20 0.77 5.38 3.10 3.72 1.18 1.36 1.16 1.01
21.98

2.25 1.22 1.12 1.65 0.96 0.75 5.30 0.98 5.95 4.00 3.92 1.35 1.49 1.21 1.32
30.42

18.8 32.9 30.0 33.2 23.2 37.1 24.5 38.2 11.3 19.4 24.9 23.0 34.9 22.4 41.6
20.5

16.7 24.8 25.4 25.2 18.6 29.7 19.4 30.0 10.3 15.0 23.6 20.1 31.9 21.5 31.8
14.8

31.2 120.0 96.2 58.4 56.0 73.5 66.2 28.8 29.5 41.0 47.0 53.4 23.6 10.0 37.5
na

114 138 97 145 212 154 111 134 121 112 102 144 180 98 93
na

Health maintenance organization Mfrs computer network products Devlps, mkts integrated software prod HMO administran serv on contract basis Designs, mkts enhancemet prod for computers Devlp, mkts power supply products Hardware & software prod supporting LANs Member-based consumer services Designs, mfrs semicond components, systems Devlps standard systems software products Designs, mfrs, mkts software packages Owning and licensing videotape stores Designs, mfrs linear integrated circuits Distrib consumer foods & food serv Retail building material stores

Medium Cap ($250 million to $1.5 billion)

Vencor Inc (NY) Westcott Communicns (NM) CML Group (NY) Snyder Oil Corp. (NY) Owens & Minor (NY) Xilinx Inc (NM) Invacare Corp. (NM) Tech Data Corp. (NM) Briggs & Stratton (NY) KCS Energy Inc (NY) Applebees International (NM) Bowne & Co. (AM) Horizon Healthcare (NY) Oakwood Homes (NY) Progress Software (NM)
S&P MidCap 400

93.8 77.1 75.1 64.2 62.2 61.3 59.8 59.0 53.1 49.5 47.2 45.3 44.5 44.4 44.4
na

26.5 35.0 20.0 15.0 16.0 30.0 16.0 25.0 10.0 na 30.0 na 25.0 18.0 28.0
na

1.37 0.55 1.26 0.80 0.94 1.71 1.54 0.83 6.14 1.20 0.45 2.20 0.94 1.40 2.02
7.97

1.60 0.74 1.30 0.59 1.05 2.30 1.75 1.05 6.22 2.41 0.60 2.18 0.90 1.45 2.40
8.75

23.8 30.0 10.7 24.4 24.7 32.5 17.4 21.5 13.7 20.2 47.8 10.5 24.9 15.3 22.0
21.7

20.4 22.3 10.4 33.1 22.1 24.1 15.3 17.0 13.5 10.1 35.8 10.6 26.0 14.7 18.5
19.7

51.4 44.7 28.8 41.1 10.0 55.6 18.4 44.9 6.8 38.8 27.0 15.1 20.6 31.9 44.8
na

126 99 50 103 142 164 104 146 126 118 189 112 174 110 109
na

Acute-care servs to complex patients Prod training, educational programs Specialty retail Oil & gas producing prop/gas processing Wholesale drug, hospital & surgical supplies Mfrs semiconductors, system develop software Designs, mfrs durable medical equip Distrib computer-related prods Manufactures air-cooled engines & auto locks Holding co.: propane distrib, oil & gas serv Franchises/opers national restaurant chain Finance & corporation printing Opers long-term care facilities Mfrs mobile homes, oper mobile home parks Devlp, support integrated application software

Shadow Stocks (small firms with low institutional interest)

Ashworth Inc* (NM) Homecare Mgmt Inc (NM) Methode Elec B (NM) Marten Transport (NM) Gates/F.A. Distrib (NM) Rotech Medical Corp. (NM) Medical Technology Sys (NM) Turf Paradise Inc (NS) Cosmetic Center B (NM) Volunteer Capital (NY) Diodes Inc (AM) BGS Systems (NM) Reflectone Inc (NM)
*Formerly Charter Golf Inc.

144.9 95.7 59.7 55.5 55.4 45.9 39.7 31.6 30.8 22.6 20.2 19.8 19.8

35.0 na 17.5 15.0 30.0 na na na 20.0 35.0 na na na

0.36 0.54 0.77 1.58 1.20 0.85 0.68 0.67 0.93 0.93 0.42 2.23 0.86

0.47 0.54 0.85 1.62 1.27 0.98 na na 1.02 0.45 na 2.55 na

30.6 30.8 22.7 10.8 16.5 23.2 12.3 16.8 18.2 12.6 21.7 9.3 9.9

23.4 30.8 20.6 10.5 15.6 20.2 na na 16.5 26.1 na 8.1 na

116.1 80.3 8.9 11.2 32.9 39.4 66.1 0.7 14.0 0.8 7.5 13.9 10.4

133 153 113 123 140 158 89 163 141 138 491 53 93

Mfrs golf apparel Home care service to elderly Mfrs electro component devices Long-haul truckload carrier Distribs microcomputers & periph Mkts, distribs home healthcare prod Mfrs, sells nursing home equip Oper horse racing track in Arizona Retail & distribn of cosmetics Own, franchisor of fast food restaurants Semiconductor devices Design, devlp software prod Flight simulators & training devices
Sources: Stock Investor/Media General data as of April 30, 1994; I/B/E/S data as of May 13, 1994.

Exchanges: NY= New York Stock Exchange; AM= American Stock Exchange; NM= Nasdaq National Market; NS= Nasdaq Small Cap

Definitions of Screens and Terms

The following is a short description of the screens and terms used in the table. EPS Growth RateHistorical Average: Annual growth in earnings per share from continuing operations over the last five fiscal years. A measure of how successful the firm has been in generating the bottom line, net profit. EPS Growth RateI/B/E/S Est.: The median growth rate in earnings per share from continuing operations over the next five years that is being forcasted by analysts as reported by I/B/E/S (345 Hudson St., New York, N.Y. 10014). An indication of the consensus in earnings growth expectations for the firm. EPS Last 12 Mo.: Earnings from continuing operations for the most recent 12 months divided by the number of common shares outstanding. EPS Current Fiscal Yr. Forecast: Earnings from continuing operations for the current fiscal year of the company that is being forcasted by analysts as reported by I/B/E/S. Price-Earnings RatioTrailing 12 Mo.: Market price per share divided by most recent 12 months earnings per share from continuing operations. A measure of the markets expectations regarding the firms earnings growth and risk. Firms with very high priceearnings ratios are being valued by the market on the basis of high expected growth potential. Price-Earnings RatioFiscal Yr. Est.: Market price per share divided by earnings per share from continuing operations that is being forcasted by analysts as reported by I/B/E/S. Historical Sales Growth Rate: Annual growth in total sales per share over the last five fiscal years for the firm. Used to provide a confirmation of the quality of the historical earnings per share growth rate. 52-Week Relative Strength: The price performance of a stock during the last year relative to the performance of the overall stock market. The market is defined as the Media General Composite Market Value Index of over 7,000 stocks. A figure of 100% indicates the stock had the same percentage price performance as the market. A figure of 105% indicates that the stock

Viewing the Results To highlight a cross section of companies, the firms passing the screens were divided up into groups based upon market capitalization. The top 15 largecap and mid-cap companies ranked by historical growth in earnings from continuing operations are shown. Also shown are 13 Shadow Stock companies that passed all the screening requirements. (Shadow Stocks are defined by AAII as stocks of non-financial companies that are small, with low institutional interest, and that have had positive annual earnings for the two previous years. The complete 1994 Shadow Stock listing appeared in the February AAII Journal.) Our screen focused on historical performance, but growth stock investors really focus on expected performance.

Looking at market consensus forecast figures helps to provide an indication of the expectations surrounding the valuation. It is the companys ability to meet and, more importantly, exceed these expectations that lead to great gains. For example, Cisco Systems has the second highest historical earnings growth of the large-cap stocks. Just after the screen was performed for this table, Cisco came out with a quarterly earnings announcement that met the markets consensus estimate. However, over the last few years Cisco has consistently exceeded the consensus estimates. The market greeted the earnings announcement with a big price decline for Cisco and many of its technology competitors. The price-earnings ratios for stocks on our list tended to be above the market average, as would be expected

for companies with above-average prospects. To better judge price-earnings ratios, many analysts look at price compared to forecasted earnings. For the S&P 500, this brings its high trailing price-earnings ratio of 20.5 back to a more reasonable price-earnings ratio fiscal year estimate of 14.8. The 52-week relative strength figures point to a collection of companies that have largely outperformed the marketquite a contrast to the valuebased stocks presented in last months Analyst Corner. The relative strength figures near 50% for a few of these companies, however, reveal the volatility of this group. Investing in growth stocks can be an extremely rewarding experience. Success, however, requires careful analysis and constant monitoring of the portfolio.

Criteria for the Computerized Investor For use with AAII's Stock Investor (version 2.1) Screening Criteria:
Found in Growth Rates Group EPSCon_G5F > 15 Five-year earnings per share growth from continuing operations is greater than 15 (Note: This can be varied up to look for stronger growth) EPSCon_G5F > INDUSTRY.EPSCon_G5F (N) Five-year earnings per share growth from continuing operations is greater than that of the narrow industry group median Found in Income Statement - Annual Group EPSCon_Y5 > 0 EPSCon_12M >= EPSCon_Y1 EPSCon _Y1 > EPSCon _Y2 EPSCon _Y2 > EPSCon _Y3 EPSCon _Y3 > EPSCon _Y4 EPSCon _Y4 > EPSCon _Y5 Found in Income Statement - Quarterly Group: EPSCon_Q1 >= EPSCon_Q5 EPSCon _Q2 > EPSCon _Q6 EPSCon _Q3 > EPSCon _Q7 EPSCon _Q4 > EPSCon _Q8 Found in Price & Share Data Group RS_52W > 0 Rel strength 52W is greater than 0 EPS Cont Q1 greater than EPS Cont Q5 EPS Cont Q2 greater than EPS Cont Q6 EPS Cont Q3 greater than EPS Cont Q7 EPS Cont Q4 greater than EPS Cont Q8 EPS Cont Y5 greater than 0 EPS Cont 12m greater or equal to EPS Cont Y1 EPS Cont Y1 greater than EPS Cont Y2 EPS Cont Y2 greater than EPS Cont Y3 EPS Cont Y3 greater than EPS Cont Y4 EPS Cont Y4 greater than EPS Cont Y5

Optional Elements Include:

Minimum Level of Sales Growth Found in Growth Rates Group Sales_G5F > 15 Five-year sales growth greater than 15 (Note: This can be varied up to look for stronger growth) Profit Margins Equal to or better than Industry Found in Ratios Group NPM_12M > INDUSTRY.NPM_12M (N) or GPM_12M > INDUSTRY.GPM_12M (N) Strong Forecasted Earnings Found in Earnings Estimates Group EPS_EG5 > 15 EPS Grth Est is greater than 15 (Note: This can be varied up to look for stronger growth) Increasing Earnings Estimates or No Decreasing Earnings Estimates Found in Earnings Estimates Group EPSUM_EY0 > 0 EPSUM_EY1 > 0 EPSUM_EG5 > 0 and/or EPSDM_EY0 = 0 EPSDM_EY1 = 0 EPSDM_EG5 = 0 EPS Est Y0-Rev up is greater than 0 EPS Est Y1-Rev up is greater than 0 EPS Grth Est-Rev up is greater than 0 EPS Est Y0-Rev down is 0 EPS Est Y1-Rev down is 0 EPS Grth Est-Rev down is 0 12-month gross margin is greater than that of narrow industry group 12-month net margin is greater than that of narrow industry group

A dividend-yield strategy can help you find potentially undervalued stocks with low downside risk, provided the dividend is secure.

Screening for Stocks Using a Dividend-Yield Approach

By John Bajkowski
Many investors turn toward the dividend yield as a measure of value in their quest for selecting underpriced securities. A stocks dividend yield is computed by taking the indicated dividendthe most recent quarterly dividend multiplied by fourand dividing it by the share price. If a stocks price rises faster than its dividend, the dividend yield will fall, indicating that the price may have been bid up too far and may be ready for a decline. Conversely, if the dividend yield rises to a high level, the stock may be poised for an increase in price, if the dividend can be sustained. This article will focus on strategies used to screen for high dividend yielding stocks, while the Stock Investing Basics article that follows covers the dividend valuation process. The Dividend-Yield Strategy Like all basic value-oriented techniques, the dividend-yield strategy attempts to identify investments that are out-of-favor. Contrarian techniques such as this are based on the premise that markets tend to overreact to good and bad news and push the price of a security away from its intrinsic value. Value investors hope to identify these mispriced securities through the use of a consistent set of rules called a valuation model. Screening is the first stage in this process and it involves scanning a group of securities to find those that merit further in-depth analysis. Absolute or relative levels may be used in screening for high-yield stocks. A screen requiring an absolute level might look for a minimum dividend yield of 4% before an investment would be considered. Absolute screens can lead to passive market timingcash levels tend to build up when investors cannot find suitable investments that meet the minimum requirement during times of market extremes. Also, screens that only look at absolute levels can be weak because they may turn up companies from a single industry that traditionally has higher dividend yields, such as utilities.

Screens based on relative levels compare the yield against a benchmark that may fluctuate, such as the current dividend yield for the S&P 500. In this case the investor does not require that the yield meet some minimum level, but instead that it maintain its historical relationship with the benchmark figure. Common screens examining relative yields include comparisons against some overall market level, industry level, historical average or even some interest rate benchmark. The screens for this article were performed using a historical average as the benchmark. Investors looking to perform custom screens can use one of a number of software programs or information services that provide fundamental data on companies. (See the January 1994 Analysts Corner for information on computerized investing tools and a listing of available screening tools.) For those without a computer, a number of publications provide regular listings of high-dividend stocks and rapidly expanding dividend stocks. (See the table on page 33 of this issue for more information on these sources.) Applying the Screens AAIIs Stock Investor program was used to perform the screening for this article. The first filter excluded utilities, real estate investment trusts, closed-end mutual funds, and financial firms. Each of these groups has unique financial characteristics requiring that they be analyzed separately. The next screen required that a company have five years of both price and dividend records. When screening against a historical level, remember to include a historical period that covers both the up and down periods of a market and economic cycle. Selecting a time period is a balance between using one that is too short and only captures a segment of the market cycle and one that is too long and includes a time period that is no longer representative of the current company, industry, or market. Periods of between five and 10 years are most common for these types of comparisons.

John Bajkowski is AAIIs financial analyst and editor of Computerized Investing.

Table 1. Top Dividend Yielders

Dividend Yield (%) 5-Year Average Yield (%) Indicated Dividend ($) Dividend Growth Rate (%) Cash Dividend Paid Since Payout Ratio (%) EPS 52-Week Growth Relative Rate Strength (%) (%)

Company (Exchange)

Description

Large Cap (above $1.5 billion)

Clorox Co.* (NY) Cooper Indus* (NY) Times Mirror* (NY) Quaker Oats* (NY) Brown-Forman Corp. B* (NY) Dresser Indus* (NY) Schering-Plough Corp.* (NY) Norfolk Southern* (NY) General Electric* (NY) CPC Intl* (NY) Honeywell Inc.* (NY) Abbott Labs* (NY) Union Pacific* (NY) Gerber Products* (NY) Johnson & Johnson* (NY) 3.6 3.6 3.5 3.4 3.3 3.2 3.2 3.0 2.9 2.9 2.9 2.9 2.8 2.8 2.8 3.2 2.4 3.3 2.3 2.5 2.7 2.2 2.8 2.7 2.4 2.3 1.5 2.4 2.0 1.5 1.80 1.32 1.08 2.12 2.84 0.68 1.80 1.92 2.88 1.36 0.96 0.76 1.60 0.86 1.04 11.9 7.3 4.1 12.9 14.1 7.5 18.2 9.3 11.3 10.3 12.2 18.9 7.8 21.3 16.7 1968 1947 1892 1906 1960 1948 1957 1901 1899 1920 1928 1926 1900 1941 1905 47.2 47.3 43.9 45.6 46.2 31.7 41.1 47.2 41.6 42.7 37.9 39.1 44.0 46.5 36.9 8.0 2.3 35.7 11.3 2.3 6.6 19.3 2.9 8.6 8.7 33.0 15.0 6.0 14.7 14.5 94 73 89 89 97 98 92 97 106 103 98 100 88 95 89 Mfrs, mkts non-durable consumer prod Compression & drill equip; electric, electron prod Newspaper & book pub; newsprint; info serv; TV Prod grocery prods, cereals, snacks, pet food Produces distilled spirits & wines Supplier of prods & serv to oil & gas devlp cos Mfrs drugs & beauty aids Holding co.: Norfolk; Western & Southern rail Power systems; consumer & indusl prod Branded grocery products business Mfrs heat & air conditiong control Pharmaceuticals; hospital, laboratory prod Transportion; energy & natural resources Consumer prod for infant care; trucking Healthcare, pharmaceutical, industrial prod

Mid Cap ($250 million to $1.5 billion)

Pacific Telecom (NM) Goodrich, B. F.* (NY) Handleman Co.* (NY) GATX Corp. (NY) Ennis Business Forms (NY) Longs Drug Stores* (NY) EG&G Inc.* (NY) American Business Prod (NY) Crawford & Co. B (NY) Block Drugs Co. (NM) Kimball Intl B (NM) Gallagher (Arthur J.) (NY) Giant Food A* (AM) Universal Foods (NY) Mercantile Stores* (NY) 5.7 5.2 4.0 3.6 3.6 3.4 3.4 3.3 3.3 3.2 3.1 3.1 3.1 3.0 2.7 4.5 4.8 2.6 3.4 2.9 2.6 2.0 3.1 1.8 1.6 2.6 2.3 2.1 2.3 2.6 1.32 2.20 0.44 1.50 0.56 1.12 0.56 0.80 0.50 1.04 0.84 0.88 0.70 0.92 1.02 8.1 6.3 4.0 9.6 13.1 6.6 13.0 9.6 14.1 15.8 12.2 8.2 15.7 13.5 6.9 1976 1938 1963 1919 1973 1961 1965 1941 1965 1971 1954 1985 1960 1934 1940 43.9 47.0 44.0 46.8 47.9 46.5 36.9 48.1 41.5 35.7 45.5 34.7 45.8 40.1 43.4 22.8 20.3 0.8 24.5 6.8 1.6 7.9 5.3 7.6 9.5 2.7 9.2 4.3 7.7 11.9 94 82 69 115 87 89 69 86 66 64 93 77 85 82 103 Telephone communication serv Mfrs, sells chemical intermed & polymeric prod Sell/distrib prerecorded music & books Mfrs railcars, specific steel & indusl equip Mfrs business forms & paper items Oper drugstore chain Mfrs, mkts electronic instruments Business forms & supplies Insurance claims adjusters Mfr denture, dental care products; drugs Mfrs pianos, organs, office & home furn Insurance broker; risk management Supermarket chain Mfrs, produces foods & beverages Dept stores; beauty salons; shopping centers

Small Cap (below $250 million)

Nash Finch Co. (NM) Marsh Supermarkets A (NM) Dibrell Brothers (NM) United Stationers (NM) MMI Medical (NM) Stepan Co. (AM) Sealright Inc. (NM) Hako Minuteman (NM) Fays Inc. (NY) Flamemaster Corp. (NM) Zero Corp (NY) Analysts Intl Corp. (NM) Super Food Services (NY) Insteel Indus (NY) General Binding (NM)
*S&P 500 stock

4.4 4.2 3.8 3.3 3.2 3.2 3.2 3.1 3.1 3.1 3.0 2.7 2.7 2.7 2.7

3.6 2.7 2.2 3.2 2.6 2.3 1.5 3.0 2.2 2.1 2.9 2.6 2.3 2.2 1.6

0.72 0.44 0.72 0.40 0.16 0.84 0.46 0.32 0.20 0.12 0.40 0.48 0.36 0.24 0.40

2.2 5.9 20.4 1.3 2.4 11.4 28.6 8.8 7.9 18.9 4.1 9.6 4.1 8.3 18.1

1965 1960 1925 1972 1988 1967 1986 1988 1975 1989 1974 1988 1971 1986 1975

49.3 45.8 34.5 34.8 24.6 41.3 45.0 42.4 40.0 42.9 49.4 36.2 40.9 31.4 42.1

2.6 3.5 26.8 7.9 -4.9 5.5 3.5 4.1 1.4 15.6 7.7 12.0 12.8 7.0 3.3

81 71 62 62 75 77 65 117 84 83 89 84 124 77 86

Distrib wholesale & retail supermarket prod Oper supermarkets & convenience stores Process, mkts tobacco Distrib wholesale office prod to retailers Medical diagnostic imaging serv Produces basic & intermediate chemicals Mfr, mkts round paperboard & plastic containers Makes, distrib floor & carpet care equip Oper chain of retail drug stores Makes flame retardant & heat resistant prod Mfrs electron packaging & special enclosures Furnishes computer programming services Wholesale food distribution & support serv Mfsr welded wire prod Mfrs business machines & supplies

Exchanges: NY= New York Stock Exchange; AM= American Stock Exchange; NM= Nasdaq National Market

Source: Stock Investor/Media General; data as of March 31, 1994.

Definitions of Screens The following is a short description of the screens and terms used in the table. Dividend Yield: Indicated dividend divided by current price. Provides a relative valuation measure when compared against historical average dividend yield. Five-Year Average Yield: Average company dividend yield during the last five years. Indicated Dividend: Expected per share dividend payment for the next year. EPS Growth Rate: Annual growth rate in earnings per share over the past five years. Dividend Growth Rate: Annual dividend growth rate in dividends per share over the last five years. An indication of the past company strength and dividend payment policy. Cash Dividends Paid Since: The number of consecutive years that a cash dividend has been paid. An indication of the stability of the companys past dividend payment policy. 52-Week Relative Strength: The price performance of a stock during the last year relative to the performance of the overall stock market. A figure of 0% indicates the stock had the same percentage price performance as the market. A figure of 5% indicates that the stock outperformed the market by 5%. Payout Ratio: Dividends per share for the last 12 months divided by earnings per share for the last 12 months. Provides an indication of the safety of the dividend. Figures between 0% and 50% are considered safe. Figures ranging between 50% and 100% are considered early warning flags. Negative values and values above 100% are considered red flags for a dividend cut if the levels persist. Beyond examining a single year, look for trends.

Dividend analysis is geared toward established firms that are past their explosive growth and capital-intensive stage. To help filter out companies paying just token dividends, a minimum dividend yield of 2% was specified. Beyond a minimum level of dividends, we screened for companies that have paid a dividend for each of the last five years and never reduced their dividend. Dividend levels are set by the board of directors based on consideration of the current company, industry, and economic conditions. Because dividend cuts are tantamount to an announcement that the firm is financially distressed, dividends are set at levels that the company should be able to afford throughout the economic cycle. The next filter required that the companys current dividend yield be higher than its five-year average dividend yield. This filter seeks out companies whose dividends have increased faster than increases in share price, or whose current share price has dipped recently. While it might seem that the screening process should be over with this last screening filter, before a company can be considered a buy the security of the dividend must be examined. A high dividend yield may be a signal that the market expects the dividend to be cut shortly and has pushed down the price accordingly. A high relative dividend yield is a buy signal only if the dividend level is expected to be sustained and hopefully increased.

Measures exist that help to identify the safety of the dividend. The payout ratio is perhaps the most common of these and is calculated by dividing the dividend per share by earnings per share. Generally the lower the number, the more secure the dividend. Any ratio above 50% is considered a warning flag. However, for some industries, such as utilities, ratios around 80% are common. The current payout ratio for the Dow Jones utility group is 82%, versus 55% for the Dow Jones industrial group. A 100% payout ratio indicates that a company is paying out all of its earnings in the form of dividends. A negative payout ratio indicates that a firm is paying a dividend even though earnings are negative. Firms cannot afford to payout more than they earn in the long term. For the final criterion we required a payout ratio between 0% and 50%, leaving 86 companies. To highlight a cross section of stocks, along with any differences due to company size, the stocks were divided up into three groups based upon market capitalization. The top 15 dividendyielding stocks for each group are listed in Table 1. Market capitalization is determined by multiplying the number of shares outstanding times a firms stock price. The largest firms have a market capitalization above $1.5 billion dollars, the middle capitalization firms range in size between $250 million and $1.5 billion, and the small capitalization firms are those below $250 million in market capitalization.

The Results The three groups, while similar in fundamentals differ slightly. The mid-cap stocks have the highest dividend yield among the three groups. It was also surprising to find a number of S&P 500 stocks among these mid-cap securities. This, along with the 52-week relative strength measure points to a collection of companies that have stumbled slightly, and the relative performance of their stock prices indicates this. The 52-week relative strength measures the relative stock price performance versus the market as a whole. Figures above 100% indicate that a stock has outperformed the market, while figures below 100% indicate underperformance. The vast majority of the companies that passed the screens have underperformed the market over the last year. The small caps, however, showed the weakest performance, both fundamentally in terms of earnings growth and technically in terms of price strength. Screening for relative high dividend yield is based upon the time-honored rule of buying low and selling high. Examining a stocks dividend yield provides a useful framework to identify potential candidates. To succeed at this strategy, you need to develop a set of tools to not only identify which stocks have relatively high dividend yields, but also which of these stocks have the strength to bounce back.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)
Found in the Company Information Group: IND_2_DIG <> 12 Sector <> Utility Found in the Growth Rates Group Found in the Income Statement - Annual Group DPS_Y5 > 0 DPS_IND >= DPS_12M Dividend Y5 > 0 Found in the Ratios Group Dividend, indicated >= Dividend 12m PAYOUT_12M <= 50 DPS_12M >= DPS_Y1 DPS_Y1 >= DPS_Y2 DPS_Y2 >= DPS_Y3 DPS_Y3 >= DPS_Y4 Dividend 12m >= Dividend Y1 Found in the Multiples Group Dividend Y1 >= Dividend Y2 Dividend Y2 >= Dividend Y3 YIELD > YIELD_A5Y Dividend Y3 >= Dividend Y4 Yield > Yield-Avg 5y YIELD >= 2 Yield >= 2 (Note: This number can be varied based upon the market situation) Payout ratio 12m <= 50 PAYOUT_12M > 0 Payout ratio 12m > 0 DPS_G5F > 0 Dividend-growth 5yr > 0 DPS_Y4 >= DPS_Y5 Dividend Y4 >= Dividend Y5

Shadow Stocks

Stock-Picking Roundup: Buy Em Low, Sell Em High

By John Markese
The stock market may conjure up images of the old cattle ranges to many investors, who certainly ride herd on their own stock. And like the colorful lingo that is exchanged among ranch hands, colorful phrases abound in the stock market. One phrase that has been making the rounds in the media recently is: Buy em at half their growth and sell em at 1.5 times their growth. Actually, this phrase is an old saying that has been around for some time. The idea behind it is simple, but like many sayings, it is well worth remembering. From Saying to Practice What does the saying mean from a practical viewpoint? The best way to tackle it is to examine a stocks priceearnings ratio relative to its earnings growth rate. When a stock is selling at a price such that its price-earnings ratio is less than half of its earnings growth, it is a buy. When a stock is selling at a price-earnings ratio that is 1.5 times earnings growth or greater, it should be sold. Everything in the middle of these two extremes is presumably a hold. The idea is to purchase a stock with some demonstrated earnings growth before the market recognizes the potential and bids up the price-earnings ratio. Eventually, the market will recognize the potential, and it will overprice that potential, raising the price-earnings ratio relative to growth above the 1.5 threshold. That will then be a signal to the investor to jump from what is assumed to be a runaway value train. As has been noted often, high growth rates of earningsabove 25%are difficult to maintain for extended time periods. Thats because the firm and the market for its product mature, and competitors invade the highly profitable product market territory. If earnings growth has been extraordinarily high for a small firm over 5 years, the next five years may not be as productive; price-earnings ratios, however, are often run-up by expectations of even higher growth. The potential for earnings growth disappointments is great. Refining the Rough Edges Concentrating on the buy side, simply looking for a price-earnings ratio relative to earnings growth below 0.5 is not enough. A firm that has deteriorating or unstable earnings can still produce high historical earnings growth, but the earnings stream is so risky that the priceearnings ratio remains low in compensation for the risk. There are a few easy screens that individual investors can employ to eliminate firms with unstable earnings growth. First, look back at five fiscal years of earnings data, and drop from contention any firm with negative earnings. Second, for every year over the last five years and including the most recent 12 months, insist that the

The Shadow Stock series was started by AAII in January 1985. The list is updated each year and consists of nonfinancial stocks that are small, with low institutional interest, and that have had positive annual earnings for the two previous years. Non-Shadow Stocks are all stocks other than Shadow Stocks. Shadow Stocks are presented to illustrate screening techniques that individual investors may find useful in their investment programs. They are presented as illustrations and are not recommendations. Further analysis of individual Shadow Stocks is necessary for any investment decision. A complete explanation of the Shadow Stock series, along with a list of all Shadow Stocks, appeared most recently in the March 1990 issue; new members receive explanations in the new member packet. John Markese is executive vice president and director of research at AAII. The series is researched by John Bajkowski.

earnings per share has increased, even if the increase was slight. Earnings could be flattening out, a condition you would notice as you look at the data, but the earnings trend would still have recently been up. The Shadow Stock Range The Shadow Stocks listed this month passed these two earnings trend screens, and had price-earnings ratios relative to earnings growth of 0.5 or lower. The priceearnings ratios of these firms averaged just above the market, with an average of 14, but their annual growth in earnings was far above the overall market, with an average of 65%. The earnings growth rates of these firms are impressive, although some had earnings five years ago of just a few pennies. The table presents several earnings reference points: the earnings for the fiscal year five years ago, two years ago and last year, as well as the earnings for the most recent 12 months. Note that the earnings for the most recent 12 months will overlap the last fiscal year to a greater or lesser extent depending on the time period the firms fiscal year covers. For example, Uno Restaurant Corp., the originator of Chicago deep dish pizza, now dishing it out throughout the country, went from $0.06 a share five years ago to $0.50 in the last full fiscal year, to most recent 12 months of earnings of $0.55. Because Unos fiscal year-end is October 1, and the data for the most recent 12 months is as of June 30 (the end of the firms most recent reported quarter), the two earnings figures overlap by three monthsJuly through September.

The Shadow Stock data provides an example of why it is important to examine earnings in the individual years; just looking at five-year annual earnings can be deceiving. Unos phenomenal 70% compound annual growth in earnings over five years would be difficult to maintain. The firm had earnings per share of $0.06 in fiscal year five, $0.14 in fiscal year four (not shown), and $0.30 in fiscal year three (not shown), resulting in a doubling of earnings from fiscal year five to fiscal year four, and then another doubling in fiscal year three. Rapid growth in new restaurants can double earnings and double them again. But the momentum of new restaurant openings is likely to slow, slowing earnings growth. Nonetheless, looking for firms with a low price-earnings ratio relative to growth is a worthwhile initial screen. Finally, the price as a percentage of the 52-week stock price high is presented as a glimpse of recent price movement, which means market recognition. These firms average 72% of their recent highs, but given the market direction of late, this statistic probably understates their price movement. Many have had substantial stock price moves up, and although the average price-earnings ratio is a reasonable 14, a few such as Unos are above 20 times earnings, indicating that the market has fairly high expectations of future growth. With a few additional simple screens, and a cautious approach that includes a close look at how these firms achieved their growth from a business and product viewpoint, buy em low at half their earnings growth is a solid bit of financial wisdom. While it wont guarantee the pick of the herd, it will at least steer you in the right direction.

Definitions of Screens and Terms

The following is a short description of screens and terms used for this months Shadow Stock listing. P/E to Annual Five-Year Growth Rate: Price-earnings ratio (price per share divided by earnings per share) divided by the annual growth rate in earnings over the last five fiscal years. An indication of how the market values the firm relative to its historical earnings growth rate. A low relative valuebelow 0.5 may indicate that the market has not yet recognized a firms potential. P/E Ratio: Market price per share divided by earnings per share. Provides a measure of the markets expectations regarding the firms earnings growth and risk. Annual Five-Year EPS Growth Rate: The compound annual growth rate in earnings over the last five fiscal years. Earnings Per Share: Net income after all expenses and taxes, divided by the number of common shares outstanding. An indication of earnings stability and trend when examining individual years over the last five-year period. EPS Last 12 Months: Earnings per share for a full year through the firms most recent reported quarter. EPS One Year Ago, Two Years Ago and Five Years Ago: Earnings per share for the years indicated based on the firms fiscal year. Price as Percent of 52-Week High: Current market price divided by the highest price over the past 52 weeks. A price momentum indicator that shows the recent movement of share price.

Shadow Stocks: Low P/E to Growth Rates

P/E to Annual Earnings per Share* Annual 5-year Price as 5-year EPS Last One Two Five Percent of Growth P/E Growth 12 Year Years Years 52-week Rate Ratio Rate Months Ago Ago Ago High Stock (Exchange) Ticker (x) (x) (%) ($) ($) ($) ($) (%) Description of Firm

Intelligent Electronics (O) Pentech International (O) Swift Energy (A) Odetics Inc. 'B' (A) Bridgford Foods (O) Code Alarm (O) Lillian Vernon (A) T2 Medical Inc. (O) Group 1 Software (O) Lynch Corp. (A) Arkansas Freightways (O) Uno Restaurant Corp. (A) Mestek Inc. (N) Ben & Jerry's Homemade 'A' (O) Bowl America 'A' (A) Hipotronics Inc. (A)

INEL PNTK SFY O.B BRID CODL LVC TSQM GSOF LGL AFWY UNO MCC BJICA BWL.A HIP

0.1 0.1 0.1 0.1 0.2 0.2 0.2 0.2 0.2 0.2 0.3 0.3 0.5 0.5 0.5 0.5

8.1 15.0 7.4 18.0 20.1 11.3 9.0 25.0 9.9 12.4 15.7 22.7 7.3 15.9 13.4 12.6

95 124 61 130 102 57 43 111 42 51 54 70 16 31 26 23

1.82 0.30 1.48 0.32 0.91 0.95 1.18 0.99 0.71 1.53 1.16 0.55 0.94 0.91 1.46 1.51

1.02 0.25 1.35 0.28 0.83 0.86 1.17 0.80 0.70 1.31 1.00 0.50 0.89 0.79 1.42 1.50

0.59 0.17 1.16 0.25 0.63 0.72 0.88 0.62 0.66 0.98 0.83 0.35 0.79 0.63 1.19 1.16

0.07 0.01 0.20 0.01 0.05 0.14 0.28 0.04 0.17 0.25 0.18 0.06 0.50 0.27 0.57 0.65

62 74 85 77 76 45 61 80 74 61 78 77 73 69 81 77

Franchise; computer stores Mkts writing/drawing prod Oil & gas explor'n, devlp, produc'n Mfrs electro equip to record Frozen & snack food products Mfrs automobile security systems Direct mail catalog sales Operates infusion therapy ctrs Mfrs IBM-compatible software Glass machin'y; test equip; quartz Motor carrier, general freight Operates pizza restaurants Climate control equip; engin'g Mfrs ice cream/franchise stores Bowling centers Hi volt test/power supply equip

*Based on firms fiscal year Exchanges: N = New York Stock Exchange A = American Stock Exchange O = Over the counter

Statistics are based on figures as of August 31, 1990. Data provided by MP Softwares MarketBase, Needham Hts., Mass. Descriptions provided by Standard & Poors Stock Guide.

Screening Criteria For use with AAII's Stock Investor program (version 2.1)
Found in the Mutliples Group: PE_TO_G5F <= 0.5 PE to EPS growth 5yr less than or equal to 0.5 Found in the Income StatementAnnual Group: EPSCon_Y5 > 0 EPS Cont Y5 greater than 0 EPSCon_Y3 > EPSCon_Y4 EPSCon_12M >= EPSCon_Y1 EPS Cont 12M greater or equal to EPS Cont Y1 EPSCon_Y4 > EPSCon_Y5 EPSCon_Y1 > EPSCon_Y2 EPS Cont Y1 greater than EPS Cont 2 EPS Cont Y2 greater than EPS Cont3 EPS Cont Y3 greater than EPS Cont4 EPS Cont Y4 greater than EPS Cont5

EPSCon_Y2 > EPSCon_Y3