Using Fundamental Tools To

Enhance Trading Strategies

Marc H. Gerstein, Director of Investment Research

May 28, 2003

 Too Smart For Our Own Good?

• Question
• What’s the most important issue a (long) investor/trader should consider?
• Good management?
• A stock that’s breaking above resistance?
• Upward revision of earnings estimates?
• An oversold oscillator reading?
• A low P/E?
• Answer
• Finding stocks that are more likely than not to go up!
• It’s less obvious than you realize
• If you spend all your time looking at bad stocks, you will suffer a loss even if you
skillfully use all your fundamental/technical tools to identify the best stock in the
bunch
• The best dog in the kennel
• If you spend all your time looking at great stocks, you will do well even if you are less
than perfect in applying your fundamental/technical tools

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 Technical versus(?) Fundamental Approaches

• Allies, not enemies

• “If we can take our ideas from fundamental analysis but filter them through the
technical screens, we’ll be miles ahead of those who analyze only fundamentals or
technicals…. When fundamentals and technicals are in gear, a savvy trader can
have a field day.”
• Dr. Alexander Elder, Come Into My Trading Room (John Wiley& Sons, 2002) page 41,
emphasis supplied
• “[A] great way to use a technical analysis program is to time entry points where a
fundamental purchase decision has already been reached. If you like IBM for
fundamental reasons, wait for the ‘technicals’ to ‘Go!’”
• OmniTrader Guide Book (Nirvana Systems, 2002) page 24
• A common task – finding good stocks
• “Screen your investment selection. To select investment vehicles, you must have a
predefined method.”
• Robert Deel, Trading The Plan (John Wiley & Sons, 1997), page 14 (the third rule of
“investology” (emphasis in original)
• To start, “put together an evaluation list that includes as many gems and as few dogs
as possible. If you do this effectively, you enhance your chances of success even
before you start to evaluate a single company.”
• Marc Gerstein, Screening The Market (John Wiley & Sons, 2002), page 33

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 A valid concern

• Fundamental analysis is often seen as being vague and nebulous

• Ask a trader why he/she bought a particular stock and you’ll get a clear answer.
• You may or may not like the trading system used, but at least you can respect the fact that
some sort of clear approach was followed
• Ask a fundamental investor he/she bought a particular stock and you may get an
answer, or you may get a shrug of the shoulders
• “There are problems with fundamentals. First, many are difficult to quantify….
Fundamental analysis does not automate easily…”
• OmniTrader Guide Book (Nirvana Systems, 2002) page 23
• An overly broad stereotype
• Today’s comprehensive databases and screening tools bring the power of
automation to fundamental analysis
• The MultexInvestor.com web site, The MSN.MoneyCentral.com web site, etc.
• Stock screening and rating protocols bring to the fundamental camp a level of
systematization that traders can recognize and be comfortable with
• Sentiment-oriented data is co-mingled with classic financials in such a way as to
start blurring some o the distinctions between fundamental and technical investing

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 Using Fundamental Stock Screening/Analysis

• Define fundamentals broadly

• What you expect
• Data relating to a company’s financial position and performance
• What you may not expect
• Data relating to sentiment
§ Analyst estimates/ratings data
§ Insider buying
§ Institutional trading
§ Short selling
§ Share Price performance

• Recognize basic fundamental “rules”

• Articulate the kinds of data readings that are likely to be associated with strong or
weak share price performance
• Example: Upward earnings estimate revision is bullish
• Learn to combine rules in a strategic manner

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 Whetting The appetite

• Performance data showing how fundamental stock screening can identify a list
of stocks that, on average, post superior price performance
• The testing/measurement method
• A time period running from February 2000 through March 2003
• Assume all stocks listed by a screen are held in equal weights
• Ignore dividends and trading costs; measure price performance only
• Re-run screens and reconstitute lists at the end of each month
• Some stock screens maintained on MultexInvestor.com
• S&P 500: -36.5% Russell 2000: -26.1% NASDQ 100: -65.2%
• Growth Screens
• Accelerating EPS Growth -10.8%
• Relative Growth +60.2%
• Relative Momentum -26.7%
• Rising Expectations -24.6%
• Sales Growth Leaders +91.4%
• Continued on next slide è

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 Whetting The appetite (continued)

• Some stock screens maintained on MultexInvestor.com (continued)

• S&P 500: -36.5% Russell 2000: -26.1% NASDQ 100: -65.2%
• Value Screens
• Favored Value Plays +68.6%
• Contrarian Opportunities +170.2%
• Income Stocks +42.5%
• Growth At A Reasonable Price +37.4%
• Relative Value +82.1%
• Quality Screens
• Fastest Turnover +37.4%
• Industry Leaders +12.6%
• Strong Operating Margins -5.6%
• Strong Return On Investment +69.5%
• Sentiment Screens
• Analyst Favorites +41.2%
• High P/E Ratios -11.6%
• Institutional Ownership -15.2%
• Lesser Known Stocks +62.8%
• Insider Buying -10.6%

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 About the screens

• The list, as it stood at the end of 3/03, contained 507 stocks

• 250 of these stocks were optionable
• The list included 58 members of the S&P 500 including such popular names as . . .
• Microsoft
• Dell
• Abbot Labs
• Lowe’s Companies
• eBay
• Yahoo
• QLogic
• Moody’s
• How relevant is the performance record? After all, we can’t own them all (I.e.
monthly regeneration and trading costs).
• Treat this “universe” or any other screen-based list, as your own “designer
stock market”
• If you’re simply picking individual stocks from a different list, frequent list
regeneration and trading costs present no special problems

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 A Designer Stock Market

• You still make selections from a large stock universe and try to
determine which ones are most likely to perform well
• What’s different is that in the designer market, you tilt the probabilities
in your favor even before you look at a single company or chart
• “Suppose a magician came along and offered to help you invest in stocks.
He refuses to do anything to improve your stock selection skills. So if you’re
a good stock picker in the real world, you’ll stay good after he waves his
magic wand. And if you’re a mediocre analyst, you’ll stay mediocre. But he
does offer to let you choose whether the stock market goes up 20 percent
or down 5 percent. I’ll be you’d accept the offer and choose a +20 percent
market. You might still pick some duds. But wouldn’t you prefer to do your
thing in a bull market that rises 20 percent?”
• Marc Gerstein, Screening The Market (John Wiley & Sons, 2002) page 34

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 Making It Work

• Build your own stock screens

• You can find free and/or premium screening applications on such sites as
MultexInvestor.com, MoneyCentral.MSN.com, SmartMoneySelect.com,
Morningstar.com, Quicken.com, WallStreetCity.com
• An excellent CD-based screener (with weekly data updates) is available through the
American Association of Individual Investors (AAII.com)
• Use “pre-set” screens
• Up-to-date lists using the screens whose performance records were listed earlier are
all made available, for free, on MultexInverstor.com
• The other firms listed above also make pre-set screens available for those who don’t
want to build their own
• Use “pre-set” screens as a starting point, modify them as you wish, and save
them as personal screens
• Reverse the process
• Identify stocks in any manner you wish and conduct fundamental analysis to
determine how well the situation matches up under the same “rules” you could have
used had you wised to build screens

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 The Fundamental Screening Rules

• Different from stereotypical ideas about fundamental analysis

• You will not be asked to answer difficult (often impossible) questions about management,
customers, suppliers, employees, proprietary technologies, and so forth (Few, if any, outside
investors can competently assess such issues based on publicly available information.)
• See the story in the numbers
• Quality companies (based on success in all or some of the areas mentioned above) tend to leave
“footprints of success” that are readily quantifiable
• One small example:
Operating Margin comparison
XYZ, Inc. Industry Average

Trailing 12 Months (TTM) 8.6% 8.8%

5-year average 9.0% 11.5%

Even though ABC’s margins are slipping and were consistently below the peer average, we see that ABC’s
“relative comparison” has become less unfavorable. This may be a clue that something uniquely positive is
happening at ABC
Imagine how we’d react if ABC’s TTM margin actually jumped ahead of the peer average, to say 9.4%!
Such situations do exist (355 companies as of the end of 3/03, 58 of which were in the “Select” 507).

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 Type Of Rules

• Direct
• Straightforward situations where we can look directly at the numbers and conclude
that all else being equal, they are good-or-bad (or, preferably, better-or-worse)
• All else being equal, a P/E of 15 is better than a P/E of 30
• All else being equal, a 22% growth rate is better than a 9% growth rate
• Behavioral
• We do not really care about the numbers themselves, but only to the extent they
shed light on how the investment community at large feels about a stock
• Example 1
§ Assume the consensus estimate for company EPS rose from $2.25 to $2.40
§ We don’t necessarily care that the company is likely to earn $2.40 a share
§ We care deeply about the fact that whatever the company is expected to earn, the expectation has
become more favorable than it used to be
• Example 2
§ Assume ABC stock rose 4% over the past month, while its industry peers, on average, fell 7%
§ We don’t necessarily care (at this time) that the stock is up.
§ We care deeply about the fact that investors found reason to separate it from its peers. This is not a
rising tide that lifts all boats. Something unique and special may be happening at this company.

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 Logic Alternatives

• Using the rules to articulate a numeric test

• P/E is less than 25
• Not a great test
• Why use 25 as a threshold? Why not 20 or 30 or any other number?
• Is a stock with a P/E of 24 really less desirable than one with a P/E of 25?
• Using the rules to articulate a comparative test
• P/E is less than Industry (or Sector or Market or Data Universe) Average
• A much better test that should be used wherever possible
• A P/E of 25 could be deemed cheap if the industry average is 30
• A P/E of 12 could be deemed expensive if the industry average is 8
• Liberal use of such tests helps us identify situations that are superior for company-
specific reasons, as opposed to general considerations that impact all companies
• The difference between a stock that goes up because of broad market rally versus the
stock that goes up (possibly despite a down market) because of something special the
company did.
• The probabilities will be tilted in your favor in you consistently apply your technical/trading
ideas to situations like these

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 Types Of Comparisons

• Cross-sectional comparisons
• Compare a company to a peer group
• P/E less than Industry Average P/E
• 5-year Growth Rate greater than Industry Average 5-Year Growth Rate
• Time-series comparisons
• Compare a the present situation to the past
• Latest quarterly growth rate greater than company’s own annual growth rate
• Annual growth rate greater than company’s own 5-year growth rate
• Complex Comparisons
• Determine if the company’s relative stature (e.g. company-to-industry comparison)
has improved or deteriorated over time
• Company’s here-and-now relative Return on Equity (company ROE divided by Industry
ROE) is greater than its 5-year relative ROE
• Not all screening programs can handle this
• If your can’t do it, you can still examine such comparisons when you review company-
specific fundamental data on a site like MultexInvestor.com

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 Categories Of Rules (Screening Themes)

• Growth
• Rules seeking favorable EPS growth rate comparisons
• Rules seeking favorable Sales growth rate comparisons
• Rules seeking Sales growth rates that are generally keeping pace with EPS growth
• If sales aren’t growing, EPS growth will probably stall; you can’t cut costs forever
• Quality
• Rules seeking favorable Margin comparisons
• Try to use Operating (or Gross) margin, rather than net margin
§ Provides better visibility of day-to-day business activities, instead of a broad combination of
business activities and other non-core corporate endeavors
§ Corporate endeavors are important, but I’d rather examine these when I look at a specific company;
if the basic business is bad, I don’t even want to bother looking so I don’t want it on my list
• Rules seeking favorable Return on Capital comparisons
• Try to use Return on Investment or Return on Assets, rather than Return on Equity
§ Provides better visibility of day-to-day business activities, instead of a broad combination of
business activities and corporate finance strategies
§ Finance strategies are important, but I’d rather examine these when I look at a specific company; if
the company is financially strained, I don’t even want to bother looking so I don’t want it on my list

• Continued on next slide è

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 Categories Of Rules (Screening Themes) - continued

• Value
• P/E reasonable compared to peer group
• P/E reasonable compared to growth rate
• The notion that PEG (P/E-to-Growth) ratio shouldn’t exceed 1.00 owes much to folklore and
nothing to mathematics
• PEG ratios as high as 2.00 are usually acceptable
• Other ratios
• Price/Sales, Price/Book Value, Price/Cash Flow
• Sentiment
• Analysts are more positive (ratings and/or estimates) than they were before
• Even if you don’t like or trust analysts, note what they say
• Many still follows them, so their pronouncements are still trend-makers and trend-busters
• Institutional buying/selling
• They’re big, so their decisions, sound or not, move stocks
• Insider buying
• Insider selling is less useful
• Short selling/covering
• Relative share price performance

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 Strategic Screening (combining themes)

• Elements of a screen
• Primary theme
• This is the category of rules that is most important to you
• Secondary theme
• This is a category of rules that differs from, but is generally supportive of you primary theme
§ If your primary theme is growth, sentiment could be a secondary theme
• Alternative theme
• This is a category of rules that is completely unrelated to, and preferably antagonistic to,
your primary theme
§ If your primary theme is growth, value could be an alternative theme
§ If your primary theme is value, sentiment (i.e. analyst estimate revision) could be an alternative
theme

• The strategic blueprint

• Articulate a primary theme
• Add at least one additional theme (secondary or alternative)
• Add more themes if you like but don’t go overboard lest you drive your result total to
zero

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 Sample Screen: Sales Growth Leaders

• For long trading ideas

• The Tests
• Year-to-year sales growth in the latest quarter was positive and above the industry
average
• Sales growth rates for the trailing 12 months and the past three years were above
the industry averages
• The estimate of EPS for the current quarter was raised in the past 13 weeks
• EPS growth beat the industry average over the trailing 12 months, the past three
years, or the past five years
• Net insider Buy transactions is greater than zero

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 Sample Screen: Relative Growth

• For long trading ideas

• The Tests
• Company's TTM Sales growth is greater than the three-year cumulative average rate
of Sales growth and greater than the average rate of TTM Sales growth for its
industry
• EPS growth exceeds Sales growth over the past three yeas and in TTM
• EPS growth in the latest quarter (year over year) is greater tha n the industry average
growth rate and is better than the growth rate that prevailed over the Trailing Twelve
Month period
• Company's TTM tax rate is at least 25%

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 Sample Screen: Contrarian Opportunities

• For long trading ideas

• The Tests
• Share price, over the past four weeks, suffered a decline of more than 15% and was
worse than four-week industry average share price change over that period
• EPS growth must be above the industry average over the past three and five year
periods
• 5-year average operating margin must be above the industry average
• 5-year average ROI must be above the industry average
• 5-year average return on equity must be above the industry average

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 Sample Screen: Favored Value Plays

• For long trading ideas

• The Tests
• Trailing 12 month P/E is less than industry average
• Forward-looking PEG ratio (forward-looking P/E divided by projected three- to five-
year growth) is less than or equal to 2.00
• Trailing 12 month Price/Sales is less than industry average
• Average analyst recommendation (1.00 = best; 5.00=worst) is less than 2.00 and
less than or equal to where it stood four weeks ago
• The estimate of EPS for the current quarter was raised in the past four weeks

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 Sample Screen: Relative Value

• For long trading ideas

• The Tests
• Trailing 12 month ratios for Price-to-Earnings, Price-to-Sales, and Price-to-Free
Cash Flow are no more than 10% above the industry average
• P/E-to-Growth (PEG) ratio be at or below 2.00
• EPS growth rates for the Trailing 12 months and past three years is at least 25%
better than the industry average growth rates over those same periods
• Stock must have outperformed those of other companies in the same industry in past
four weeks

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 Sample Screen: Strong Return On Investment

• For long trading ideas

• The Tests
• Trailing Twelve Month (TTM) Return on Investment (ROI) is more than 20% above
industry average TTM ROI
• Five-year average ROI is more than 20% above industry five-year average ROI
• TTM ROI is at more than 20% above the company's own five-year average ROI
• Company's TTM return compared with its industry average (company return divided
by industry average return) is more than 20% better than the degree of superiority
compared to the five-year average
• Consensus EPS estimate for current quarter has not been reduced over the past
eight weeks
• # of shares purchased by institutional investors over the last quarter reported by
each institution is greater than the number of shares sold

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 Sample Screen: Analyst Favorites

• For long trading ideas

• The Tests
• Stock has an average rating less than or equal to 1.75 (1.00=most bullish,
5.00=most bearish)
• Current average rating is less than it was four weeks ago, and the four-week ago
average rating is less than the 13-week-ago rating
• At least one analyst went beyond the near-term and issued a long-term EPS growth
projection
• Short interest is no more than three percent of the float or a lesser percent than was
the case one month earlier
• Forward-looking PEG ratio is no more than 2.00

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 Sample Screen: Lesser Known Stocks

• For long trading ideas

• The Tests
• Stock's trading volume over the most recent 10 market days must average at least
20,000 shares
• Stock is covered by no more than five analysts
• Institutions own no more than 50% of the outstanding float
• Institutional percentage ownership must be less than 80% of the average level of
institutional ownership for stocks in the industry
• Latest quarter's year-to-year EPS growth rate must be positive and above industry
average
• Over the past 52 weeks, stock's percentage price change should be at least zero
• Percentage price change over the past four weeks be no worse than -10%
• Net institutional share purchases in the latest quarter reported by the institutions be
no less than zero

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 Exiting A Long Trade - The Challenge

• First impression
• Reverse the kinds of rules we applied to the buying process
• Sample screen
• Trailing Twelve Month (TTM) Return on Investment (ROI) is more than 20% below
industry average TTM ROI
• Five-year average ROI is more than 20% below industry five-year average ROI
• TTM ROI is less than 20% above the company's own five-year average ROI
• Company's TTM return compared with its industry average (company return divided
by industry average return) is more than 20% below the degree of superiority
compared to the five-year average
• What’s wrong
• Overkill
• Do we really need to see a company miss on all these measures before we adopt a bearish
stance?
• Relevance
• Assuming such rules suggest the stock is a hold, would we feel comfortable stating aboard
if, for example,EPS are turning markedly lower, or the balance sheet getting weaker?

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 Exiting A Long Trade - The Solution

• Don’t pre-judge the reasons why a stock might be saleable

• There are many possible reasons why a stock might be buyable or sellable
• If you miss a buying opportunity because of the way you pre-judged the qualities you
want to see in a stock you own, that’s OK
• There are other fish in the sea
• If you miss a selling opportunity because of the way you pre-judged the qualities you
do not want to see in one of your stocks, that’s a big problem
• Since you’re dealing with stocks you already own, an oversight can cause real financial loss
• Focus on Sentiment to catch signals the market might be turning cool toward
the stock
• Then, switch to your regular technical/trading signals to determine if you should act
• Note that this process treats the rules as sell-alerts, not outright sell signals
• Once a stock is in your sell-alert radar, imagine yourself in the shoes of another person,
one who might buy the stock you’d sell
§ If the stock appears attractive to this hypothetical other investor, that’s a hint you
ought not sell
§ If the stock would hold little appeal for the other investor, that indicates you should
sell

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 Suggested Sell-Alert Rules

• During the past week, there was a downward revision in the EPS
estimate for the company's current fiscal year
• Overall analyst ratings have become more bearish in the past four
weeks
• The Short Interest Ratio is above 3 percent and has grown in the past
month
• The stock's relative (company to industry) four-week share-price
performance is at least 35 percent worse than it was during the 13
weeks before that
• The stock under performed the industry average by at least 35 percent
during the past four weeks
• During the most recently reported period, institutions have been net
sellers of the company's shares

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 Managing The Sell-Alert Rules

• Each rule is likely to produce a huge list

• This is to be expected
• At the end of the day, about half of all stocks are more more or less below average
• Since you care only when existing longs appear on these screens, and are not
looking to cull the list for new ideas, you don’t have the same incentive to narrow
further as you do when screening for buying opportunities
• At any given time, most of your stocks are likely to trigger at least one sell rule
• This, too, is to be expected
• Every trade has a buyer and a seller, so difference of opinion is normal
• The Solution: Consider a sell signal to have been generated only if the stock
meets several rules
• It can be useful to create a scoring system that more heavily emphasizes some rules
as opposed to others

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Thank You!

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