While there are a number of criteria used to select stocks for the Workshop, the two most important are earnings and price momentum. Earnings drive stock prices over the long term, and price momentum tends to drive prices over the short term. Both are powerful tools for mechanical stock selection.
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Friday we talked about the Value Line Timeliness rating that functions as our first filter, much like Dow membership prescreens large-cap stocks for the Foolish Four. Without some kind of barrier to keep out the riffraff, mechanical strategies are far less likely to work. For example, if I just ran a stock screening program like Hoover's Stock Screener looking for high-dividend-yield companies, I would pick up a large number of foreign companies, utilities, and real estate trusts, even if I limited it to the New York Stock Exchange. When I ran such a screen for stocks with dividend yields greater than 4%, I came up with 468 companies.
Using the Value Line Timeliness rating as the first screen gives us 100 stocks (or 400 if you include the top two categories), most of which have excellent earnings and strong price momentum. It then remains to narrow the field down to an optimal number of companies. That's where the fun starts. Most of the strategies we follow in the Workshop screen for strong earnings in one way or another. It seems like I've said this a thousand times, but earnings are the single most important factor in long-term share-price growth. More precisely, the expectation of future earnings drives share prices.
Fundamental stock pickers such as Peter Lynch, Warren Buffett, and our own staff watch earnings like a hawk. They also pay attention to things like debt ratios, gross margins, insider ownership, Flow Ratios, brand dominance, etc. But, scratch the surface of any of those terms and you will find earnings.
Debt ratios are important because interest payments reduce earnings. High gross margins mean a company has more leeway to cut administrative costs, and the money saved flows to earnings. Insider ownership shows that the management will personally benefit from growing earnings. Brand dominance gives a company pricing control, which translates to higher earnings. Fundamental stock analysis all comes down to the company's ability to generate cash free and clear.
The Foolish Four's dividend yield is something of a proxy for earnings, in that a company pays dividends out of earnings. (Some would argue that using earnings directly might improve the Foolish Four's results, which may very well be true. The only problem is that dividend yields are readily available for historical backtesting, while earnings were are not as easily tracked back over decades when we originally designed the strategy.)
In the Workshop, we use several different earnings measures. The first one tried was the EPS rating from Investor's Business Daily (IBD). IBD ranks every stock it covers according to the earnings potential. The formula is proprietary, but gives the top 1% of companies a rating of 99, the next 1% are rated 98, etc. The rating is the percentage of all companies that a given company is better than.
IBD's EPS rating is used in three strategies. Unemotional Growth uses it as a primary sort, and RS-IBD and Formula 90 use it as a tiebreaker.
Other Workshop strategies use earnings data from Value Line. The Keystone EPS and Spark both use "%EPS 12-month Chg Latest Qtr." Behind the abbreviations, that criterion tells you how much earnings per share have grown over the past 12 months, based on the most recent quarterly report. The PEG strategies use the projected EPS growth rate, which is nothing more than the rate at which most analysts expect to see earnings grow in the near future. Screening for companies that rate high by these criteria gives you companies with exceptionally strong earnings.
Simple enough, so far?
Earnings drive stock prices over the long run. That is the one basic fact of financial life that almost no one disputes. But, over the short run, momentum is also a powerful predictor of prices. Stocks that are going up tend to continue going up. (Except when they don't. The correlation isn't perfect, obviously.)
The low-price component of the Foolish Four strategy corresponds to the price momentum criteria in the Workshop, except that the Foolish Four looks for stocks that have gone down recently, since it is looking for undervalued stocks.
In the Workshop, momentum is called Relative Strength (RS), or sometimes Total Return. All three terms refer to how fast a stock's price has appreciated relative to the market and can be used interchangeably. RS-IBD uses Investor's Business Daily's Relative Strength rating. (You knew I was going to say that, right? You're getting the idea!) The RS rating works just like the EPS rating, with the top 1% of stocks rated 99, etc.
The RS rating looks at price appreciation over the past year, with additional weighting given to recent performance. So, if two stocks each went up 100% in the past year, but Stock A went up 75% six months ago and has grown more slowly over the past six months, while Stock B did all of its growing in the last six months, Stock B would be ranked higher than Stock A.
Virtually all Workshop strategies use some kind of Relative Strength criteria, either the IBD ranking or Value Line's Total Return-X weeks. Total Return, however, is far more versatile than the IBD rating because Value Line reports Total Return for the past week, month, quarter (13 weeks), half-year (26 weeks), year, etc., all the way out to 10 years. As a result, we have RS-26, RS-13, RS-4, and RS-52. The most frequently used is probably RS-26.
We have two "pure" Relative Strength strategies -- RS-26 and RS-13 -- that we follow officially. RS is also used to create variations of other strategies, thus we have PEG-26 and PEG-13, identical strategies except that one uses Total Return-26 weeks as its Relative Strength criteria and the other uses, you guessed it, Total Return-13 weeks.
The one thing we all seem to agree on in the Workshop is that Relative Strength is a necessary factor in designing just about any kind of screen.
One other criteria used in a number of Workshop screens is market capitalization. Market cap is simply the total price of a company -- the current price times the number of shares outstanding. Some Workshop strategies, notably the Keystone family and Spark, use a market-cap filter to focus on large-cap stocks. (Whew! That was a simple one -- about time!)
OK, that's been a whole lot of words. Congratulations to those of you who made it through. Now, I have just one more request. Click over to our Workshop Screen Explanations page and see if the screen descriptions are starting to make sense to you. While you're there, you can check out the returns for these strategies to remind yourself why you are going through all of this. If you're feeling lost, e-mail me ([email protected]) and I will try to beef up this trail of bread crumbs.
On our next Workshop Thursday we will talk a little (I hope) about the actual mechanism of selecting stocks using these criteria.
Fool on and prosper!