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Keystone, the Big Stock Growth Screen      

By Moe Chernick ([email protected])

El Segundo, CA (June 10, 1999) -- The Keystone is a mechanical stock strategy that, over the last 12 years, has doubled the Standard & Poor's 500 Index's average annual return without undue risk.

The screen has produced an average return of 31% per year from 1987-1998. In contrast, the S&P 500 averaged just under 18% over that time period. If you had invested $10,000.00 in Keystone at the beginning in 1987, you would have had $255,000 by the end of 1998, more than double what the Foolish Four would have returned to you over the same period and more than three times the cumulative return of an index fund. In those 12 years you would have suffered through only two losing years, 1990 and 1992, with a maximum loss of less than 3%. So today let's look at what Keystone is and how it works.

The Keystone was developed by Robert Sheard as a large-cap growth screen to complement the Foolish Four, which is a large-cap value screen. The screen selects high quality, large U.S. companies that have experienced strong price appreciation over the last six months. Let's look a little more closely at the screening process.

Since Robert Sheard intended to develop a screen of growth stocks similar to the Dow, the first hurdle is that a company must be based in the U.S. This also prevents some of the erratic returns that are common in some foreign markets.

The screen includes only stocks that are growing actively. This is the opposite of the Foolish Four, which looks for stocks that are out of favor. In order to find good growth stocks, the Value Line Investment Survey Timeliness rating is used. Rather than limit the screen to the most timely stocks, the screen searches through those ranked 1 or 2 to ensure that enough larger stocks are included in the pool from which stocks are selected.

Next we look at market capitalization to take advantage of the power and relative stability of the super caps. Large companies generally have a longer history and a proven record of returns and therefore tend to be more stable than smaller companies. This, of course, is true only relative to small growth stocks. It doesn't imply that the individual large cap stocks are more stable.

The final factor in Keystone is relative strength. It has been demonstrated that stocks that have gone up recently tend to outperform the market in the future. One good source for information about relative strength is What Works on Wall Street by James O'Shaughnessy.

Let's now put the four characteristics together to make the Keystone. First we filter out all non-U.S. stocks from the Value Line database. The screen next filters for stocks that have Timeliness ratings of 1 or 2. This gives you a list of less than 400 U.S. stocks that Value Line believes are the best buys now. The stocks remaining are sorted by market capitalization, largest companies first. The Dow has 30 stocks on it and therefore the top 30 stocks left on our list become our Keystone version of the Dow 30. This gives us a nice selection of large-capitalization stocks to choose from.

The 30 stocks remaining are then sorted by Value Line's 26-week Total Return -- obviously, the higher the recent total return, the better. The 26-week return is the relative strength portion of the screen. Why wasn't the IBD RS rating used? Only because of the difficulty of backtesting.

That's all there is to it. Take the top 5 stocks, and you have the Keystone 5. Hold those stocks for a year and repeat the process one year later. If you want to trade off returns for a bit more stability, you can take the top 10 from this list. The returns for the top 10 are only slightly less than those of the top 5, and the volatility is lower.

If you don't have Value Line, no problem. That's why the Workshop is here. Just click the link to Current Rankings below, look up Keystone ,and you'll get the complete list of 30 Keystone stocks in their proper order. The list is updated every Friday.

In my next article, we will look deeper into the theory and into the numbers to see why we believe that this screen will continue to work in the future.

Until next time, Fool on!