Saturday, August 23, 2008

The User's Guide to This Week's 'Value' Screen

This week we'll be taking a look at some potential investments I found using a stock screener.

If you've never used one of these nifty online gizmos, you should give it a whirl. They're an efficient way to sift through the vast equities universe and find companies that meet your specific criteria. It's also a good mental exercise, especially with a really powerful screener that can scan using scores of variables. Keep an eye on yourself: What you wind up looking for will tell you a lot about your investing style, and that can be every bit as valuable as a good stock tip.

I, for one, love to buy stocks on sale. The more insultingly low the price, the better.

Now, this sort of "value" investing can be a little risky, because prices are usually low for a reason. (Though that reason might not have anything to do with the company itself.) So the trick to mitigating the risk of any value strategy is to refine it. To do this, we add what Ben Graham calls a "margin of safety." In this case, that could mean looking for companies with low stock prices AND a record showing historical outperformance -- beating peers and benchmarks -- while delivering ever-increasing earnings.

So I ran a simple screen of U.S. equities using three criteria -- no fancy indicators or mathematical sleight of hand. I sought:

Companies that were down at least 10% for the year, and

Companies that had increased their net earnings at least 30% for the past ten years, and

Companies that were in exceptional financial health.

This screen yielded four companies. That's good: The fewer results, the better.

Now, look, any knuckle-dragging bohunk laborer can bust up a rock with a chisel. That doesn't impress me in the slightest. But a skilled craftsman can use that same tool to construct a stone wall that will last a thousand years. An artist might use a chisel to fashion a sculpture so beautiful as to make a man weep. The tool is only a device to save labor; it is the skill of the user that determines the results. The point: Building a great screen is the first step, not the last.

So we will attempt to add intelligence to our screen by asking the following questions:

1. How have earnings per share fared over time? Is that likely to continue? Where does that put per-share results in two years? What do analysts forecast?

2. What is the current earnings multiple? How close is it to the stock's historical average? Where will the multiple be in two years?

3. Given these earnings estimates and PE predictions, what will the fair market value of the stock be in two years? What sort of growth is this? Given post bear-market rbounds, is this price target realistic?

4. If the price target is realistic and the upside presents a premium, am I willing to accept the risk/reward this investment represents, or would I be better off in a low-cost index fund? Do I understand the business? Do I want to be an owner of the company? Can I articulate why?

All of the information I'll use is available from free sources like Google Finance. And I'll try to figure out how to put some of this data in tables to make it a little easier to digest. If I find satisfactories answers to these four questions, I'll add the company to my general portfolio.

In the meantime, here is where my "Deep Discount" picks from two weeks ago stand as of Friday's close. All in all, I'm pleased with these results: They didn't double overnight, and I wasn't expecting them to. These stocks may take a year or more to recover to where I think they should be. I remain confident they will.

If you're interested, look back at the past month's chart for MGM -- it's nuts. Beta is 2.18 -- meaning MGM's price sginificanly magnifies the market's swings. When I see choppy trading like that, I get happy. And I tend to take "fast gains" and then wait for another opportunity to re-purchase the shares.

CIT 8.76, 9.70 +10.7%
MGM 29.79, 33.25 +11.8
KMX 14.10, 15.11 +7.2%
MER $26.85, 25.22 -6.1%
GM 10.23, 10.44 +2.1%

Now, I want to say something about Merrill Lynch. I have to be very careful about this stock. Why? Because I really admire the CEO. I have a lot of faith in him. The danger when that happens is that I run the risk of running over the cliff with him. Now, I certainly don't think Merrill is in danger, I just have to make sure I'm not making my investments show friends when this here is show bidness. I have established $22 as the point where I decide to double down or close the position. The third option -- sit still -- is not available. Yes, I set the rule, and I suppose I could ignore it. But the hallmark of a great investors is -- wait for it -- discipline.

If you want to check out a good stock screener, click here.

Tomorrow: Screen Result No. 1

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