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Chapter 11 Security Screening. Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity. - General George S. Patton. Outline. Introduction Why screening is necessary What constitutes a good screen? Sources of information
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Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity. - General George S. Patton
Outline • Introduction • Why screening is necessary • What constitutes a good screen? • Sources of information • Screening processes • Examples of commercial screens
Introduction • Security screening involves reducing the security universe down to a manageable size • Picking stocks is an art rather than a science • There is no single best way to choose individual investments
Why Screening Is Necessary • Time constraints • Everyday examples of screens
Time Constraints • The NYSE and AMEX, and Nasdaq list thousands of potential investments • There is no time to analyze every security and process the associated information • Many people never develop a well-conceived way to deal with the information overload
Everyday Examples of Screens • University admission test • The football team
University Admission Test • More people apply for admission than are ultimately admitted • Universities use two steps: • An initial screen • Closer individual scrutiny for those passing the first round
The Football Team • More players try to join the football team than the rosters can carry • Coaches may use screens: • 40-yard dashes for running backs • Bench presses for offensive linemen
What Constitutes A Good Screen? • Ease of administration • Relevance and appropriateness • Acceptance by the user • Ordinal ranking of screening criteria
Ease of Administration • The screen should be easy to administer and implement • E.g., narrow stocks down to thinly traded stocks by using the Wall Street Journal • Thin trading refers to a security with a relatively small number of shareholders and a lack of trading volume
Relevance and Appropriateness • Screens should logically have something to do with the ultimate objective • For example, start at the top of the NYSE listings with your screen
Acceptance By the User • Screens lose value if people fundamentally disagree with it • For example, people may not believe in SAT scores as a screen for admission
Ordinal Ranking of Screening Criteria • Use a screen pecking order for multiple-stage screening: • The first screen is the one that eliminates the most alternatives • The second screen eliminates the second-most alternatives, etc.
Sources of Information • Value Line • Standard & Poor’s • Mergent • Brokerage information • Internet
Value Line • The Value Line Investment Survey: • Follows 1,700 common stocks • Rates each stock in two categories: • Timeliness: the advisability of buying a stock now • Safety: the confidence Value Line analysts have in their forecasts about the firm • Is followed closely by many market analysts
Standard & Poor’s • Stock Report • Stock Guide
Stock Report • The S&P Stock Report is a one-page document that: • Is updated quarterly • Contains a description of a company • Contains an estimate of what the future holds for a company • Contains financial statement information, dividend payment dates, beta, and other risk measures
Stock Guide • The S&P Stock Guide: • Is a monthly publication • Contains summary statistics on common stocks, convertible preferred stocks, warrants, and mutual funds • Is a companion to the Bond Guide
Mergent • Mergent’s manuals • Mergent Dividend Record
Mergent’s Manuals • Mergent’s Manuals: • Were formerly Moody’s Manuals • Contain seven sets of volumes covering industrial firms, public utilities, over-the-counter industrials, transportation issues, and bank/finance issues • Include the Company Archives Manual, which provides data on defunct companies since 1996
Mergent Dividend Record • The Mergent Dividend Record: • Contains information on the recent dividend history of a company, including: • Payment dates • Ex-dividend dates • Etc.
Brokerage Information • Brokers can be a good source of information • All full-service brokers have the ability to provide their customers with stock research
Internet • Examples of good sources: • www.thomsoninvest.net: contains consensus earnings estimates and a stock screener • quote.yahoo.com • www.smartmoney.com • www.morningstar.com • www.fool.com • www.quicken.com
Screening Processes • Multiple-stage screening • Subjective screening • Screening with the popular press only • A quick risk assessment screen with the Stock Report
Multiple-State Screening • Most investment applications require several screening stages • E.g., EPS by itself is not very useful • E.g., dividend yield should not be the only screen for growth stocks
Subjective Screening • Not all screens need to be quantitative • For example, socially responsible investing: • Tobacco stocks, nuclear power, animal testing, the environment, human rights, etc.
Screening With the Popular Press Only • Price/earnings ratio • Dividend yield • Stock price • Exchange listing • Familiarity • 52-week trading range • Options availability
Price/Earnings Ratio • Low PEs are good: • Investors pay little to get a lot • High PEs are good: • The efficient marketplace anticipates that future earnings will be higher than those of the past
Dividend Yield • Dividends do not materially alter a recipient’s wealth • People like to receive dividends: • Strokes the ego • Important for income or growth of income objectives
Stock Price • Some people believe in an optimum trading range for stock prices • The cost of a share should be merely a market • People prefer to avoid odd lots • E.g., investing $2,000 means the stock price cannot be higher than $20
Exchange Listing • Some clients may want to restrict their investments to a particular exchange: • AMEX • NYSE • Nasdaq
Familiarity • Invest in companies that you know something about • Familiarity is a subjective criterion
52-Week Trading Range • “The stock is trading at the low end of its annual high and low” • If the market is efficient, annual highs and lows are of no value in predicting future prices
Options Availability • Some people invest in equity issues that have options available because they are versatile • Options information is contained in the financial press
A Quick Risk Assessment Screen With the Stock Report • ROA and ROE • Evaluating ROA and ROE
ROA and ROE • The Stock Report contains ten-year histories of ROA and ROE: • Useful for a quick comparison of companies: • ROA is net income after taxes divided by total assets • ROE is net income after taxes divided by equity • If the firm has debt, ROE will exceed ROA
Evaluating ROA and ROE • A “good, safe investment” has a history of stable ROA and ROE figures, with ROE somewhat higher than ROA • If ROE is substantially higher than ROA, the firm is heavily leveraged (risky)
Examples of Commercial Screens • Value Line publications • Computerized data
Value Line Publications • Timeliness and safety rankings are one of the most widely used screens • E.g., limit stock picks rated either 1 or 2 for timeliness • Value Line Investment Survey can be used for sector screening • Contains industry rankings
Computerized Data • Value Line Investment Survey for Windows • Compustat
Value Line Investment Survey for Windows • A 7,500 security database • Can be screened by more than 200 variables • Can be used to prepare statistical summaries and detailed tabular reports
Compustat • Used by academic researchers • Available for mainframes and microcomputers • Variables include: • Current ratio • Retained earnings • Unfunded pension liabilities, etc.
