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Chapter 10

Security Screening

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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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

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Outline

Introduction Why Screening is Necessary What Constitutes a Good Screen? Sources of Information Screening Processes Examples of Commercial Screens

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Introduction

Security screening involves reducing the security universe down to a manageable size

Picking stocks is an art rather than a scienceThere is no single best way to choose individual

investments

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Why Screening Is Necessary

Time Constraints Everyday Examples of Screens

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Time Constraints

The NYSE and AMEX, and Nasdaq list thousands of potential investmentsThere 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

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Everyday Examples of Screens University Admission Test The Football Team

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University Admission Tests

More people apply for admission than are ultimately admitted

Universities use two steps:An initial screenCloser individual scrutiny for those passing

the first round

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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 backsBench presses for offensive linemen

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What Constitutes A Good Screen? Ease of Administration Relevance and Appropriateness Acceptance by the User Ordinal Ranking of Screening Criteria

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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 JournalThin trading refers to a security with a

relatively small number of shareholders and a lack of trading volume

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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

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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

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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 next highest number of alternatives, etc.

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Sources of Information

Value Line Standard & Poor’s Mergent Brokerage Information Internet

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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: a measure of potential risk with a stock

Many market analysts attach considerable significance to the Value Line report on a stock

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Value Line Timeliness & Safety Ranking System

RankingNumber of Stocks with This Ranking Meaning

1 100 Best

2 300 Above average

3 900 Average

4 300 Below average

5 100 Worst

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Sample Value Line Report

Source: The Value Line Investment Survey, December 10, 2004. Copyright © 2004 by Value Line Publishing, Inc.: used by permission. For subscription information to the Value Line Investment Survey, please call (800) 634-3583.

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Standard & Poor’s

Stock Report Stock Guide

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Stock Report

The S&P Stock Report is a one-page document that: Is updated quarterlyContains a description of a companyContains an estimate of what the future holds

for a companyContains financial statement information,

dividend payment dates, beta, and other risk measures

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Sample S&P Stock Report

Source: Standard & Poor’s Stock Guide (New York: Standard & Poor’s Corporation, 2004): Reprinted with permission.

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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

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Sample S&P Stock Guide

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Mergent

Mergent’s Manuals Mergent Dividend Record

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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

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Mergent Dividend Record

Mergent Dividend Record:Contains information on the recent dividend

history of a company, including: Payment dates

Ex-dividend dates

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Brokerage Information

Brokers can be a good source of information

All full-service brokers have the ability to provide their customers with stock research

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Internet

Examples of good sources:http://finance.yahoo.com http://www.smartmoney.comhttp://www.morningstar.comhttp://www.fool.comhttp://www.bloomberg.com

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Yahoo!® Finance

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Screening Processes

Multiple-Stage Screening Subjective Screening Screening with the Popular Press Only A Quick Risk Assessment Screen with the

Stock Report

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Multiple-Stage Screening

Most investment applications require several screening stagese.g., earnings per share by itself is not very

useful

e.g., in choosing a growth stock, it would not make sense to search initially for those with the highest dividend yield

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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.Best of class investing recognizes that all

firms can be faulted in some way and looks for “role models” within each industry

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Screening with the Popular Press Only Price/Earnings Ratio Dividend Yield Stock Price Exchange Listing Familiarity 52-Week Trading Range Options Availability

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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

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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

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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 lotse.g., investing $2,000 means the stock price

cannot be higher than $20

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Exchange Listing

Some clients may want to restrict their investments to a particular exchange:AMEX

NYSE

Nasdaq

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Familiarity

Invest in companies that you know something about

Familiarity is a subjective criterion

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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

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Options Availability

Some people invest in equity issues that have options available because they are versatile

Options information is contained in the financial press

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A Simple Financial Pages Stock Screen

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A Quick Risk Assessment Screen with the Stock Report ROA and ROE Evaluating ROA and ROE

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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 and positive earnings, ROE will exceed ROA

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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)

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Examples of Commercial Screens Published Paper Data Computerized Data

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Published Paper Data

Value Line Publications

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Value Line Publications

Timeliness and safety rankings are one of the most widely used screense.g., limit stock picks rated either 1 or 2 for

timeliness

Identifying attractive stocks is a process called sector screening

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Computerized Data

Value Line Investment Analyzer Compustat

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Value Line Investment Analyzer A 7,500-security database

Can be screened by more than 300 variables

Can be used to prepare statistical summaries and detailed tabular reports

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Compustat

Used by academic researchers Available for mainframes and

microcomputers Variables include:

Current ratioRetained earningsUnfunded pension liabilities