Feature: Changing the Holding Period of AAII Stock Screens
Many members closely follow the performance of the screening strategies presented in Stock Investor Pro, our stock screening program and research database, and in the AAII Stock Screens area of AAII.com. While the market has seen its performance ebb and flow, some strategies have exhibited surging performance since the inception of our stock screen tracking. We have been testing and tracking a wide variety of screening strategies for over seven years now.
Some of the screens attempt to capture the investment philosophy of famous investors such as Warren Buffett, while other screens explain and implement basic investing approaches—such as investing in stocks with low price-to-sales ratios. It is important to keep in mind that the screens following the approach of a famous investor do not represent their actual stock picks. The criteria for each screen are defined by our own interpretations of the investment approaches. A strategist may or may not actually invest in a passing stock.
Our goal has been to gain an understanding of how the various strategies perform in different market environments to see if any strategies do a better job than others of putting together profitable portfolios. Each month we execute over 50 separate screens using AAII’s Stock Investor Pro and report on the current companies passing each individual screen. AAII Stock Investor subscribers can perform the screens themselves, while other members can access the screening results by clicking on the All Screens link within the AAII Stock Screens area of AAII.com. The results are posted to the site in the middle of each month.
Hypothetical portfolios for each screening strategy are constructed each month and the performance of each approach is tracked. The performance reflects buying and selling each month at month-end closing prices. The impact of factors such as commissions, bid-ask spread, dividends, and time-slippage (time between the initial decision to buy a stock and the actual purchase) are not considered. This overstates the reported performance, but all approaches are subject to the same conditions and procedures. Higher turnover portfolios would typically benefit more from these simplified rules. Sell rules are the same as the buy rules. The screens are simply reapplied using each subsequent month’s data. Thus, a stock is “sold” (no longer included in the portfolio) if it ceases to meet the initial criteria, and new stocks are added if they qualify. Stocks that no longer qualify are dropped even if the strategist behind a particular approach suggests different sell rules versus buy rules.
The screening results are based upon monthly screening and rebalancing, resulting in frequent and costly turnover—too frequent for most investors to realistically follow on their own in a real world of bid-ask spreads, constant stock price movements, commissions and tax liabilities. We thought it would be interesting to take two of our more successful approaches—one with a value focus and another with a growth focus—and see how their performance might be impacted by less a frequent screening and portfolio rebalancing regimen.
The Neff Contrarian approach was selected as a representative value approach, while the O’Neil CAN SLIM strategy was selected to embody growth investing. As Figure 1 indicates, both strategies easily beat the S&P 500 over the last seven years. Table 1 shows the characteristics of the stocks passing the two screens.
|Table 1. Current Portfolio Characteristics|
|Current Characteristics (Medians)||
|P/E to EPS est growth||0.8||1.6||1.3|
|EPS growth rate (hist 5 yr)||24.1%||45.7%||9.9%|
|EPS growth rate (est 3-5 yr)||16.2%||18.4%||14.1%|
|Market cap (million)||$611.7||$401.5||$353.9|
|Relative strength vs. S&P||14.0%||56.5%||–2.0%|
|Price change 52 week||–10.5%||63.0%||0.0%|
|Average no. of passing stocks||18||10||—|
|Highest no. of passing stocks||36||32||—|
|Lowest no. of passing stocks||4||0||—|
Value screens, such as the price-earnings ratio screen, typically look for low prices relative to actual measures of company performance or assets. The price-earnings ratio, or multiple, is computed by dividing a stock’s price by its most recent 12 months’ earnings per share. The price-earnings ratio is followed closely because it embodies the market’s expectations of future company performance and risk through the price component of the ratio and relates it to historical company performance as measured by earnings per share.
A simple search for low price-earnings ratios, however, can be misleading as a screen for undervalued stocks. Typically, firms with high growth potential trade with correspondingly high price-earnings ratios, while those with low price-earnings ratios are expected to have low growth or high risk. Screening solely for stocks with low price-earnings ratios may leave you with a list of companies with little or no growth prospects or great uncertainty regarding the firm prospects.
One of the most popular techniques used to seek value involves finding stocks with low price-earnings relative to earnings growth. The price-earnings-to-growth ratio (PEG ratio) is computed by dividing the price-earnings ratio by the earnings growth rate. Low ratios indicate that a stock may be undervalued, while stocks with high ratios may be overvalued. The PEG ratio helps investors judge whether the market is overpaying for these stocks.
The dividend-adjusted PEG ratio serves as the foundation of the Neff stock screen. It is calculated by dividing the price-earnings ratio by the sum of the estimated earnings growth rate and the dividend yield. The dividend-adjusted PEG ratio encompasses each of the key components of Neff’s value investing style—the price-earnings ratio, earnings growth, and the dividend yield.
Other factors in the Neff screen seek out strong, but sustainable growth in earnings and sales, above-average operating margins and positive free cash flow. The screening criteria are detailed below.
Neff’s Contrarian Approach: Screening Criteria
Creating a hypothetical portfolio by investing in all of the stocks that pass the Neff screen every month and selling them at the end of the month would have resulted in a cumulative gain of 571.4%, or a 29.6% annual rate of return.
Table 2 lists the 14 companies passing the Neff screen at the end of April. This number is just below the average passing figure of 18 over the last seven years. As many as 36 companies have passed the Neff screen, while we witnessed only four companies passing one month. The greatest number of companies passed at the start of the bear market in 2000, while only four companies passed in March 2002, another weak period for the market.
Figures 2 and 3 highlight the performance of value strategies versus growth approaches and large-cap stocks versus small-cap stocks. Table 1 comfirms that the Neff strategy tends to turn up well-priced stocks—the price-earnings ratios and price-to-sales ratios are well below the market norm. Figure 2 highlights how growth strategies outperformed value strategies for the first few years of our study and until the bear market started in 2000.
Figure 3 illustrates how different-sized companies performed in different years. Mid-cap strategies have outpaced other strategies, but not until the start of the 2000 bear market. Figures 2 and 3 help to explain the type of market environment in which these strategies dominated.
The companies currently passing the Neff screen are surprisingly varied and include a couple of airlines, a natural resource company, a few financial firms and even a software company.
Growth strategies want to buy growth, period. Their focus is on companies that have rapidly expanding sales and earnings. The approach tends to be more volatile—prices can move up or down substantially, with small changes in expectations. William O’Neil’s CAN SLIM approach is one of the purest growth strategies that we track and a surprisingly strong performer in weak and strong markets. The screen looks for strong and increasing quarterly earnings growth, strong and stable annual earnings, a limited float (shares available for trading), minimum institutional sponsorship, and strong price strength.
The CAN SLIM approach focuses on companies with proven records of quarterly and annual earnings growth that are still in a stage of earnings acceleration. The primary earnings filter requires increasing earnings per share in each of the last five years. Less than 10% of the companies in Stock Investor have such a strong earnings record.
Price momentum is the other critical CAN SLIM factor. Stocks passing the screen must be trading with a current price within 10% of their 52-week high and must have outperformed 70% of all traded stocks in the last 52 weeks.
Creating a hypothetical portfolio by investing in all of the stocks that pass the CAN SLIM screen every month and selling them at the end of the month would have resulted in a cumulative gain of 749.2%, which translates into a 33.9% annual rate of return.
Table 3 lists the six companies passing CAN SLIM screen at the end of April. The current crop of passing companies includes a couple of banks, a home builder, a few medical-related firms and a software company.
On average 10 companies have passed the CAN SLIM screen, with a maximum of 32 stocks one month and one month without any passing stocks. The greatest number of companies passed the screen during the strong growth market period of the late 1990s, while very few companies passed during 2004, a year with the weakest observed performance for the strategy.
With annual returns of 29.6% and 33.9% many investors may be tempted to blindly follow these strategies. Unfortunately, the logistics of buying anywhere from zero to 36 stocks each month and then selling them at the end of the month and starting all over the next month is not practical.
Quarterly and semiannual holding periods were examined for this article to see how longer holding periods and less frequent screening would impact performance.
One would expect that the momentum-oriented CAN SLIM strategy would suffer more from less frequent screening than the value-oriented Neff strategy. Normally over half the stocks passing the CAN SLIM screen don’t pass the screen the next month, while the figure is around a third for the Neff approach.
However, our observations reveal a different outcome over the last seven years (Figure 4). The monthly CAN SLIM screen had strong performance through bull and bear markets until 2004, when only a few stocks had the combination of long-term earnings strength and short-term price and earnings momentum required to pass the CAN SLIM screen. The quarterly CAN SLIM portfolio did not show as strong an upward gain as the CAN SLIM rebalanced monthly, but it managed to avoid holding the stocks that hurt the CAN SLIM approach in early 2004. Avoiding monthly losses of 14.0% in February 2004 and 4.4% in March 2004, coupled with being invested in the market in the second quarter of 2004 (while the monthly CAN SLIM sat out one month) helped the quarterly CAN SLIM catch up with the monthly CAN SLIM. In the end, the monthly CAN SLIM portfolio gained 749.2%, or 33.9% annually, while the quarterly CAN SLIM gained 727.9%, or 33.4% annually.
The semiannual CAN SLIM strategy turned in impressive 482.0% total gain, which translates into a strong 27.1% annual gain. While not as good as the monthly or quarterly constructed portfolios, a 27.1% annual rate of return is still extremely high and easily beats any benchmark for the period (Table 4).
The Neff strategy resulted in a 571.4% cumulative return, or a 29.6% annual gain, when using monthly screening and rebalancing (Figure 5). Screening and rebalancing on a quarterly basis resulted in a cumulative gain of 364.9%, which translates into an annual 23.3% gain. Looking at the holdings during periods of divergence, such as in 1999, indicates that much of the difference can be attributed to holding losing positions longer with the quarterly and semiannual rebalancing, which allowed the losses to impact the overall performance more dramatically—reinforcing the maxim that investors should let their winnings run, but quickly cut their losses. One would have expected this situation to have impacted the growth-oriented CAN SLIM approach even more dramatically, but the luck of the draw did not hurt the quarterly CAN SLIM approach.
The Neff strategy rebalanced semiannually still managed to show an index-beating 212.1% cumulative return, which translates into a 16.8% annual return. In contrast, the S&P 500 gained a cumulative 19.2%, or 2.4% annually, over the same time period, while the S&P SmallCap 600 index gained a cumulative 67.3%, or 7.3% annually (Table 4).
In looking at the results, it is important to remember that our observations over the last seven years may not hold true in the future. The results are based upon portfolios of zero to 36 stocks where one stock could make a dramatic difference. Throughout 2004, the CAN SLIM approach held 10 or less stocks at any single point in time.
However, these screens have shown a knack for identifying stocks worthy of consideration. Moving to less frequent portfolio construction and rebalancing may reduce the observed portfolio gains, but the resulting portfolios were still market-beating strategies. When coupled with an additional trading strategy of cutting losses quickly, quarterly or semiannual rebalancing is a more practical approach for most investors.