The IBD Stable 70 Screen

Many of our readers are familiar with William O’Neil’s CAN SLIM growth approach for selecting and managing a portfolio of stocks. O’Neil founded Investor’s Business Daily (IBD), a financial newspaper that represents stock and market information consistent with the CAN SLIM system. Two years ago, IBD started an annual feature called the Stable 70 list, which consists of companies with strong, long-term earnings growth. When putting together the criteria for the Stable 70 list, the editors at IBD tried to isolate the characteristics of those companies that had weathered the recent economic and stock market downturn, much as William O’Neil tried to identify the characteristics of companies prior to their big stock run-up when developing the CAN SLIM approach. In essence, this time they were trying to put together a screen that would yield “recession-proof” companies.

This article will discuss how to apply the IBD Stable 70 screen using AAII’s Stock Investor Pro fundamental stock screening and database program, which covers a universe of approximately 8,000 NYSE, Amex, and Nasdaq National Market, Nasdaq Small Cap, and over-the-counter bulletin board or pink sheet stocks.

Stable 70 Screening Criteria

Investor’s Business Daily applies the following criteria to its database of over 2,700 publicly held companies to arrive at the Stable 70 list:

• share price of at least $12,
• five-year earnings growth of at least 10%,
• year-on-year earnings growth of at least 10% for each of the last five fiscal years,
• quarter-on-quarter earnings and sales growth of at least 10%, as defined by growth between the latest fiscal quarter and the same quarter one year prior,
• An “earnings stability” rate of 20% or less, which shows how a firm’s annual earnings compare with the trend in earnings over the last five years—the lower the percentage, the more consistent its profit, year after year.

Applying the Screen

Typically when attempting to recreate a screening methodology, there are some compromises and adjustments that may need to be made. Oftentimes this is caused by differing data elements available for a given screening system, or even the flexibility of the screening system.

Table 1 lists the 42 companies that passed the IBD Stable 70 screen adapted for use with Stock Investor Pro. The companies in the table are ranked by their price as a percent of 52-week high with data as of August 1, 2003. Adjustments that were made in order to implement the screen are described below.

Strong Annual Earnings Growth

Despite the best efforts of many companies during the technology stock boom of the late 1990s to detract attention from bottom-line earnings, earnings continue to serve as a barometer of long-term viability. As its name may reveal, the IBD Stable 70 screen looks for companies that have had strong, stable earnings growth over the last several years. To this end, the screen looks at a company’s earnings growth over the long term, as well as on a year-to-year and quarter-to-quarter basis.

The IBD Stable 70 screen first isolates companies with an annualized compound growth rate in earnings from continuing operations over the last five years of 10% or more. Investor’s Business Daily does not explicitly state which earnings figure it uses, but earnings from continuing operations ignore extraordinary and “one-time” charges and provide a better indication of a company’s earnings potential going forward. Of the 8,112 companies that comprise the Stock Investor Pro database as of August 1, 2003, roughly one-third—2,850 companies—passed this first screening requirement. Looking at Table 1, Donaldson Company has the lowest five-year earnings growth rate at 14.3%. While it has had long-term success in growing earnings, it is probably not surprising that this manufacturer of air cleaners and exhaust products is not among the “high fliers” in the group, given its line of business.

Another thing to keep in mind when evaluating earnings growth rates is the base-year earnings figure for the company. If this number is negative or starts out very low, small absolute changes in earnings can translate into high growth rates. One company may have grown earnings from $0.01 per share to $0.02, while another grew earnings from $5.00 per share to $10.00. Both companies have an earnings growth rate of 100%, yet the latter’s growth is far more impressive than the former’s.

Donaldson ranked near the top among the companies that passed the final IBD screen with its base-year earnings per share from continuing operations figure of $1.01 as of July 1997, which grew to $1.97 for the fiscal year ending July 2002. Cognizant Technology Solutions, on the other hand, had the second-highest five-year earnings growth rate at 80.8%. But it had the lowest base-year earnings figure of $0.03 per share as of December 1997, which it grew to $0.58 per share for the fiscal year ending December 2002.

Beyond long-term growth, the IBD Stable 70 screen seeks out companies that have had strong year-to-year (annual) growth in earnings as well. A company may have a high compound growth rate over the long term, but it can also experience setbacks over the course of the calculation period that are not reflected in the growth rate. The market favors consistent growth and rewards companies with strong and stable growth. For this reason, the IBD Stable 70 screen implemented for this article attempts to isolate those companies that have been able to maintain strong positive growth on a year-to-year basis. Here, the IBD Stable 70 screen requires that companies have increased earnings from continuing operations by at least 10% over each of the last five fiscal years. In addition, earnings for the trailing 12 months (last four quarters) must at least equal those from the last reported fiscal year. Applying this set of criteria to the universe, 387 companies pass; when the criteria are combined with the historical earnings growth criterion, 307 companies are left passing the IBD Stable 70 screen thus far.

Quarterly Sales & Earnings Growth

Company fortunes can turn rather quickly, especially those in volatile industries such as biotechnology and semiconductors. For this reason, the IBD Stable 70 screen seeks out companies that have exhibited strong quarterly growth as well as long-term earnings growth.

When looking at quarterly growth, it is important to compare the growth between same-period quarters. In other words, compute the growth in earnings or sales in the first fiscal quarter from the same quarter one year earlier. Virtually all companies undergo some level of seasonality with their sales and earnings. By examining same-quarter growth, you are limiting seasonality biases that may exist if you were comparing first quarter results to those of the second quarter.

The IBD Stable 70 screen looks for companies that have had same-quarter earnings and sales growth rates for the latest fiscal quarter of at least 10%. The quarterly earnings filter looks for companies that have a growth rate in earnings per share from continuing operations for the latest fiscal quarter (Q1) from the same quarter one year ago (Q5) of at least 10%.

Of the 8,112 companies in the Stock Investor database, 3,921 companies passed this screen. Leading the pack of the final passing companies is Capital One Financial, with a growth rate of 61.6%. No doubt this financial services holding company has benefited from the spate of mortgage refinancing that has taken place over the last several months with interest rates at their lowest levels in over 40 years. At the other end of the spectrum is 99 Cents Only Stores, with a quarter-on-quarter earnings growth rate of 10.5%, just clearing the hurdle. Adding this screening element to the IBD screen lowered the number of passing companies to 227.

In the long run, sales help drive earnings. While in the short run a company can squeeze out extra earnings by increasing efficiency and cutting costs, long-term earnings growth is driven by a corresponding increase in sales. A dip in sales may also be an early warning for deeper trouble down the line. For this reason, the IBD Stable 70 screen looks at sales growth, albeit if only for the latest fiscal quarter. Just as with the quarterly earnings screen, this criterion too looks for sales growth for the latest fiscal quarter of at least 10% over the same quarter one year ago. In Stock Investor Pro, this requirement yielded 2,728 companies as an individual screen and lowered the total number of passing companies down to 128 for the IBD Stable 70 screen.

Although not part of the screen itself, the five-year compound growth rate in sales is presented in Table 1. The companies with the highest long-term growth rates in sales are also among those with the highest earnings growth rates, and vice versa. Donaldson Company has the lowest long-term earnings growth rate and also the lowest five-year sales growth rate at 6.2%. Meanwhile, Cognizant Technology Solutions, which had the second-highest five-year earnings growth rates, has the highest long-term sales growth rate at 56.1%.

Figure 1. Screen Performance CLICK ON IMAGE TO SEE FULL SIZE.

Stable Earnings Growth

The final piece of the IBD Stable 70 screen looks for companies with stable earnings. To this end, Investor’s Business Daily came up with an earnings stability rate, which shows how a company’s annual earnings compare with the trend of its earnings over the last five years. In technical terms, the earnings per share growth rate five-year stability factor, in percentage form, indicates one standard deviation of the variability around the trendline fitted through three to five years of earnings per share history (with the slope of the trendline providing the growth rate in earnings over the period). In calculating this stability factor, a company must have a minimum of 12 trailing four quarter periods of positive earnings, requiring at least 15 quarters of data in order to be considered for the screen. To pass the IBD Stable 70 screen, a company’s earnings stability factor must be 20% or less. This means that a company’s standard deviation of earnings must be less than 20%.

With only eight quarters of data available for each company, Stock Investor is not able to calculate a stability rate similar to that of IBD. Therefore, the screen uses the R-squared for earnings per share from continuing operations over the last seven years as a proxy for the filter. In simple terms, the R-squared measures how closely actual data falls near to a trendline that is plotted using linear regression. A higher value for R-squared indicates a higher degree of stability or predictability for the plotted points. Whereas IBD looks for companies with a low earnings stability factor, which translates into high earnings stability, in the screen built with Stock Investor Pro using R-squared, a higher value indicates more stable earnings. Therefore, the next filter requires companies to have an R-squared for earnings per share from continuing operations calculated over the past seven years that is 80% or higher. Using R-squared also added an underlying set of criteria to the IBD Stable 70 screen—a company must have had positive earnings from continuing operations for each of the last seven fiscal years.

As an individual screen, the R-squared requirement is by far the screen’s most restrictive element, with only 542 of 8,112 companies passing. Adding this element to the IBD Stable 70 screen leaves us with 46 passing companies.

Rounding out the IBD Stable 70 screen is the requirement that the company’s stock price be at least $12, which eliminates only one company, bringing the total to 45. In addition, the screen eliminates those companies that do not trade on the major exchanges—New York, American, or Nasdaq—as well as those companies that trade as American depositary receipts (ADRs). This results in the final group of 42 passing companies that are presented in Table 1.

Company Characteristics

Backtesting the IBD Stable 70 screen using data from the past five and a half years revealed that the IBD Stable 70 screen has been able to easily outperform the small-, mid-, and large-cap indexes over this time period (see Figure 1). Furthermore, the screen turned in only one down year, when it lost 12.3% in 2002. However, even then it still outpaced the three S&P indexes shown in Figure 1.

The characteristics of the stocks passing the IBD Stable 70 screen are presented in Table 2. The 42 companies that passed the screen at the beginning of August were well below the average number of companies—76—that have passed the screen over the last five-plus years. We also see that the IBD Stable 70 screen has a relatively low turnover rate of 12%. Since this screen is purely fundamental in nature—it does not employ any relative strength or price momentum screens—companies that pass the screen will remain on the list at least until they file new quarterly and/or annual financials that could impact the quarterly or annual growth rates in sales or earnings criteria.

The IBD Stable 70 screen is basically a pure-growth screen, which is reflected in the median price-earnings ratio (price divided by earnings per share for the trailing 12 months) for the current cast of companies. At 23.7, it is above the median price-earnings ratio for all exchange-listed stocks.

In looking at several different growth rates, we see that in each instance those companies passing the IBD Stable 70 screen surpass the median for all stocks. Most striking are the long-term growth rates in earnings and sales. The median historical earnings growth rate for the IBD Stable 70 companies is 29.8% compared to 2.7% for all companies, while the historical sales growth rate for the companies passing the screen is 21.7% versus 8.6% for all companies.

The median market cap (share price times number of shares outstanding) for the stocks passing the IBD Stable 70 screen is $2.24 billion, eclipsing the median for all exchange-listed stocks and placing these stocks well into the mid-cap range.

While the companies that passed the IBD Stable 70 screen have been strong performers in terms of earnings growth, they do not outshine other stocks in terms of price performance, as represented by current stock price as a percent of 52-week high. The companies passing the IBD Stable 70 screen have share prices that are within 88.5% of their 52-week high, whereas exchange-traded stocks are within 88.0% of their 52-week high.

Conclusion

The IBD Stable 70 screen looks for companies that are equipped to withstand economic and stock market downturns by isolating companies that have had strong long-term growth in earnings. Furthermore, the screen isolates companies that have been able to grow earnings in a stable manner.

However, the companies that pass this or any other stock screen do not represent a recommended list. Stock screening is merely the first step in stock selection. It is important to perform additional due diligence to identify stocks that may be investment candidates.