Rules of Attraction: The MAGNET Stock Selection Process
Most investment strategies, especially fundamental stock screens, typically have some sort of style “bias”—leaning more toward a value- or growth-oriented approach. However, Jordan Kimmel blends value, growth and momentum investing styles into a singular approach, which he termed the MAGNET Stock Selection Process. Kimmel is the managing member of the Magnet Investment Group, LLC, which has previously licensed its stock selection process to John Nuveen & Co. for unit investment trusts. Kimmel hosts his own weekly radio show “Profitable Investing With Jordan Kimmel.”
The MAGNET approach has been termed “CAN SLIM at a reasonable price.” The CAN SLIM approach is based on William O’Neil’s analysis of the 500 companies with the biggest price increases between 1953 and 1993. O’Neil quantified the characteristics of these stocks to form the CAN SLIM approach, which focuses primarily on earnings and price momentum. MAGNET does hold some similarities with William O’Neil’s CAN SLIM approach. However, MAGNET adds a value emphasis as well as a focus on revenue growth instead of earnings growth.
Kimmel outlined the MAGNET Stock Selection Process in his book “Magnet Investing,” (Next Decade, Inc., 2000) which is currently in its second edition. This book served as the foundation for this article.
A MAGNET stock, according to Kimmel, offers a blend of technical and fundamental characteristics “that pull investors into shares, as though by magnetic attraction, resulting in rapid price increase.” Kimmel believes the MAGNET process “encompasses the best of the momentum aspects of the market, while demanding the downside protection of a value approach, and insisting on top-line revenue growth.”
The MAGNET acronym is as follows:
M—Management must be outstanding; momentum must be improving;
A—Acceleration of earnings, revenues and margins;
G—Growth rate must exceed valuation;
N—New product or management may be the driver;
E—Emerging industry or product creates opportunity; and
T—Timing needs to be right (technically poised for large price increase).
Table 1 summarizes Jordan Kimmel’s MAGNET approach.
|Table 1. The MAGNET Stock Selection Process in Brief|
Philosophy and Style
MAGNET stocks contain a combination of technical and fundamental characteristics that “pull investors into shares, as though by magnetic attraction.” The MAGNET Stock Selection Process combines what Kimmel believes to be “the best of the momentum aspects of the market, the downside protection of a value approach, and top-line revenue growth.”
Universe of Stocks
No restrictions. Kimmel applies the MAGNET model across all industry and market-cap segments. He does call for a minimum share price of $8, presumably to ensure the stock is priced high enough for institutional buyers. Since the MAGNET model places emphasis on revenue growth, it often isolates smaller companies.
When to Buy
Kimmel believes that careful fundamental research answers the question of “what to buy,” but he then uses a variety of technical analysis tools to help him decide when to buy. Tools he uses include moving averages, moving average convergence/divergence (MACD), stochastics, relative strength, volume, point & figure charts, and insider trading.
Stock Monitoring and When to Sell
Kimmel has created quantitative filters to sift through the stock universe in search of MAGNET stocks. He feels that with today’s computerized screening tools, individual investors can easily identify their own MAGNET stocks. Furthermore, in what he terms today’s “institution-dominated market,” Kimmel feels that individual investors have an advantage over large mutual funds and pension plans in that they have the flexibility in buying and selling that these large institutions lack.
Kimmel uses the MAGNET model across all market-cap segments. However, as an approach focusing on revenue growth, the MAGNET process does tend to isolate smaller stocks.
Management and Momentum
Management and momentum make up the first aspect of the MAGNET approach.
In Kimmel’s view, a company’s management is the most fundamentally important element of a company. This same management is responsible for attracting top talent, encouraging innovation from its employees, and providing effective leadership.
To show that management has a vested interest in the company, and that its interests are more closely aligned with those of individual shareholders, Kimmel prefers that management own a “substantial percentage” of its stock. However, he does not quantify what that percentage should be.
A stock’s momentum usually refers to the relationship between the movement of its price and the movement of the overall market. The most common representation of this relationship is relative strength. There are many ways to measure and present relative strength. Oftentimes, relative strength measures the price performance of an individual stock against a major market index such as the S&P 500. But no matter which measure you may use, MAGNET stocks should have increasing price strength relative to the market for at least the last few months.
Although it is captured in the first element of the MAGNET model, relative strength is really a confirming signal for Kimmel. He draws a clear distinction between good companies and good investments. You may think you have found a great company, but if there is no demand to drive up the stock price, Kimmel would say it is not a good investment.
In addition, in “Magnet Investing” Kimmel discusses that he believes the market it forward-looking, trading about six months in advance. To him, this means that you may find a company with historical financial numbers that don’t look the greatest, but the stock could still have strong price momentum. In these instances, according to Kimmel, it is likely that the “smart money” may know something the rest of the world does not. Furthermore, when you see a company with strong historical financial numbers whose stock is plummeting, you may want to look for the other shoe to drop.
Acceleration of Earnings, Revenues and Margins
The growth factor for the MAGNET model revolves around revenue growth and, to a lesser extent, earnings growth.
As Kimmel puts it, “revenue growth is what it is.” If a company sells more of a product or is able to raise the price of its product, its revenues are going to increase. In his mind, it is difficult—but not impossible—to manufacture sales.
Although he does mention earnings growth as one means of identifying growth companies, Kimmel spends a fair amount of time railing against Wall Street’s obsession with earnings, given that earnings are susceptible to “manipulation” by management. He goes as far as to say “if you lie about revenues, you go to jail, but it’s perfectly legal to massage earnings.”
Kimmel points out that although companies can grow revenues through acquisitions, they are not always beneficial to the company (or investors) over the long term. For this reason, the MAGNET model also looks at profit margins—the percentage of revenues a company ends up with as profits. If a company is able to maintain or expand its margins as it makes acquisitions, that is fine with Kimmel.
In his book, Kimmel refers to gross profit margins as an indicator of management effectiveness. Gross income is what is left over after deducting a company’s cost of goods sold, and the gross margin is the percentage of gross income to revenues.
Analysts use the gross profit margin to see how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin is a favorable profit indicator. Raw material costs have a tremendous impact on gross income and, likewise, a company’s gross profit margin.
Since margins vary across industries, it is best to compare company levels to industry norms. Also, it is useful to analyze company margin trends over time. Kimmel is not impressed by companies that are improving earnings simply by tightening their belts and cutting costs. MAGNET companies with growing earnings and accelerating margins will, by definition, see their earnings increase.
When examining the trend in gross profit margin, Kimmel does not require that it be continually rising. At a minimum, however, it should not show a decline from prior reporting periods. Margins can also serve as a proxy for examining the quality of management, part of the “M” element of the MAGNET process.
Growth at a Discount
Having provided elements to attract momentum and growth investors, Kimmel lastly hopes to cater to value investors by stressing the importance of not overpaying for a company’s growth prospects. This will serve to attract value-oriented investors to MAGNET stocks.
In “Magnet Investing,” Kimmel calls for looking for companies whose current market valuation, as measured by the price-earnings ratio, is no more than one-half its projected growth rate. Therefore, if analysts are forecasting a company to grow at 20% over the next three to five years, its price-earnings ratio cannot be any higher than 10 to meet the MAGNET selection criteria. Another way to put this is that a company’s ratio of price-earnings to estimated earnings growth rate, or PEG ratio, must be 0.5 or lower. Kimmel feels that such valuations normally occur just before companies “become popular” with investors or when they have temporarily fallen out of favor with the market.
New Product or Management
Followers of William O’Neil’s CAN SLIM approach may find similarities in this element of the MAGNET approach. When a new management team comes into a company or when a company introduces a new product, this often spurs renewed interest in the company. However, these elements tend to be qualitative in nature and difficult to capture with a quantitative screening approach.
As a proxy, Kimmel points to price momentum—when a company is experiencing increasing price momentum, something is usually going on with the company. This “something” may be new management or a new product.
Price momentum was already captured in the “M” element of the MAGNET approach.
Emerging Industry or Product
Kimmel feels that companies in emerging industries represent good investment opportunities for investors who have a clear understanding of the technologies and processes being used. Again, this represents a qualitative aspect of company analysis. However, Kimmel has said in other interviews and publications that companies able to find a new market for their product(s), or that come out with a truly new product, are likely to see accelerating sales and earnings, improving margins, and improving price momentum.
Timing is the final aspect of the MAGNET stock selection process. Kimmel points out that you can find a company that is growing revenues and sales, is improving its margins and is attractively priced, yet it only becomes more attractively priced as its stock price falls.
For this reason, Kimmel says it is very important to distinguish between a good company and a good investment. To help him decide when to buy, he uses several technical indicators to enhance his market timing. He uses technical analysis as confirmation once a company meets the fundamental requirements of the MAGNET model. The indicators he uses include moving averages, stochastics, moving average convergence/divergence (MACD), relative strength, volume analysis, insider trading, and point & figure charting.
While Kimmel feels it is dangerous to invest without technical analysis, the focus of this article is on the fundamental screening process.
Screening With the MAGNET Approach
To attempt to isolate MAGNET stocks that will attract growth, momentum, and value investors alike, Kimmel outlined two different screens in “Magnet Investing” using the now-defunct Telescan Prosearch module. The first is a “simple” screen that attempts to capture the core of the MAGNET Stock Selection Process; the second, “complex” screen uses more detailed criteria. The two screens we present here are our interpretations of what Kimmel presented in “Magnet Investing.” Table 2 presents our two MAGNET screens.
|Table 2. Translating Style in Screening: The MAGNET Stock Selection Process|
Financial Liquidity and Leverage
Sales & Earnings Growth
We used AAII’s Stock Investor Pro fundamental stock screening and research database to develop our MAGNET screens. As of May 15, 2009, the database included 9,586 companies. Table 3 lists the specific criteria that subscribers to SI Pro can use to build the screens.
|Table 3. MAGNET Approach Criteria for Use With AAII’s Stock Investor Pro|
|Data Category||Field||Operator||Factor||Compare to (Field, Value, Industry)|
|% Rank||% Rank-Rel Strength 52 week||>=||90|
|% Rank||% Rank-Rel Strength 13 week||>=||90|
|Growth Rates||Sales-Growth 12m||>=||15|
|Multiples||PE-Forward EPS Est Y1||<=||0.5||EPS Growth Est (under Earnings Estimates)|
|Data Category||Field||Operator||Factor||Compare to (Field, Value, Industry)|
|% Rank||% Rank-Rel Strength 13 week||>=||75|
|% Rank||% Rank-Rel Strength 52 week||>=||75|
|Growth Rates||Sales-Growth 12m||>=||25|
|Growth Rates||EPS Cont-Growth 12m||>=||25|
|Multiples||Price/Sales||<||Industry Price/Sales (select Medians, Industry)|
|Price & Share Statistics||Institutional Ownership %||>=||5|
|Price & Share Statistics||Institutional Ownership %||<||Industry Institutional Ownership % (select Medians, Industry)|
|Price & Share Statistics||Price||>=||8|
|Ratios||Current ratio Q1||>=||1.5|
|Ratios||LT Debt/equity Q1||<=||40|
Simple MAGNET Screen
The simple MAGNET screen presented in “Magnet Investing” covers the “core” elements of the MAGNET model—Momentum (relative strength), Acceleration (strong revenue growth), and Growth at a discount. Kimmel stresses time and again that companies capturing elements of growth, momentum, and value are few and far between. Kimmel believes that even this simplified version of the MAGNET model will allow investors to capture the spirit of the MAGNET system.
The first element of the simple MAGNET screen looks for stocks with positive momentum. Kimmel feels that once price momentum begins to build, it will serve to attract more money to the stock. He calls for “relatively high” relative strength figures over the last 12 and 52 weeks.
For our simple MAGNET screen, we require companies to have 13- and 52-week relative strength figures that both rank in the top 10% of the entire stock universe.
The second portion of this simple MAGNET screen seeks companies that are growing faster than others in the same industry. Time and again, Kimmel refers to the importance of top-line revenue growth when analyzing MAGNET stocks.
In “Magnet Investing,” Kimmel calls for a minimum of 15% growth in recent earnings and revenues. While he believes most MAGNET stocks will have even higher growth, he sets the 15% threshold to avoid eliminating larger-cap stocks that may be dominating their industry.
Therefore, for our simple MAGNET screen, companies must have sales growth for the trailing 12 months (last four quarters versus the prior four quarters) of at least 15%.
Growth at a Discount
The last piece of the simple MAGNET screen looks for companies meeting the definition of “growth at a reasonable price,” or GARP. Kimmel used Telescan’s “growth ratio,” which compared a company’s projected earnings per share growth rate to its projected or forward price-earnings ratio for the next fiscal year. Kimmel indicates that he wants stocks with growth ratios that are “relatively high,” but gives no further quantification.
In the absence of further guidance as to acceptable valuation levels for MAGNET stocks, we resort to the PEG ratio Kimmel discusses in “Magnet Investing” as a proxy for Telescan’s growth ratio. Our MAGNET screen looks for companies whose projected or forward price-earnings ratio for the next fiscal year (price divided by estimated earnings for the next fiscal year) is no more than one-half the consensus annualized long-term projected earnings per share growth rate.
With the “core” parameters in place, Table 4 lists the four companies passing our simple MAGNET screen as of May 15, 2009. These companies are ranked in descending order by 13-week relative strength.
|Table 4. Companies Passing the MAGNET Simple Screen|
|Company (Exchange: Ticker)||Sales Growth||
P/E to EPS
Est Grth 5 Yr
|Co 12 Mo (%)||Indus 12 Mo (%)||Co (X)||Indus (X)||13-Wk (%)||52-Wk (%)|
|STEC, Inc. (M: STEC)||25.1||78.4||0.4||2.9||0.6||8.7||32.3||24.2||98||95||memory drives|
|American Dairy (N: ADY)||57.4||278.9||0.3||1.8||0.5||31.9||50.1||23.7||94||99||milk powder|
|Electronic Game Card (O: EGMI)||54.8||54.9||0.2||4.9||0.9||11.2||77||44.2||93||99||gaming device|
|Chinacast Education (M: CAST)||46.4||65||0.5||3.9||1.2||11.8||51.5||55.5||90||92||e-learning servs|
Exchange Key: A = American Stock Exchange, M = NASDAQ, N = New York Stock Exchange; O = over the counter.
Source: AAII's Stock Investor Pro/Reuters Research, Inc. Data as of May 15, 2009.
Complex MAGNET Screen
The complex MAGNET screen Kimmel presents in “Magnet Investing” modifies and builds upon the “simple” screen by adding several additional filters.
For the complex screen, Kimmel institutes an $8 per share minimum in order for a company to pass. While we didn’t find any explanation for this requirement in “Magnet Investing,” we found reference in an article Kimmel co-wrote for Active Trader—South Africa to the idea that many institutions will not buy a stock priced lower than $8. Much like O’Neil’s CAN SLIM approach, the inflow of institutional money plays a key part in stock price increases.
Our own complex MAGNET screen requires that the current share price be $8 or greater.
While he doesn’t explicitly mention it in “Magnet Investing,” Kimmel does include institutional ownership in his complex screen. Following the reasoning of William O’Neil, institutional buying and selling is what ultimately drives stock prices. Ideally, you would like to have some level of institutional ownership. These investors signal to other institutional managers that it is “okay” to invest in that particular company. However, O’Neil also suggested a cap on institutional ownership. This means there is still room for additional institutional money to flow in, further boosting the stock price.
In his complex screen, Kimmel only put a cap on institutional ownership. However, for our complex screen we institute an institutional ownership minimum of at least 5% of a company’s outstanding shares. This indicates that some institutions have already been drawn to these companies. Since we are not able to recreate Kimmel’s institutional ownership screen in Stock Investor Pro, we improvised by requiring that institutions own no more than the median institutional ownership percentage for a company’s respective industry.
Debt Levels & Liquidity
Once again, Kimmel used ratios related to balance sheet strength and liquidity in his complex screen that he does not explain in his book. They are the current ratio and the debt-to-equity ratio.
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations. It is the ratio of current assets to current liabilities. The ratio is mainly used to get an idea of the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, and receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1.0 suggests that a company would be unable to pay off its obligations if they came due at that point. Ideally, you would compare the ratios of companies within the same industry because business operations differ in each industry. However, for his complex screen, Kimmel calls for companies to have a current ratio of at least 1.5. In Stock Investor Pro, we are able to replicate this filter.
The debt-to-equity ratio measures a company’s financial leverage by dividing its long-term debt by stockholder’s equity. It indicates what proportion of equity and debt the company is using to finance its assets. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a company takes on too much debt, it can lead to bankruptcy.
Again, debt-to-equity ratios vary from industry to industry. However, Kimmel’s complex screen requires companies to have a debt-to-equity ratio of no more than 40%. Using Stock Investor Pro, we capped a company’s long-term debt-to-equity ratio at 40%.
In his complex screen, Kimmel used Telescan to isolate companies with price-to-sales ratios that are as low as possible. If you were merely to screen for companies with low price-to-sales ratios, however, Kimmel says you will only end up with “a lot of supermarkets.” To avoid industry concentration that can result from screening on price-to-sales ratios using absolute values, we used Stock Investor Pro to screen for companies that have a current price-to-sales ratio that is lower than the industry median value.
For the simple MAGNET screen, Kimmel wanted 13-week and 52-week relative strength to be as high as possible. However, for the more complex screen, he relaxed these parameters a bit, calling for companies to rank in the top 25%. Furthermore, he used six-week relative strength in place of the 13-week figure used in the simple screen.
For our complex MAGNET screen, then, we require companies to have 13-week and 52-week relative strength ranks that are both in the top 25% of the entire stock universe.
Revenue & Earnings Growth
The revenue growth requirement for the simple MAGNET screen called for companies to have a 12-month growth rate of 15%. For the complex version, Kimmel ups this to 25%. For our complex MAGNET screen, we use 25% as the hurdle rate for 12-month revenue growth.
Kimmel also adds earnings growth to his complex screen, looking for companies with one-year earnings growth that is as high as possible. Our complex screen again uses 25% as the minimum growth rate for earnings over the last 12 months.
Having created our own version of Kimmel’s complex MAGNET screen, we find that no companies currently pass all of the filters. However, this is not surprising. As Kimmel admits, there are very few companies that are attractive to growth, momentum, and value investors.
At AAII.com going forward, we will present statistics as to the average number of companies passing these two screens as well as the performance of portfolios invested in these MAGNET screens.
Jordan Kimmel’s MAGNET stock selection process isolates companies that will attract value, growth and momentum investors alike. By identifying these rare companies that are sought by different types of investors, Kimmel believes there is a much greater pool of buying power to push stock prices higher.
For now, remember that stock screening is not about generating a “buy” or “recommended” list. Quantitative filters such as the two MAGNET screens we have presented here can help you identify companies with similar characteristics. It is still up to you to perform additional due diligence to decide whether a stock matches your risk tolerance and time horizon before adding it to your investment portfolio.