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    Searching for the Upcoming Stock Market Winners

    by John Bajkowski

    Searching For The Upcoming Stock Market Winners Splash image

    In September 1989 the AAII Journal published an article by Marc Reinganum, titled “Investment Characteristics of Stock Market Winners.” The article revealed characteristics that were common to 222 stocks highlighted as winners prior to their rise to super-stock status. These types of examinations can be noteworthy if they help to establish financial relationships likely to hold true over time.

    Reinganum developed nine trading rules to identify these winners and found that the use of these rules or screening criteria produced returns that were significantly higher than the market. While the group passing the filter was slightly more risky than the market, the additional risk did not account for the extraordinary returns of the winners. The rules lay down the maximum price to pay for a stock, minimum levels of profitability and growth, and price momentum targets.

    A slightly modified set of the rules has been programmed into Stock Investor Pro—AAII’s fundamental stock screening program and research database.

    The screening criteria are:

    • The price-to-book ratio (price per share divided by owner’s equity per share) is less than or equal to 1.5;

    • Earnings per share from continuing operations for each of the last two fiscal quarters (Q1 and Q2) are greater than the earnings per share from continuing operations for the same quarter one year prior (Q5 and Q6);

    • Same-quarter growth in earnings per share from continuing operations from Q5 to Q1 is greater than the same-quarter growth in earnings per share from continuing operations from Q6 to Q2;

    • The five-year growth rate in earnings per share from continuing operations is greater than zero;

    • The pretax profit margin (pretax net income divided by sales) for the last 12 months is positive;

    • The weighted relative strength for the last four quarters ranks in the top 70% of the entire database (percent rank greater than or equal to 70);

    • The current stock price is within 15% of the highest price at which the stock has traded over the last two years; and

    • The average number of shares outstanding for the last fiscal quarter (Q1) is no greater than 20 million.
    The companies passing the screen, along with a simple hypothetical portfolio, have been reported and tracked on AAII.com for over five years.

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

    As revealed in Figure 1, the screen has produced results that surpass the performance of both small- and large-capitalization companies over the period of the study. The strategy showed a 12.0% loss in 1998, but positive returns for each of the subsequent years. The cumulative gain for the strategy is 202.4%, compared to a total gain of 12.4% for the large-cap S&P 500 index and 24.2% for the S&P SmallCap 600.

    Performance vs. Benchmarks
    Return (%)
      Cumulative Best
    Month
    Worst
    Month
    YTD
    2003
    2002 2001 2000 1999 1998
    Stock Market Winners 202.4 17.5 -16.7 18.3 32.1 41.6 27.6 21.7 -12.0
    S&P 500 12.4 9.8 -14.5 10.4 -22.1 -7.6 -9.1 21.0 28.6
    S&P MidCap 400 51.3 12.1 -18.6 10.9 -14.5 -0.6 17.5 14.7 19.1
    S&P SmallCap 600 24.2 13.4 -19.3 10.1 -14.6 6.5 11.8 12.4 -1.3
    All Exchange-Listed Stocks 60.6 23.9 -20.2 24.4 -13.3 21.2 -14.2 35.1 5.9

    Table 1 highlights the characteristics of the current stocks passing the screen compared to the typical exchange-listed company. Both the price-earnings ratios (share price divided by earnings per share) and price-to-book value ratios point to a group of stocks priced more cheaply than the overall market—a direct result of the price-to-book filter of the screen.

    The historical five-year annual growth rate indicates significantly higher growth levels than the market, even though the screen only specifies a positive five-year growth rate in earnings.

    TABLE 1. Winners' Characteristics Compared to All Stocks
      Stock
    Market
    Winners
    Exchange-
    Listed
    Stocks
    Price-earnings ratio 12.5 17.4
    Price-to-book ratio 1.36 1.68
    EPS growth rate (hist 5 yr.) 16.10% 1.40%
    Market cap (million) $63.20 $226.30
    Relative strength vs. S&P 54.50% 2.50%
    Monthly Observations
    Average no. of passing stocks 22
    Highest no. of passing stocks 60
    Lowest no. of passing stocks 1
    Monthly turnover 61%

    The companies passing the screen tend to be smaller firms than typical exchanged-listed stocks. A median market cap of $63.2 million puts this group of passing stocks into the micro-cap segment—below the size threshold that many small-cap mutual funds hold. The small-cap focus is no doubt influenced by the filter specifying the maximum number of shares outstanding at 20 million.

    The stocks currently passing the screen have performed 54.5% better than S&P 500 over the last 52-weeks. The weighted relative strength ranking is the primary price momentum indicator used in the screen. The weighting requires that the most recent quarterly price change should be given a weight of 40% and the previous three quarters each weighted 20%. This weighting puts a higher emphasis on recent stock market performance. A filter requiring that the current price is within 15% of the high price for the last two years reinforces the price strength requirement of the screen.

    While only 10 stocks currently pass all of the trading rules, on average 22 companies have passed the filters over the last five and a half years. As little as one stock passed the filters during the monthly stock screening examinations. Typically, only a handful of companies were passing the screen toward the end of the bull market run of the 1990s, while a large number of companies (often over 40) have been passing the filter since 2001.

    The monthly turnover rate of 61% is the highest for the growth and value strategies tracked on AAII.com. In a typical month, only four of 10 stocks will pass all of the filters again the next month when the screen is run. The current passing companies, listed in Table 2, are from an odd mix of industries. There are three small banks, two construction material distributors, a title insurance company, a medical supplies manufacturer, a wireless service provider, a same-day delivery company and even a company that explores and develops oil and gas properties.

    The list of only 10 passing companies is the smallest group of passing companies since late 2000. No list of companies passing a filter makes for a complete diversified portfolio, but often it contains a few companies that are worthy of consideration for your portfolio. Like all screens, the screen is the first step in selecting stocks, and should be followed up with in-depth company research and analysis. Further information on this screen can be found in the help system of Stock Investor and the Stock Screens area of AAII.com.


     


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