Purposely Not Seeking Revenue or Profit Growth
Thursday, September 22, 2016

A new stock screen I created omits one characteristic that may surprise some (or perhaps many) of you: growth. Nothing in the screen requires a passing company to be growing revenues or profits. It is an admitted deviation from how I’ve previously looked for stocks.

I’m not alone in omitting growth. The four AAII Stock Screens with the best long-term performance all do not seek growth: Estimate Revisions Up 5%, Piotroski High-F Score, Estimate Revisions Top 30 Up and O’Shaughnessy Tiny Titans. Add in Price-to-Free-Cash Flow, and five of the seven screens with the best performance since the start of 1998 (when we started tracking the returns for our screens) do not specifically require growth. Even our Model Shadow Stock Portfolio—a real-world portfolio—has a long-term annualized return of 15.5% since its inception in 1993. This compares to the Vanguard Small Cap Index fund’s (NAESX) return of 9.9% over the same period.

There’s no argument about whether growth is a positive trait. Rising revenues can drive profits, cash flow and retained earnings higher. It can also increase the denominator in the price-earnings, price-to-cash-flow and price-to-book ratios (and will obviously increase the denominator in the price-to-sales ratio). When the denominator in a valuation ratio grows, either the stock’s price has to rise or its valuation will become cheaper. Growth in cash flow also allows a company to raise its dividend and buy back more shares, all positive things. The problems with growth are what one pays for it and the ability to forecast it.

Stop and think about how much attention growth stocks get. Investors love growth stories, as well as stories about companies with the potential for explosive growth. As these stories circulate, the stocks get more attention, more fans and higher valuations. Lost in the hoopla is the opportunity for mispricing. Stocks priced below their fair valuation are investors’ friends; you’re unlikely to find them where the crowds are standing.

The long-term record backs this up. The 2016 SBBI Yearbook reports large-cap value stocks as realizing an annualized return of 11.0% between 1928 and 2015, besting large-cap growth stocks by a margin of slightly more than 20%. (Large-cap growth stocks have a long-term annualized return of 9.1%). The difference is bigger among small-cap stocks: 13.7% for value versus 9.3% for growth. Granted, value stocks don’t outperform all the time, but they do win more often than not. Large-cap value stocks realized higher returns than large-cap growth stocks during six out of the last eight completed decades, 1930-2010. Admittedly, growth has had the advantage over the past few years, but if the long-term historical trends hold, the pendulum will swing back in favor of value.

Setting aside returns, there is the problem of being able to predict growth. Analysts are notoriously bad at it. Plus, various studies have shown that forecasting skills deteriorate the further out an analyst tries to predict profits. This is why some strategies set an upper limit on the price-earnings-to-earnings-growth (PEG) ratio. Doing so allows for a margin of error. While I could do the same, I think it’s better to forgo seeking out growth and simply find profitable and cash-flow-positive companies that are likely to be trading at bargain prices.

So, if I’m omitting growth, what I am looking for? The actual screen is being reviewed to ensure I didn’t inadvertently make an error in creating the custom criteria I intend to use, but I can give you an overview.

  • Low valuation: Specifically in the bottom 40% of all stocks
  • Profitability: Companies must be profitable for the past 12 months, last reported quarter and projected to be profitable for the current fiscal year
  • Positive cash flow: Normal business operations must be generating more cash than they use
  • Momentum: Passing stocks must rank in the top 40% of all stocks for 26-week return

I will then use a scoring system to rank the passing stocks based on the following criteria:

  • Accruals: As I explained last week, stocks with low accruals tend to outperform
  • Improving asset turnover: An increase in this ratio implies a company is becoming more efficient
  • Rising dividends: Initiating or raising a dividend leads to higher returns
  • Share repurchases: Though stock buybacks can be controversial, they can boost the stock's price if there is a net decrease in shares outstanding
  • Positive EPS revisions: Our rising earnings estimates screens rank among the best-performing screens, as noted above
  • Decrease in relative debt: Used to avoid companies taking on more leverage

Taking a step back to look at the broader picture, the screen incorporates three factors: value, momentum and quality. Viewed another way, this is a value screen designed to weed out value traps by seeking out stocks with momentum and deemphasizing companies with weaker fundamentals. By using a two-step process of screening and then ranking the results by a score, I am allowing the screen to be inclusive enough to find many names while still having a mechanism to weed out the riskier stocks.

Have a thought or comment about the screen? You can send me an email or post on our discussion boards.

More on AAII.com

Highlights from the AAII Journal

The Week Ahead

Dow Jones industrial component Nike (NKE) will report earnings on Tuesday.

August new home sales will be the first economic report of note, released on Monday. Tuesday will feature the July S&P Case-Shiller home price index (HPI) and the Conference Board’s September consumer confidence survey. August durable goods orders will be released on Wednesday. Thursday will feature August international trade, August pending home sales and the second revision to second-quarter 2016 gross domestic product (GDP). August personal income and spending, the September Chicago purchasing managers index (PMI), and the University of Michigan’s final September consumer sentiment survey will be released on Friday.

Federal Reserve Chair Janet Yellen will speak on Thursday. Several other Federal Reserve officials will also make public appearances: Minneapolis president Neel Kashkari on Monday and Wednesday; Dallas president Robert Kaplan on Monday; St. Louis president James Bullard, Chicago president Charles Evans and Cleveland president Loretta Mester on Wednesday; Kansas City president Esther George on Wednesday and Thursday; and Philadelphia president Patrick Harker, Atlanta president Dennis Lockhart and board governor Jerome Powell on Thursday.

The Treasury Department will auction $26 billion of two-year notes on Monday, $34 billion of five-year notes on Tuesday, and $13 billion of two-year floating rate notes and $28 billion of seven-year notes on Wednesday.

What’s Trending on AAII
  1. The Top ETFs Over Five Years: Health Care Loses Some Ground

  2. Retiree Portfolios and Warren Buffett’s Allocation Instructions

  3. Advocating the Paycheck Strategy for Lifetime Investing

AAII Sentiment Survey

The percentage of individual investors expressing pessimism about the short-term direction of the stock market is at its highest level since February. This week’s AAII Sentiment Survey also shows a slight increase in neutral sentiment and a further decline in optimism.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 3.1 percentage points to 24.8%. The drop keeps optimism at its lowest level since June 22, 2016 (22.0%). It also keeps bullish sentiment below its historical average of 38.5% for the 79th week out of the past 81.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged up 0.7 percentage points to 36.9%. The increase puts neutral sentiment above its historical average of 31.0% for the 34th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.4 percentage points to 38.3%. Pessimism was last higher on February 10, 2016 (48.7%). Bearish sentiment is still within its typical historical range, though it’s above its historical average of 30.5% for the third time in four weeks.

During the past two weeks, pessimism has jumped by a cumulative 9.8 percentage points, while optimism has fallen by a cumulative 5.0 percentage points. Concerns continue to exist about a potentially larger drop in stock prices than occurred earlier in the month. It is also not completely clear how much influence the upcoming election is having on sentiment, though it is mentioned regularly without any prompt from us in response to the survey’s weekly special question.

The survey period runs from Thursday through Wednesday. As such, the majority of this week’s survey responses were recorded before yesterday’s Federal Reserve statement and yesterday’s new record high for the NASDAQ. (AAII members have previously expressed mixed opinions about the new record highs established by the major indexes this summer.)

In addition to worries about a potential larger drop in stock prices, some AAII members have previously expressed concern about valuations, global economic uncertainty and the pace of corporate earnings growth. Giving other individual investors reason for optimism are this summer’s rise in stock prices, the perceived lack of investment alternatives, corporate earnings, low/stable energy prices and sustained, albeit slow, economic growth.

This week’s special question asked AAII members how, if at all, oil prices are affecting their outlook for the stock market in general. Just under half of all respondents (46%) said oil prices are not influencing their outlook for stocks. Some said the presidential election is having a greater impact on their sentiment. Approximately 11% of all respondents view low oil prices as being good for the economy, and thereby the market. Slightly more than 8% viewed low oil prices as being negative, with some saying the lower prices reflect weak economic conditions.

Here is a sampling of the responses:

  • "Not impacting my outlook, unless oil starts moving up or down.”
  • "Continuing low oil prices are good for consumers and most businesses, so I expect a positive impact on stock prices.”
  • "I’ll be concerned if oil prices drop or rise considerably.”
  • "Oil prices have some impact, but I believe the upcoming election has more impact.”
  • "Low oil prices continue to indicate weak global demand in the coming months.”

This week’s Sentiment Survey results:

Bullish: 24.8%, down 3.1 points
Neutral: 36.9%, up 0.7 points
Bearish: 38.3%, up 2.4 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!