AAII Stock Screens 2015 Review: Small-Cap Wins During a Large-Cap Year

As I am writing this in mid-December, the first two weeks of this month have sapped what little momentum U.S. stocks had to this point in the year, with the S&P 500 index on track for its first annual decline since 2008. Much of this is attributable to the near certainty that the Federal Reserve will increase interest rates for the first time in nine years, a move that may have already taken place by the time you read this article. However, even before this late-year swoon, 2015 was a disappointing year for the typical stock.

Before I delve in to the performance data of the AAII stock screens, however, let’s take a look back on the year that was 2015. The U.S. economy continued its slow and steady expansion, while the unemployment rate fell. The U.S. unemployment rate stood at 5.0% in November, compared to 5.8% a year ago. Positive economic data continually fueled speculation as to when Fed chair Janet Yellen and the Federal Open Market Committee would finally start the “liftoff” of short-term interest rates.

Overseas, the year began with a political crisis in Greece. A snap election elevated the left-wing Syriza party to power, which rejected the austerity measures imposed by foreign lenders during its last financial bailout. Eventually, an agreement was reached for a third bailout for the country, preventing a Greek default and its exit from the European Union. China’s weakening economy had global markets on edge for much of the year as well. Chinese officials repeatedly cut interest rates and pumped liquidity into the world’s second-largest economy in the hopes of giving it a boost.

At home, while data seems to point to an improving U.S. economy, corporate earnings have hit their weakest patch since 2009. According to FactSet, companies in the S&P 500 are expected to see earnings decline 4.4% in the fourth quarter of 2015. If this forecast proves correct, it would mark the first time the index has seen three consecutive quarters of year-over-year declines in earnings since the first quarter through third quarter of 2009.

Stir all of this together and you have a recipe for a lackluster 2015 for U.S. equities, especially compared to last year. In 2014, the Dow Jones industrial average notched 38 record high closes. This year has only seen six as of the end of November, the last of which came on May 19. On April 23, the Nasdaq composite reached levels it had not seen in 15 years at the peak of the dot-com stock bubble. For a few months after, U.S. indexes moved mainly sideways, until late August.

On Monday, August 24, U.S. stocks tumbled right out of the gate, with the Dow Jones industrial average plunging more than 1,000 points in the opening minutes of trading. The Dow ended down 588.40 points, or down 3.6%, to close at its lowest level in 18 months. That Monday marked the largest one-day point decline ever on an intraday basis, according to The Wall Street Journal. The S&P 500 dropped 3.9%, officially entering correction territory (as defined as a decline of 10% from a recent peak). This ended the fifth-longest correction-free streak for the S&P 500, at 1,421 days. That day also marked the first time since 2002 that the S&P 500 fell by at least 2% for three trading sessions in a row, according to Schaeffer’s Investment Research. In addition, the CBOE Volatility Index (VIX) jumped to a six-year high before settling for a 45.3% gain to its highest close in nearly three years.

Fortunately, the correction did not turn into a full-blown bear market. After re-testing the August 24 lows in late September, the U.S. indexes rallied in October, nearing their highs for the year.

As was the case last year, large-cap growth stocks were the clear “winner” this year. The S&P 500 Growth index experienced a total return—including dividends—of 7.0% through the end of November, compared to a 2.0% total loss for the S&P 500 Value index. The S&P 500 index had a price gain of 1.0% through the end of November, while the S&P MidCap 400 index had risen 0.6% and the S&P 600 SmallCap index was up 1.7%. The Nasdaq 100, the index of the 100 largest stocks traded on the Nasdaq market, had risen 10.1% year-to-date.

Given the performance of U.S. stocks through the first 11 months of 2015, valuations are relatively unchanged compared to the same point last year. The S&P 500 stocks tracked by AAII’s Stock Investor Pro fundamental stock screening and research database program were trading with a median price-earnings ratio (P/E)—based on trailing 12-month earnings per share—of 21.2. The price-earnings ratio for the index was 21.3 at the end of November 2014 and 21.1 for the same period in 2013. The five-year average price-earnings ratio for these large-cap stocks was 18.1 and the forward price-earnings ratio based on 2016 earnings was 16.7. As of November 30, 2015, the S&P MidCap 400 stocks were trading with a median price-earnings ratio of 21.6. In comparison, the five-year average for the mid-cap index was 19.1 and the forward price-earnings ratio, based on 2016 earnings, was 16.7. The S&P SmallCap 600 index stocks had a median price-earnings ratio of 22.0 at the end of November. By means of comparison, the five-year average median price-earnings ratio was 19.5 and the forward price-earnings ratio was 17.0.

Screen Performance

Last year, the AAII stock screens reflected the overall weakness in U.S. stocks. Of the 64 different screening methodologies tracked on AAII.com—the MAGNET Simple Revised and MAGNET Complex Revised screens were added in 2015—31 were up for the year through the end of November while 33 were down. Of the 31 that posted gains year-to-date, however, 26 outperformed the S&P 500’s 1.0% gain through November 30. The median price change of all AAII stock screens, again through November 30, 2015, was a 1.1% decline, compared to a price gain of 3.1% last year through the end of November 2014. In 2015, none of the screens turned in their best annual returns.

Table 1 provides summary performance, risk and volatility statistics for the stock screening strategies we track at AAII.com. The strategies represent our quantitative interpretations of a wide array of investment approaches. (See the box “The AAII Stock Screens” for more information about them.)

Table 1. Performance of Stock Screens on AAII.com

All of these screens have been created and backtested using Stock Investor Pro and all but two—the Dogs of the Dow and Dogs of the Dow—Low-Priced 5 screens—are prebuilt into the software. Table 1 presents the price change performance (excluding dividends and transactions costs, such as commissions, bid-ask spreads, time and price slippage, etc.) over various time periods for each stock screening strategy.

The screens are grouped in Table 1 by style to identify their underlying premise. These style groupings are: value, value with price momentum, growth, growth with price momentum, growth & value, growth & value with price momentum, earnings estimates and specialty. Within each group, the screens are ranked in descending order by year-to-date price performance through November 30, 2015. The end of the table shows performance data for several market indexes and stock groups.

Impact of Dividends

The Price Gain and Average Annual Price Gain columns in Table 1 represent the annualized percentage price gain or loss realized by a hypothetical portfolio invested in the stocks passing a given screen over varying periods from January 1, 1998, through November 30, 2015.

Keep in mind, however, that these figures represent price change only, and do not include dividend payments or dividend reinvestment. Therefore, the results of screens that tend to isolate large, dividend-paying stocks—such as the Dogs of the Dow (in the value category)—do not receive a boost from dividend payments or reinvestment.

The 10 stocks passing the Dogs of the Dow screen at the end of November were yielding 3.8%, compared to 3.3% at the end of November 2014; investors holding shares in these stocks, therefore, would have a higher annual return by approximately this amount for the coming year.

The Top Screen of 2015

After being the fifth-worst-performing AAII stock screen in 2014, when it lost 19.9%, the Foolish Small Cap 8 screen gained 49.5% year-to-date as of November 30, making it the top-performing AAII stock screen of 2015. This methodology for screening for small stocks was developed by David and Tom Gardner, founders of the Motley Fool.

Our screen based on their approach is discussed in greater detail starting on page 12. In 2015, eight stocks passed the screen between the end of 2014 and the end of October 2015. Furthermore, at least one company passed the screen each month. Since 1998, the Foolish Small Cap 8 screen has, on average, generated 15 passing companies a month. The discussion starting on page 12 looks at the companies driving the screen’s 2015 performance.

The Passing Companies Behind the Top Strategy of 2015

The Foolish Small Cap 8 screen’s 2015 performance was no laughing matter, with a 49.5% gain year to date through November 30, 2015. In a year where the typical stock screen lost 1.1%, this strategy’s performance was even more impressive. However, when evaluating the performance of a given stock-picking approach, it is useful to look beyond the simple gain/loss data and examine the individual stocks that contributed to the overall return.

Unlike last year’s top AAII screen, the Foolish Small Cap 8 screen was fully invested throughout the entire year. However, the screen, on average, only generated two passing companies each month. For the year, eight unique companies were uncovered by the screen.

The Foolish Small Cap 8 methodology for screening for small stocks was developed by David and Tom Gardner, founders of the Motley Fool (www.fool.com). Their strategy uses eight criteria to look for profitable and rapidly growing small companies with strong price momentum. It’s partly based upon the premise that the lack of coverage and interest in small-cap companies presents a better opportunity to locate undiscovered, attractive investment candidates.

The Foolish Small Cap 8 screen was designed to flag potential growth companies based upon a combination of market- and business-related factors. The filters used to identify good businesses are as follows:

• Recent earnings and sales growth of at least 25%;
• Net profit margin of at least 7%;
• Positive operating cash flow; and
• Insider ownership of at least 10%.

The next three Foolish 8 screens narrow the universe of stocks from which the top companies may be located. These market-related factors are:

• Daily dollar trading volume between $1 million and $25 million;
• Share price of at least $7; and
• Relative strength greater than 90%.

Lastly, the Foolish 8 screen caps a company’s annual sales at $500 million, which is used to identify smaller companies.

Historically, the strategy has averaged 15 stocks per month, whereas the typical AAII stock screen has averaged roughly 20 passing companies a month since the start of 1998.

When following a given strategy, spreading your investment around into more stocks will lower your volatility, as investing in a small number of companies makes a portfolio more susceptible to individual stock price movements. The 10 AAII stocks screens that average the lowest number of passing companies each month are at least 80% more volatile than the S&P 500 index. Six of the 10 are more than twice as volatile as the large-cap index. However, having a good number of passing companies does not guarantee low volatility. The Piotroski High F-Score screen has a risk index of 2.07, meaning it is 107% more volatile than the S&P 500. This places it in 13th place among all AAII screens in terms of volatility. However, looking at its historical performance, much of that volatility has been to the upside.

Table 3 presents the eight stocks that passed the Foolish Small Cap 8 screen in 2015, as well as their performance while they were held in the hypothetical portfolio, the number of months each stock was held this year and select current financial data.

Table 3. Stocks Passing the Foolish Small-Cap 8 Screen During 2015

Company (Ticker)	Price Gain While in Port (%)	Mos in Port During 2014	P/E Ratio (X)	Price- to- Book Ratio (X)	Div Yield (%)	P/E to EPS Est Grth (%)	5-Yr Hist EPS Grth (%)	EPS Est Ann’l Grth 3-5 Yrs (%)	Market Cap ($ Mil)	52-Wk Rel Strgth (%)
Natural Health Trends Corp. (NHTC)	37.2	3	15.4	12.13	0.4	na	35.4	na	592.3	254.9
Sucampo Pharmaceuticals, Inc. (SCMP)	27.7	6	24.5	6.52	0.0	na	21.4	na	777.2	45.4
Supernus Pharmaceuticals Inc. (SUPN)	11.2	4	70.3	7.18	0.0	1.20	67.0	70.0	790.6	81.3
Paycom Software Inc. (PAYC)	5.9	1	136.3	27.08	0.0	2.10	67.0	53.9	2,577.0	50.7
United Insurance Holdings Corp. (UIHC)	2.5	3	16.1	1.78	1.1	0.90	40.1	20.0	407.7	0.4
Diamond Hill Investment Group (DHIL)	-3.6	1	19.3	6.72	0.0	na	17.1	na	750.3	66.1
Healthequity Inc. (HQY)	-12.2	2	126.9	9.79	0.0	3.10	na	35.0	1,888.3	32.1
POZEN Inc. (POZN)	-24.7	1	na	8.53	0.0	na	35.7	na	248.8	-15.2
Performance figures do not include dividends or transaction costs. Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 11/30/2015.

Natural Health Trends Corp. (NHTC) was the best-performing stock that passed the Foolish Small Cap 8 screen in 2015. It was held in the portfolio for only three months—May, June and July—but it generated a cumulative price gain of 37.2% over that period. Natural Health Trends Corp. is a direct-selling and e-commerce company that offers a line of NHT Global–branded products, including wellness, skin care and lifestyle. The company sells its products to a network of consumers or business builders that either use the products themselves or resell them to consumers. Its wholly owned subsidiaries have presence in the global markets, including North America; Greater China, which consists of Hong Kong, Taiwan and China; Russia; South Korea; Japan; and Europe, which consists of Italy and Slovenia.

Three of the companies that passed the Foolish Small Cap 8 screen in 2015 lost money while held in the hypothetical portfolio. The worst-performing stock from this group was POZEN Inc. (POZN), which fell 24.7% in August, the only month it was held in the portfolio.

The 2015 results for the Foolish Small Cap 8 screen are a departure from its average performance since the start of 1998. Its annual average price gain of 12.3% since the beginning of 1998 places it 29th among the 64 AAII stock screens. On a risk-adjusted basis, it slips to 39th place, with an average annual return of 9.0%.

Historical Performance

AAII has performance history for our stock screens dating back to the start of 1998—almost 18 years now. We have seen a shakeup among the top performing methodologies since inception. After turning in the best performance of 2014 with its 50.3% gain, the Rule #1 screen went from first to worst in 2015, losing 47.1%. As a result, it fell out of the top five in terms of since-inception performance among all AAII screens. As a result, the Estimate Revisions Up 5% (Est Rev Up 5%) screen now sits atop the list for long-term performance, with a gain of 25.7% since inception.

The Estimate Revisions Up 5% screen has managed to achieve its long-term gains not only by generating strong annual gains but also by not grossly underperforming in its down years, which have numbered few: the screen has only had two down years since 1998. The screen looks for upward revisions in annual earnings estimates; specifically, it identifies companies that have had their annual earnings estimates raised by at least 5% over the last month. This and our other earnings estimate revisions screens add these stocks in the month following the revisions made to earnings estimates by analysts. The Estimate Revisions Up 5% screen has the eighth-highest bull market gain among all AAII stock screens at 444.0%, which is actually lower than that of the second-best all-time-performing AAII screen, the Estimate Revisions Top 30 Up screen. This screen has a bull market gain of 601.9% and a gain since inception of 24.7%. (For purposes of calculating returns, the current bull market began on March 1, 2009, and came to an end on June 30, 2015.) For 2015, the Estimate Revisions Up 5% screen has generated a year-to-date gain of 7.8% and has a bear market loss of 23.4%.

Rounding out the top three AAII stock screens since inception is the Piotroski High F-Score screen, with an average annual gain of 24.3%. This pure value screen looks for stocks with a very low price-to-book-value ratio and with positive financial characteristics (a high F-score). It has built its performance by doing extraordinarily well in bull markets, with a bull market gain of 933.2%, second among all AAII screens. However, in 2015 it slumped 37.4%, making it the second-worst AAII stock screen for the year to date. Value strategies did not fare very well in 2015, as indicated by the underperformance of the S&P 500 Value index relative to the S&P 500 Growth index, so the performance of this value screen is not overly surprising.

In contrast, two of AAII’s worst-performing screens since inception are Estimate Revisions Lowest 30 Down and Estimate Revisions Down 5%, giving credence to the belief that earnings estimates play a huge factor in the subsequent short-term performance of stocks. As of the end of November, the Lowest 30 Down screen had lost 10.3% while the Down 5% screen had surrendered 5.8%.

The worst-performing AAII stock screen since inception, however, is the Murphy Technology methodology, which, on average, has lost 2.8% a year since the beginning of 1998.

Risk-Adjusted Return

Table 1 also presents the risk-adjusted return for each of the screens. This calculation adjusts the performance of each screen using their volatility as measured through standard deviation of returns, penalizing screens with higher standard deviations (for a more detailed explanation of the risk-adjusted return calculation, see the box here). Using risk-adjusted returns, we still find the two long-term best-performing screens at the top: Estimate Revisions Up 5% and Estimate Revisions Top 30 Up. However, the Piotroski High F-Score screen falls out of the top five, replaced by the Stock Market Winners screen, which ranks third with a risk-adjusted average annual return of 16.3%.

The Stock Market Winners approach is based on research performed by William O’Neil and published in his book “The Greatest Stock Market Winners: 1970-1983.” The screen is based on variables from five categories. The first, “smart money,” includes the behaviors of professionally managed funds and corporate insiders. The second contains valuation measures such as price-to-book-value and price-earnings ratios. The third grouping includes the technical indicator of relative strength. The fourth consists of accounting earnings and profitability measures. The final group contains miscellaneous variables that did not fit into the other four groups, including the number of common shares outstanding.

Bull & Bear Market Results

The majority of stocks have some positive correlation with the overall market: When the market is going up, so do the values of many stocks. However, the extent of the increases vary.

When investing in individual stocks, you would like to outperform the market, otherwise you are probably better off investing in an index fund. By tracking the performance of our stock screens over the latest bull and bear markets, we are able to see whether a strategy can outperform the market during an uptrend or limit losses during a downtrend.

Among the AAII stock screens, the Price-to-Free-Cash Flow screen has turned in the best bull market performance, gaining 957.8% between March 1, 2009, and June 30, 2015.

Five screening strategies were not able to capitalize on the market’s overall upward momentum during the last bull market and turned in losses: MAGNET Complex Revised (–64.8%), Muhlenkamp (–46.6%), Kirkpatrick Value (–17.0%), MAGNET Complex (–16.2%) and MAGNET Simple Revised (–8.4%). By way of comparison, the S&P 500 gained 180.7% during the last bull market.

Over the last bear market, O’Neil’s CAN SLIM screen had the smallest loss at –10.1% from November 1, 2007, through February 28, 2009. The screen benefited from being out of the market for much of that time, as its strict price momentum filters have few, if any, candidates during a prolonged market downturn. When no stocks pass a strategy at the beginning of a calendar month, we consider the hypothetical portfolio to be fully invested in cash and thereby out of the market. The biggest loser over the last bear market was the Dogs of the Dow Low Priced 5, which dropped 82.9%.

Monthly Variability

The monthly variability columns in Table 1 show the best and worst single-month returns of each of the 64 AAII stock screens. O’Neil’s CAN SLIM screen, which seeks out stocks with strong price momentum, has the highest single-month gain at 69.6%. On the other end of the spectrum, the Murphy Technology screen has the biggest one-month decline at 44.9%.

Risk Index

The risk index compares the variability of returns, as measured by the standard deviation of return, for a given stock screening strategy to that of a benchmark. Standard deviation is a measure of return volatility computed using monthly returns since the beginning of 1998. The risk index divides the standard deviation of a strategy’s return by the standard deviation of return for a benchmark, in this case the S&P 500. The risk index provides a relative measure of risk by comparing the variation in return for a screen since the beginning of 1998 to the typical variation in return for the benchmark index. The risk index of the S&P 500, therefore, is 1.00; methodologies with a risk index below 1.00 are below average in risk.

Almost all of AAII’s screens have risk indexes above 1.00, which is to be expected. Stock screens, after all, typically pass anywhere from a handful of stocks to around 50, while the S&P 500 is made up of 500 very heavily traded companies. In fact, as of the end of November, only two screens have a risk index lower than 1.00: Graham Defensive Investor—Utility and Dividend—High Relative Yield. These two screens are made up of “safer” stocks, with one focusing on utility stocks and the other seeking out dividend-paying stocks.

Ranking the 64 stock screens according to risk index, we see that the Graham Defensive Investor—Utility screen has the lowest risk index, 0.97. This means the approach is only 97% as volatile as the S&P 500 since the start of 1998. The screen’s risk-adjusted return matches that of its average annual return of 6.8%.

Benjamin Graham’s philosophy divides investors into two groups by the amount of time they are able to devote to researching and managing a stock portfolio, as well as by their level of market experience. For the defensive or passive investor, analysis is geared toward avoiding serious mistakes or losses. Graham tries to establish a procedure that provides freedom from great effort and frequent decision-making. Graham feels that the defensive investor should confine his or her holdings to the shares of important companies with a long record of profitable operations and strong financial condition. By “important,” he means a company of substantial size with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

The 2.07 risk index value for the Piotroski High F-Score screen indicates that, since the beginning of 1998, the monthly variability of returns for the stocks held in this portfolio has been more than twice that of the S&P 500. This makes the Piotroski High F-Score screen the 13th-riskiest screen among the 64 screens AAII tracks. The screen also has the highest risk index among all value strategies AAII tracks. Among all AAII stock screens, the median risk index value is 1.56. This indicates that the typical stock screen tracked by AAII has 56% more volatility than the S&P 500.

The MAGNET Simple screen has the highest risk index (2.97) and standard deviation of returns (45.8%). Accordingly, its annualized gain of 14.3% since 1998, which is above the median annualized gain for all screens of 9.6%, becomes a lackluster risk-adjusted return of 9.1% since 1998 (the median risk-adjusted return for the screen universe is 9.5%).

A MAGNET stock, according to Jordan Kimmel, offers a blend of technical and fundamental characteristics. 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 stands for the following:

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).

Ulcer Index

The Ulcer Index is a measure of downside volatility; it was named as such because downside volatility causes stress and stomach ulcers. Needless to say, a lower number is better, meaning that there is less volatility on the downside.

Stock screens with high overall volatility, as measured by standard deviation, but relatively low downside volatility, as measured by the Ulcer Index, are especially attractive. These stocks’ price movements tend to be to the upside instead of to the downside. The Piotroski High F-Score screen is a great example, with a risk index of 2.07 and an Ulcer Index of 14.0%, below the median Ulcer Index of all the screens (16.4%).

Average Holdings & Turnover

One benefit of quantitative stock screening is the ability to winnow down a universe of stocks to a more manageable number. For stock screens to be useful, however, there should ideally be enough stocks passing to provide various alternatives, but not too many that investors are overloaded with choices.

The rightmost columns of Table 1 present the average number of passing stocks and the turnover percentage for each of our stock screens. For many of the screens, you will notice patterns depending on the market cycle. For example, as we noted previously, the Foolish Small Cap 8 screen has generated, on average, 15 stocks per month since the start of 1998. However, in 2015, as corporate earnings growth came under pressure, only eight stocks passed the screen for the entire year with an average of two companies passing a month.

The rightmost column in Table 1 shows the average monthly turnover percentage for each of the screens. The Estimate Revisions screens have some of the highest monthly turnovers of any of the screens that AAII tracks, ranging from 81.3% to 92.7%. From a conceptual standpoint, this characteristic for these screens makes perfect sense. As we stated before, the Estimate Revisions screens look for companies that have had upward or downward earnings revisions over the past month. Not many companies will continuously pass these screens, since that would suggest that analysts are continuously revising the estimates of a specific company upward or downward month after month. Also, keep in mind that, as a general rule, value screens tend to have lower turnover and growth screens tend to have higher turnover.

The screen with the lowest turnover is the Dogs of the Dow screen, with an average monthly turnover of 7.6%. The median average monthly turnover for AAII’s screens is 38.3%.

Conclusion

The AAII stock screens are not intended to be buy or recommended lists. Instead, they allow investors to see how different investment strategies perform over varying market conditions. Since market conditions change, it is important to be adequately diversified to weather the ups and downs of the market.

One way to achieve sufficient diversification is by using multiple stock screening methodologies to help you select stocks. However, it is not enough to simply choose those strategies that have the best long-term performance. Instead, it is useful to understand the forces influencing both the overall market and a strategy’s performance, and how changing economic conditions can impact both the market and individual stocks. Examining the characteristics of an investment methodology may reveal some practical problems you can face when trying to translate quantitative stock screening in real-world portfolio building.

Something else to keep in mind is that once you decide on which methodologies to follow, you cannot just let the quantitative screens choose your stocks.

Screening is a multi-step process. The first step is to apply the quantitative filters to the stock universe to help you arrive at a set of candidates that all share the same base set of characteristics. This does not necessarily mean they are all good investments. It is important to take your list of passing companies and, at a minimum, perform some cursory qualitative analysis to decide whether or not they are right for your stock portfolio.

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