Screening for the Future Stock Market Winners

What does it take to become a winner? Several stock market strategists have undertaken studies to answer that question, in the belief that winning characteristics could be used to find future winners.

The CAN SLIM stock screen approach, developed by William O’Neil, was based on the analysis of the common traits of the biggest stock market winners dating back to 1953. This approach—which because of its focus is classified as a growth screen—has become one of the most popular, and best performing, strategies tracked by AAII. Other studies, however, have focused on different winning characteristics.

In an article in the September 1989 issue of the AAII Journal titled “Investment Characteristics of Stock Market Winners,” Marc Reinganum examined the common traits of a group of winning stocks. Based on Reinganum’s research, AAII developed the Stock Market Winners screen, which we classify as a growth and value approach. Last year, this screen was one of the top performers (it came in fourth overall, and was the second-best growth & value screen, after the Zweig screen). It also has an impressive long-term record, although year-by-year the returns have been volatile and the long-term performance record was boosted by a phenomenal return in 2003.

Defining the “Winners”

Reinganum’s study examined 222 stocks highlighted in a publication by (ironically) William O’Neil & Co. titled “The Greatest Stock Market Winners: 1970 to 1983.” The goal was to establish the characteristics that were common to these stocks prior to their rise to super stock status.

Reinganum then developed nine trading rules to help to identify the winners:

• A price-to-book-value ratio less than 1.0;
• Accelerating quarterly earnings;
• Positive five-year growth rate;
• Positive pretax profit margin;
• Relative strength rank of at least 70;
• Relative strength rank of the stock in the current quarter is greater than the rank in the previous quarter;
• O’Neil Datagraph rating of at least 70 (a weighted combination of earnings, capitalization, relative strength, and other factors where 1 is the lowest and 99 is the highest rating);
• Stock selling within 15% of its two-year high;
• Fewer than 20 million common shares outstanding.

Based on these trading rules, we developed our own Stock Market Winners screen, which attempts to quantify as many of these rules as possible. You can find the screening criteria for this strategy at the end of this article to see how our interpretation differs from the original. Stock Investor Pro, AAII’s fundamental stock screening and research database, includes the Stock Market Winners screen.

Performance

Figure 1 shows the performance of the Stock Market Winners screen. Outside of 1998, the stocks passing this screen have been able to generate positive returns each year. Overall, the Stock Market Winners screen has managed to outperform the small-, mid-, and large-cap indexes over the eight-year period, gaining a cumulative 716.4% between January 1998 and the end of 2005, compared to a 28.6% increase for the S&P 500.

Figure 1. Stock Market Winners Screen

Return (%) 1998 1999 2000 2001 2002 2003 2004 2005 Cum'l* Monthly Std. Dev. (%) Stock Market Winners (12.0) 21.7 27.6 41.6 32.1 131.5 9.6 25.9 716.4 7.0 S&P 500 26.7 19.5 (10.1) (13.0) (23.4) 26.4 9.0 3.0 28.6 4.6 S&P MidCap 400 17.7 13.3 16.2 (1.6) (15.4) 34.0 15.2 11.3 121.4 5.5 S&P SmallCap 600 (2.1) 11.5 11.0 5.7 (15.3) 37.8 21.4 6.7 93.6 5.8 All Exchange-Listed Stocks 5.9 35.1 (14.2) 21.2 (13.3) 81.1 22.8 4.5 199.9 6.6 *Price performance of hypothetical portfolio rescreened and rebalanced monthly using month-end closing prices and no transaction costs. Data as of December 31, 2005.

Profile of Passing Companies

The characteristics of the stocks passing the Stock Market Winners screen as of January 13, 2006, are presented in Table 1.

Eight companies passed the Stock Market Winners screen as of January 13, 2006, and are listed in Table 2 in ascending order by price-to-book-value ratio. The current group of passing companies numbers less than half of the historical average of 17. The Stock Market Winners screen has some of the highest turnover of all the strategies AAII tracks—on average, 60.4% of the portfolio is replaced each month.

Unlike the CAN SLIM approach, which is focused on earnings and price momentum (with no value elements), the cornerstone of the Stock Market Winners screen requires a price-to-book-value ratio of less than 1.5. The maximum level is higher than the original study so that a slightly larger group of companies would pass the overall screen.

Because of this strict value-oriented rule, it is probably not surprising that the companies passing have a lower price-earnings multiple, 13.8, than the typical exchange-listed stock as well as a lower median price-to-book-value ratio (1.24 versus 2.31).

The low price-to-book screen identifies neglected stocks, but many of those stocks deserve to be neglected. Therefore, secondary, or conditioning, screens are needed to help identify neglected stocks that may be poised for a turnaround.

One of these so-called conditioning filters in the Stock Market Winners screen requires that earnings from continuing operations for the most two recent quarters (Q1 and Q2) be above their respective quarters a year ago (Q5 and Q6, respectively). Comparing one quarter to the same quarter last year eliminates the seasonality in earnings that many companies experience.

To capture companies with accelerating quarterly earnings momentum, the Stock Market Winners screen also requires that the rate of change between the recent quarter and its counterpart last year be greater than the increase between the previous quarter and its counterpart.

By isolating companies with positive and accelerating quarterly growth in earnings, companies passing the Stock Market Winners screen have long-term earnings growth rates greater than the typical stock: 24.7% for the passing companies as compared to 9.9% for the typical exchange-listed stock.

Another element of the Stock Market Winners strategy is to identify stocks that have already shown upward price momentum. To this end, the screen makes use of a weighted relative strength measure that emphasizes more recent price performance by giving the most recent quarterly price change relative to the S&P 500 a weight of 40% and each of the previous three quarters a 20% weighting. Stocks passing the screen must have a weighted relative strength value that is greater than 70% of all stocks.

The stocks passing the screen as of January 13, 2006, have outperformed the S&P 500 by 17 percentage points over the last 52 weeks, while the typical exchange-listed stock lagged the S&P by one percentage point over the same period.

Lastly, the Reinganum study found that 90% of the firms had fewer than 20 million shares outstanding before their main price increase, and this is the limit used in the AAII Stock Market Winners screen. Limiting the number of shares outstanding leads this screen to isolate very small companies in terms of market capitalization (shares outstanding multiplied by price per share).

The stocks currently passing the screen have a median market capitalization of $30.9 million whereas the typical exchange-listed stock has a market cap of $449.0 million.

Conclusion

No matter how well a stock screening methodology has performed (or underperformed) over the long term, it is important to realize that stock screening is only the first step in the stock selection process. The stocks passing the Stock Market Winners screen do not represent a “recommended” or “buy” list of stocks. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.