Before putting forward reasons not to use a stock screener, perhaps it is worth exploring what investors hope to achieve when they do.
Investors seeking excess returns will buy a given stock because they believe the company’s results will exceed the expectations of the market, as implied by the stocks’ current price. Interestingly, investors compete to find mispriced stock. Their collective effort is reflected in the price making it more difficult to find mispriced stock.
In this competition, investors use screeners to gain an advantage by maximizing the efficiency of their research process. They focus on a small, but promising group of stocks. In a matter of minutes, the analyst sorts thousands of publicly traded stocks by price to book (P/B) ratios and price to earnings (P/E) ratios. In this first step, numbers taken from the balance sheet or earnings statement are used as a rough proxy for value.
For some, further research might mean reading annual reports and other sources to get a better understanding of the qualitative aspects and future prospects of the business.
For others, further research begins by loading a decade or more of financial results into an elaborate model (spreadsheet). Typically, numbers from the earnings statement are divided by numbers on the balance sheet and the result is supposed to reflect some qualitative aspect of the business.
So what’s wrong with focusing your limited time and (present company obviously excluded) limited talent on a subset of highly promising stocks?
1) Stock screeners may tempt you to act more like a trader and less like a long-term owner.
Using a stock screener is like walking into a grocery and demanding a list of all the goods sorted by price to weight (or volume). The weight acts as a rough proxy for value. It will be an interesting list and upon further analysis you will very quickly identify some really cheap goods. You will also be tempted to take home goods you will later realize you do not want.
For the sake of this discussion, I will assume at least 50% of investment success is discipline. Finding a cheap stock is one thing, owning it for years is another. The reasons to use a stock screener addres only the efficiency finding a list of cheap stocks but do not adress the effectiveness of a screener in identifying stocks you’d be comfortable owning for years.
2) Qualitative, not quantitative, analysis is key.
I hazard a guess that it takes at least 100x more time to assess the qualitative aspects of a business than it takes to assess if the stock is quantitatively cheap. I can assess if a stock is quantitatively cheap within minutes, but the time I need to assess the qualitative aspects of a business is measured in days. Perhaps this is due to limited talent or my unlimited cowardice, so for the sake of this discussion, I will assume it takes the average investor hours (as opposed to days) to get comfortable with the qualitative aspects of a business.
While some may decide to buy a stock within minutes, I boldly predict that they will learn about the qualitative aspects of the business in due course. In any case, that decision to buy does not mark the end of their effort
If my assumption is roughly right, analysts should take note that spending time to figure out a much better way of generating lists of cheap stocks could only serve to accelerate 10% of the total effort. Conversely, the investor who figures out a slightly better way of doing qualitative analysis can rationally expect to generate excess returns.
Just some thoughts.
In my next article I will share my thoughts on how to optimise the proces of qualitative analysis.
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