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The Science of Hitting
The Science of Hitting
Articles (489) 

Why I Don't Use Stock Screens

Some thoughts on screening for investment ideas.

June 10, 2018 | About:

I recently stumbled upon a great video of Brian Bares of Bares Capital Management discussing his investment process with Dave Sather’s students at Texas Lutheran University (link). In response to a question about his process for finding investment opportunities, Mr. Bares said the following:

“Most managers use price as an input to their process. What do I mean by that? ‘Well, let’s look for cheap stocks, and then let’s convince ourselves of the quality of those names. Let’s start with low P/E or low EV/EBITDA, and rank order our securities.’ We think, especially with a concentrated portfolio, that’s a huge mistake. And it has taken me a long time to harden this conclusion, and it’s nonobvious. Price is the last thing we look at because we don’t want to make a mistake on the business quality or the management quality because that is going to be the determinant of your success… If we’re going to make a mistake, I want to make a mistake on the price, not on the quality. That’s why we do the pricing last.”

If you’re a long-term investor, I think that approach makes a lot of sense. Screens, as they are commonly constructed, are good at finding stocks that are (or at least appear) cheap on traditional metrics like the price to earnings (P/E) ratio. These screens are built to find what’s cheap now. A securities current valuation is the primary hurdle with this approach.

But that's backwards from how I think about sourcing ideas. When I research a company, my primary focus is (1) the quality of the business and (2) the quality of management team. I only think about valuation afterwards. If the idea doesn’t clear those hurdles, it’s not the kind of company I want to invest in, regardless of its current price. Just to be clear, that’s obviously not the only way to invest. It’s an approach I’m comfortable with, and one that I think will work for me over the long run.

You could argue that a screen doesn’t have to be valuation driven. Can’t you focus on metrics that point to the quality of the business? I’m certainly not opposed to that idea, and it sounds good in theory. However, in my experience, I have not found screening for business quality to be particularly useful.

In many cases, I’ve run into accounting issues when trying to screen for quality. For example, UPS (UPS) has reported an astronomical return on equity in recent years (in excess of 100%), largely because the business is run on a sliver of shareholders equity. While it’s important to understand what that means for the business, the output (a triple digit ROE) is not particularly useful. And this isn’t a rare occurrence: using Fidelity’s screening tool, I found more than 250 companies with an ROE in excess of 100%. That’s a lot of noise to sift through.

When I’ve used screens in the past, that type of thing was common. And after that happens a few times, you start to wonder if there are high-quality businesses being knocked out of your screen for erroneous reasons as well. For example, returning to UPS, the company was close to having negative shareholders’ equity at the end of 2014. If that happened, the stock wouldn’t make it through any screen that filtered against ROE. This is one example of how screens can get tripped up by financial accounting.

When you’re completing this exercise, you also have to decide whether you’re going to screen against projected numbers (which excludes companies without analyst coverage) or historic results. If you choose the latter, you have to select between adjusted or GAAP financials (the GAAP results can be skewed by one-time charges and other items that may not be representative of the underlying business). Which route you go with will have an impact on the output.

Once you consider those factors, I think the value of a quality based screen is greatly diminished.

But as I alluded to earlier, I don’t think quality screens are where the real issues lie. I think the trouble comes when you’re running screens against valuation metrics to try and find investment opportunities. I do not think a price focused screen is the right starting point for a long-term investor. It focuses your attention on the last thing first and clouds your thinking. As Mr. Bares notes, that’s a big mistake.

If you’re not going to run any screens, how else can you find new ideas? The approach I’ve taken over the years is to read as much as possible and to follow the actions of investors that I respect. I try to gravitate towards managers with less AUM, because they’re capable of owning small and medium sized companies that are off the beaten path (the places Warren Buffett (Trades, Portfolio) would probably be looking if he wasn’t constrained by Berkshire’s size).

For example, I recently looked at Hexcel (HXL), HEICO (HEI), and Tyler Technologies (TYL) because Lou Simpson (Trades, Portfolio) owned them. In each case, I found an interesting company that I would own at the right price. All three are unlikely to show up on a price focused screen because they seem expensive (relative to earnings or free cash flow). Maybe that will change in the future. If it’s a high quality business, I think it’s worth analyzing and understanding it in detail, even if a current investment seems unlikely. When future opportunity arises, I want to be ready to move.

Another way to increase your odds of finding good ideas is to fish in the right waters. That means focusing on industries within your circle of competence, especially if those industries have a history of producing high-quality businesses with sustainable competitive advantages.

With those tools, I think you can put together a smaller list of ideas that may be worth your time.

Even after you do that, you will still probably have many dozens of potential investments to analyze. From there, it’s all about taking the time (by which I mean years) to start going through them one by one. It will take a lot of effort, but that’s why the rewards are so staggering if you’re successful.

I’ll close with something Warren Buffett (Trades, Portfolio) said at the 2001 shareholder meeting:

“When I started, I went through the manuals page by page. I went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals - twice.”

Get to work!

Disclosure: None

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (9 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

I use Gurufocus’ All-In-One screener as a tool to identify the universe of companies meeting my investment criteria. The list that is generated tells me nothing about the valuation of these companies. A tremendous amount of research – market growth, competition, product development, business operations, etc. is necessary to generate an estimated intrinsic value. Screens are great at developing a universe of candidates but not the worth of those candidates. Anybody investing in such a list – without further due diligence – isn’t a value investor. They are an analytical investor with little to no knowledge of their holdings.

Praveen Chawla
Praveen Chawla premium member - 4 months ago

I agree with Thomas above. Screeners are useful as idea generation funnel. For real value investing you need to dive down into the details. The most important things are really understanding the qualitative issues (business model, competitive advantage, managent acumen and integrity) not just the quantittive measures.

Carstin
Carstin premium member - 4 months ago

All investors have different risk profiles. But all investors - especially paid money managers - have the same goal: generating the highest returns.

All the best backtesting and the individual experience of many great investors show that purchasing quantitatively cheap stocks generate outsized returns. Buffett's own career itself reflects that.

Granted that deep value investing is not possible with large amounts of capital. But that is not a problem for retail investors and it is not a problem for many small funds.

The Science of Hitting
The Science of Hitting - 4 months ago    Report SPAM

Tom, Praveen and Carstin - Thanks for the thoughtful comments!

SanFranciscRoE
SanFranciscRoE - 4 months ago    Report SPAM

Excellent read! Quality first (and foremost), price second. Great advice.

joseph85750
Joseph85750 - 3 months ago    Report SPAM

Ever heard of Phil Town Rule#1? This is what I use, and do very well. But it can be hard to find the good Rule 1 stocks.

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