Quantitative screens can be an excellent tool to sort through vast amounts of data to provide clarity and focus. It also can be beneficial on that it brings discipline and consistency to your investment process. However, like any tool if used improperly it may cause more damage than good. Some might be familiar with the phrase ‘garbage in, garbage out’ – which simply means that a model’s output is only as good as the quality of model’s input. The question of which inputs to use can be a difficult choice, whether it’s a growth indicator, profitability measure, or some other statistic. In the age of cheap and advanced computing power, I believe we have become too reliant on a quant-only strategy. There is no model that can be effective without our understanding of both the input and output.
As for the output – once the screen has been run, this is where our work begins (not ends). I provide a simple example below.
Santarus Inc (SNTS, Financial). At first review some potentially strong numbers for profitability, growth, and valuation. These are common grounds for screening.
- Profitability
Return On Equity | 114.2 |
Return On Assets | 28.7 |
Return On Capital | 79.0 |
- Quarterly Growth (year over year)
Net Income Growth = 341%
- Valuation
P / Cash Flow = 8.4X
Furthermore, the company touted the growth and profitability in the quarterly earnings announcement. From the company’s press release dated March 3, 2010;
“We grew 2009 product-related revenue by 29%, while reducing total costs and expenses by 7% compared with the prior year. Our strong operating results were further enhanced by the $20 million milestone relating to FDA approval of ZEGERID OTC.”
A very quick review reveals the positive impact of a $20 million milestone payment earned by the company in December of 2009 related to the FDA approval of Zegerid OTC. I don’t mean to imply this is a negative for the company, quite the contrary. However, it’s a simple illustration of how we always need to scrub our data. This one number had a tremendous impact on all three criteria listed above. This is type of payment is unique and may or may not be one time in nature. Same thing applies to one-time charges, reserve reversals, tax reversals, etc. It’s not difficult to uncover these special items and it can go a long way toward improving your model’s output.
