Chapter 11

Security Screening

Prof. Rushen Chahal

Prof. Rushen Chahal

Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity.

- General George S. Patton

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Outline
Introduction Why screening is necessary What constitutes a good screen? Sources of information Screening processes Examples of commercial screens

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Introduction
Security screening involves reducing the security universe down to a manageable size Picking stocks is an art rather than a science
There is no single best way to choose individual investments

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Why Screening Is Necessary

Time constraints Everyday examples of screens

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Time Constraints
The NYSE and AMEX, and Nasdaq list thousands of potential investments
There is no time to analyze every security and process the associated information

Many people never develop a well-conceived way to deal with the information overload

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Everyday Examples of Screens

University admission test The football team

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University Admission Test

More people apply for admission than are ultimately admitted Universities use two steps:
An initial screen Closer individual scrutiny for those passing the first round

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The Football Team

More players try to join the football team than the rosters can carry Coaches may use screens:
40-yard dashes for running backs Bench presses for offensive linemen

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What Constitutes A Good Screen?

Ease of administration Relevance and appropriateness Acceptance by the user Ordinal ranking of screening criteria

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Ease of Administration
The screen should be easy to administer and implement E.g., narrow stocks down to thinly traded stocks by using the Wall Street Journal
Thin trading refers to a security with a relatively small number of shareholders and a lack of trading volume
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Relevance and Appropriateness

Screens should logically have something to do with the ultimate objective For example, start at the top of the NYSE listings with your screen

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Acceptance By the User

Screens lose value if people fundamentally disagree with it For example, people may not believe in SAT scores as a screen for admission

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Ordinal Ranking of Screening Criteria

Use a screen pecking order for multiple-stage screening:
The first screen is the one that eliminates the most alternatives The second screen eliminates the second-most alternatives, etc.

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Sources of Information
Value Line Standard & Poor s Mergent Brokerage information Internet

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Value Line
The Value Line Investment Survey:
Follows 1,700 common stocks Rates each stock in two categories:
Timeliness: the advisability of buying a stock now Safety: the confidence Value Line analysts have in their forecasts about the firm

Is followed closely by many market analysts

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Value Line Timeliness & Safety Ranking System

Ranking 1 2 3 4 5 Number of Stocks with This Ranking 100 300 900 300 100
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Meaning Best Above average Average Below average Worst

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Sample Value Line Report

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Standard & Poor s

Stock Report Stock Guide

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Stock Report
The S&P Stock Report is a one-page document that:
Is updated quarterly Contains a description of a company Contains an estimate of what the future holds for a company Contains financial statement information, dividend payment dates, beta, and other risk measures

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Sample S&P Stock Report

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Stock Guide
The S&P Stock Guide:
Is a monthly publication Contains summary statistics on common stocks, convertible preferred stocks, warrants, and mutual funds Is a companion to the Bond Guide

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Sample S&P Stock Guide

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Mergent
Mergent s manuals Mergent Dividend Record

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Mergent s Manuals
Mergent s Manuals:
Were formerly Moody s Manuals Contain seven sets of volumes covering industrial firms, public utilities, over-the-counter industrials, transportation issues, and bank/finance issues Include the Company Archives Manual, which provides data on defunct companies since 1996

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Mergent Dividend Record

The Mergent Dividend Record:
Contains information on the recent dividend history of a company, including:
Payment dates Ex-dividend dates Etc.

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Brokerage Information
Brokers can be a good source of information All full-service brokers have the ability to provide their customers with stock research

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Internet
Examples of good sources:
www.thomsoninvest.net: contains consensus earnings estimates and a stock screener quote.yahoo.com www.smartmoney.com www.morningstar.com www.fool.com www.quicken.com
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Quote.Yahoo.Com

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Screening Processes
Multiple-stage screening Subjective screening Screening with the popular press only A quick risk assessment screen with the Stock Report

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Multiple-State Screening
Most investment applications require several screening stages
E.g., EPS by itself is not very useful E.g., dividend yield should not be the only screen for growth stocks

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Subjective Screening
Not all screens need to be quantitative For example, socially responsible investing:
Tobacco stocks, nuclear power, animal testing, the environment, human rights, etc.

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Screening With the Popular Press Only

Price/earnings ratio Dividend yield Stock price Exchange listing Familiarity 52-week trading range Options availability
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Price/Earnings Ratio
Low PEs are good:
Investors pay little to get a lot

High PEs are good:

The efficient marketplace anticipates that future earnings will be higher than those of the past

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Dividend Yield
Dividends do not materially alter a recipient s wealth People like to receive dividends:
Strokes the ego Important for income or growth of income objectives

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Stock Price
Some people believe in an optimum trading range for stock prices The cost of a share should be merely a market People prefer to avoid odd lots
E.g., investing $2,000 means the stock price cannot be higher than $20

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Exchange Listing
Some clients may want to restrict their investments to a particular exchange:
AMEX NYSE Nasdaq

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Familiarity
Invest in companies that you know something about Familiarity is a subjective criterion

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52-Week Trading Range

The stock is trading at the low end of its annual high and low If the market is efficient, annual highs and lows are of no value in predicting future prices

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Options Availability
Some people invest in equity issues that have options available because they are versatile Options information is contained in the financial press

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A Simple Financial Pages Screen

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A Quick Risk Assessment Screen With the Stock Report

ROA and ROE Evaluating ROA and ROE

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ROA and ROE

The Stock Report contains ten-year histories of ROA and ROE:
Useful for a quick comparison of companies:
ROA is net income after taxes divided by total assets ROE is net income after taxes divided by equity If the firm has debt, ROE will exceed ROA

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Evaluating ROA and ROE

A good, safe investment has a history of stable ROA and ROE figures, with ROE somewhat higher than ROA If ROE is substantially higher than ROA, the firm is heavily leveraged (risky)

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Examples of Commercial Screens

Value Line publications Computerized data

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Value Line Publications

Timeliness and safety rankings are one of the most widely used screens
E.g., limit stock picks rated either 1 or 2 for timeliness

Value Line Investment Survey can be used for sector screening

Contains industry rankings
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Computerized Data
Value Line Investment Survey for Windows Compustat

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Value Line Investment Survey for Windows

A 7,500 security database Can be screened by more than 200 variables Can be used to prepare statistical summaries and detailed tabular reports

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Compustat
Used by academic researchers Available for mainframes and microcomputers Variables include:
Current ratio Retained earnings Unfunded pension liabilities, etc.

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