Stock ScreeningHere is a step by step process to stock screening that can be used whether you're a mechanical investor or not. Using a process forces you to plan for your screen: you shall identify its main factors, secondary factors and those of lower importance. The process is adapted from Screening the Market by Marc R Gerstein, director of Investment Research at Reuters (ex Multex). A generic Mechanical Stock Screening can consist of:
Investing Universe Go back to TopThe objective of the Investing Universe is to reduce the list of companies to the ones most likely to fit your Investment Strategy and risk profile. Risk being highly correlated with company size, Market Capitalization is the prime criterion for Investing Universe. Now, other investing universes can be used.In fact, mechanical stock picking strategies come from backtesting using few criteria. In addition, a single screening criterion should not filter out too many stocks. As a result, Mechanical Stock Picking often starts with a reduced Investing Universe so that the screening remains simple and do not include too many criteria. Investing Universes are usually:
Examples:
A note on Market Capitalization Many studies have shown that Small Cap usually outperforms so you may want to tilt your strategy toward them. Be cautious about doing this. Small Cap have lower survivorship rate, therefore backtesting and academic studies usually show optimistic results. Moreover, liquidity and Bid-Ask spread may be an issue: many counter-studies have shown that the Small Cap premium were coming from micro cap that no-one could buy because of low volume and high Bid-Ask spread. If we remove micro-cap, then small cap premium is much lower. Be cautious if you invest in Market Cap below 150M. A rough (emphasis on "rough") idea about the combination of Market Capitalization and Investing Style you may use in your stock screening is:
Primary Theme Go back to TopThe Primary Theme is the main idea of your screen.Criteria used to identify an Investing style are presented in their respective page: Value Investing, Growth Investing, Momentum Investing. Your Primary theme should ideally be the one that filter out the most number of Stocks from your Investing Universe. Therefore tighten criteria or add another criterion compatible with your primary theme until at least 50% of the stocks in your Investing Universe have been screened out. On the other hand, it is important to know when tightening a criterion is no more useful. Avoid screening out more than 90% of the Investing Universe with a single criterion. For instance, don’t screen for the 10 lowest PE in a 5,000 Stocks Universe. It is better to first screen out say 90% of the stocks by selecting the 10% lowest PE: 500 Stocks will still pass. At this stage, it’s probably better to add a new criterion rather than further tightening the PE test. Another approach would be to reduce the Investing Universe. The Primary Theme may be omitted in Mechanical Stock Picking. In this case, either the Investing Universe and/or the Ranking contains criteria identifying the Investing Style. The Dogs Of the Dow is one such example. It has no Primary Theme: the Value Investing style is identified by the Ranking by High Dividend Yield. Secondary Themes Go back to TopSecondary themes complement the Primary theme. They are not mandatory but can be used to improve your screen: reduce risk and weed out potential dogs. Main secondary themes used in stock screening include:
Ranking Go back to TopRanking is the process of sorting stocks from best to worst according to some criteria.Stock Ratings are Ranking used at the beginning of the screening process. You can also use Ranking at the end of the screening process: you rank stocks passing your screen in order to select and buy the top ones only. Ranking is used to avoid an absolute approach to screening where you add and add criteria until you reach a final buy list. With such an approach, in order to reach a reasonable number of stocks, you may either have to use stringent conditions or use many criteria. There is a point of diminishing return in using stringent conditions or too many criteria. In addition, by using only absolute criteria, you will end up with a variable number of stocks: in some cases you may end up with no stocks. With Ranking, you will always end up with the same number of stocks whatever the market conditions: it is self-adaptive to market environment. Stock Ratings are good examples: there are always 100 stocks with Value Line Timeliness Rank #1, whatever the market environment. Therefore, avoid screening down to the last few Stocks. Use screening to weed out most companies but still keep a fair number. At that stage, instead of adding extra screening criteria, rank the stocks passing and select the top ones. Ranking is usually done according to one criterion but can be done with several criteria with weights assigned to each criterion. Ranking parameter depends on your Investing Style: Value Investing, Growth Investing, Momentum Investing. Most stock screeners allow to rank the final results according to one criterion, whether this criterion was used or not in the screening. If you want to rank according to a combination of criteria (called Scoring by Gerstein), then you may consider Morningstar Premium Screener that includes a nice Scoring functionality. It allows you to assign higher weights to criteria that are most important to you. Alternatively, you may export your screening results to a spreadsheet such as Excel and perform your own scoring. Most screeners allow export of the results. Rebalancing in Stock Screening Go back to TopRebalancing simply consists in re-running a screen at a later time: at that point, you will:
Portfolio Rebalancing provides a mechanical framework for Selling Stocks. It is an important aspect of Investing. Indeed, two portfolios built with the same stocks but held for different periods will have different results, often dramatically different. The million dollars question is of course: “How often to rebalance ?” Rebalancing frequency is largely influenced by your Investing Style:
Reciprocally,
Regarding trading fees for short rebalancing frequencies, these are no more a concern. Stock Basket Accounts allow to rebalance on a monthly basis, or even shorter periods, with no extra transaction cost. They are ideal for mechanical stock picking. You can check the Stock Broker Fees calculator to see how rebalancing frequency and other parameters impact your trading costs. |
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