Chapter 11
Security Screening
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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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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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, AMEX, and Nasdaq list
thousands of potential investments
• There isn’t time to analyze every security and
process the associated information
 Many
people never develop a wellconceived way to deal with the information
overload
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Everyday Examples of Screens
 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: Another
Everyday Example of Screening
 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 multiplestage screening:
• The first screen is the one that eliminates the
most alternatives
• The second screen eliminates the next highest
number of alternatives, etc.
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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-Stage Screening
 Most
investment applications require
several screening stages
• e.g., earnings per share by itself is not very
useful
• e.g., in choosing a growth stock, it would not
make sense to search initially for those with the
highest dividend yield
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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.
• Best of class investing recognizes that all firms
can be faulted in some way and looks for “role
models” within each industry
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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
marker
 Some 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 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 and positive earnings, 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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Sources of Information
 Library
Information
• Value Line
• Standard & Poor’s
• Mergent
 Internet
• Morningstar
• Yahoo!
• WSJ.com
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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: a measure of potential risk with a stock
• Many market analysts attach considerable
significance to the Value Line report on a stock
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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
Meaning
Best
Above average
Average
Below average
Worst
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Sample
Value Line Report
Source: The Value Line Investment Survey, December 10, 2004. Copyright © 2004 by Value Line Publishing, Inc.: used by permission. For
subscription information to the Value Line Investment Survey, please call (800) 634-3583.
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Value Line Investment
Analyzer
A
7,500-security database
 Can
be screened by more than 300 variables
 Can
be used to prepare statistical summaries
and detailed tabular reports
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Standard & Poor’s
 Stock
Report
 Compustat
 NetAdvantage
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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
Source: Standard & Poor’s Stock Guide (New York: Standard & Poor’s Corporation, 2004): Reprinted with permission.
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Compustat
 Used
by academic researchers
 Available for mainframe and personal
computers
 Hundreds of screening variables include:
• Current ratio
• Retained earnings
• Unfunded pension liabilities
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Mergent
 Mergent’s
Manuals
 Mergent Dividend Record
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Mergent’s Manuals
 Mergent’s
Manuals:
• Contain seven sets of volumes covering
industrial firms, public utilities, over-thecounter 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
 Mergent
Dividend Record:
• Contains information on the recent dividend
history of a company, including:
– Payment dates
– Ex-dividend dates
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Internet
 Examples
•
•
•
•
•
of good sources:
http://finance.yahoo.com
http://www.smartmoney.com
http://www.morningstar.com
http://www.fool.com
http://www.bloomberg.com
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Yahoo!® Finance
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