1 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.

2 Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity. General George S. Patton

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

4 Why Screening Is Necessary u Time Constraints u Everyday Examples of Screens

5 Time Constraints u The NYSE, AMEX, and Nasdaq list thousands of potential investments There isn’t time to analyze every security and process the associated information u Many people never develop a well- conceived way to deal with the information overload

6 Everyday Examples of Screens u 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

7 The Football Team: Another Everyday Example of Screening u More players try to join the football team than the rosters can carry u Coaches may use screens: 40-yard dashes for running backs Bench presses for offensive linemen

8 What Constitutes A Good Screen? u Ease of Administration u Relevance and Appropriateness u Acceptance by the User u Ordinal Ranking of Screening Criteria

9 Ease of Administration u The screen should be easy to administer and implement u 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

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

11 Acceptance By the User u Screens lose value if people fundamentally disagree with it u For example, people may not believe in SAT scores as a screen for admission

12 Ordinal Ranking of Screening Criteria u 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 next highest number of alternatives, etc.

13 Screening Processes u Multiple-Stage Screening u Subjective Screening u Screening with the Popular Press Only u A Quick Risk Assessment Screen with the Stock Report

14 Multiple-Stage Screening u 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

15 Subjective Screening u Not all screens need to be quantitative u 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

16 Screening with the Popular Press Only u Price/Earnings Ratio u Dividend Yield u Stock Price u Exchange Listing u Familiarity u 52-Week Trading Range u Options Availability

17 Price/Earnings Ratio u Low PEs are good: Investors pay little to get a lot u High PEs are good: The efficient marketplace anticipates that future earnings will be higher than those of the past

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

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

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

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

22 52-Week Trading Range u “The stock is trading at the low end of its annual high and low” u If the market is efficient, annual highs and lows are of no value in predicting future prices

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

24 A Quick Risk Assessment Screen with the Stock Report u ROA and ROE u Evaluating ROA and ROE

25 ROA and ROE u 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

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

27 Sources of Information u Library Information Value Line Standard & Poor’s Mergent u Internet Morningstar Yahoo! WSJ.com

28 Value Line u 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

29 Value Line Timeliness & Safety Ranking System Ranking Number of Stocks with This RankingMeaning 1100Best 2300Above average 3900Average 4300Below average 5100Worst

30 Sample Value Line Report Source: The Value Line Investment Survey, December 10, Copyright © 2004 by Value Line Publishing, Inc.: used by permission. For subscription information to the Value Line Investment Survey, please call (800)

31 Value Line Investment Analyzer u A 7,500-security database u Can be screened by more than 300 variables u Can be used to prepare statistical summaries and detailed tabular reports

32 Standard & Poor’s u Stock Report u Compustat u NetAdvantage

33 Stock Report u 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

34 Sample S&P Stock Report Source: Standard & Poor’s Stock Guide (New York: Standard & Poor’s Corporation, 2004): Reprinted with permission.

35 Compustat u Used by academic researchers u Available for mainframe and personal computers u Hundreds of screening variables include: Current ratio Retained earnings Unfunded pension liabilities

36 Mergent u Mergent’s Manuals u Mergent Dividend Record

37 Mergent’s Manuals u Mergent’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

38 Mergent Dividend Record u Mergent Dividend Record: Contains information on the recent dividend history of a company, including: –Payment dates –Ex-dividend dates

39 Internet u Examples of good sources:

40 Yahoo! ® Finance