1 Chapter 11 Security Screening

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

4 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

5 Why Screening Is Necessary u Time constraints u Everyday examples of screens

6 Time Constraints u The NYSE and AMEX, and Nasdaq list thousands of potential investments There is no 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

7 Everyday Examples of Screens u University admission test u The football team

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

9 The Football Team 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

10 What Constitutes A Good Screen? u Ease of administration u Relevance and appropriateness u Acceptance by the user u Ordinal ranking of screening criteria

11 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

12 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

13 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

14 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 second-most alternatives, etc.

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

16 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: the confidence Value Line analysts have in their forecasts about the firm Is followed closely by many market analysts

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

18 Sample Value Line Report

19 Standard & Poor’s u Stock Report u Stock Guide

20 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

21 Sample S&P Stock Report

22 Stock Guide u 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

23 Sample S&P Stock Guide

24 Mergent u Mergent’s manuals u Mergent Dividend Record

25 Mergent’s Manuals u 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

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

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

28 Internet u Examples of good sources: contains consensus earnings estimates and a stock screenerwww.thomsoninvest.net quote.yahoo.com

29 Quote.Yahoo.Com

30 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

31 Multiple-State Screening u 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

32 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.

33 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

34 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

35 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

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

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

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

39 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

40 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

41 A Simple Financial Pages Screen

42 A Quick Risk Assessment Screen With the Stock Report u ROA and ROE u Evaluating ROA and ROE

43 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, ROE will exceed ROA

44 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)

45 Examples of Commercial Screens u Value Line publications u Computerized data

46 Value Line Publications u Timeliness and safety rankings are one of the most widely used screens E.g., limit stock picks rated either 1 or 2 for timeliness u Value Line Investment Survey can be used for sector screening Contains industry rankings

47 Computerized Data u Value Line Investment Survey for Windows u Compustat

48 Value Line Investment Survey for Windows u A 7,500 security database u Can be screened by more than 200 variables u Can be used to prepare statistical summaries and detailed tabular reports

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