Stock screens are perhaps the greatest gift that computers and the internet have given to investors. With just a few clicks, taps or keystrokes you can slice and dice the entire universe of public companies in hundreds of different ways.
If you want high-yield shares, that’s easy. High growth? That’s easy too. As is high ROE, low price to book, consistent free cash flow or almost anything else you could think of. It’s all there at your fingertips.
But while stock screens are a powerful tool in the search for sound investments, they can also be dangerous if used without care.
Stock screens are necessary, but not sufficient
It’s an easy mistake to make. After you’ve run your screen you have a list of stocks sitting there all fitting your most important criteria.
They have high yields, high growth rates, high returns on equity, low debt and whatever else it is you’re looking for. You have money burning a hold in your metaphorical pocket and you want to put it to work.
It is in the nature of humans to believe what we read, and when you’re looking at a stock screen it’s only natural to think that everything on the screen is a worthy investment. After all, it was you who set up the criteria.
But that’s confusing a necessary condition with a sufficient condition. If you want to marry a physically attractive person that doesn’t mean all physically attractive people will make good spouses.
Just because you want to invest in high-yield shares that have growing dividends and strong balance sheets doesn’t mean that all shares with high yields, growing dividends and strong balance sheets will make good investments.
The initial criteria, whether that’s high yield, low debt or physically attractive, are just that; initial. A lot of additional work in the form of a “deep dive” analysis should be put in before an investment decision is made.
Investing is as much emotional as it is logical
Even if you had a super-screen that could consistently beat the market over the long term, it’s unlikely to beat the market every day, week, month or even every year.
Imagine that you’ve invented this super-screen and you’ve been trading according to its rules for several years, beating the market handily along the way.
But then things change.
Momentum strategies start to outperform, and you’re a value investor. This goes on for a year or two, or three or four or five. How many years of underperformance do you think you could stand if all you were doing was following the orders of your computer?
I think you would probably need superhuman belief and faith in that strategy if all you knew about the companies was their dividend yield or their PE ratio.
I think that in reality most investors would eventually crack under the pressure, sell up and either chase whatever is working today (a very bad idea) or crawl, battered and bruised, back to the world of funds and index trackers.
Without the deep dive of detailed company analysis, I don’t think it’s possible to build up the kind of understanding or “feel” for the companies that you’re invested in which will help to see you through bad times as well as good.
Of course, a deep analysis does not guarantee a good outcome, but if the investment doesn’t work out well you will at least understand why it didn’t work which, if applied to future investment decisions, is information that can be even more valuable than the profit you might otherwise have made (just don’t do it too often).
I’m sure there are people who can invest like robots, and Ben Graham is perhaps the best example of them. But with an investment fund of millions of dollars, his firm could afford to hold more than a hundred positions at once, taking advantage of the statistical nature of most mechanical investment strategies in a way that most private investors cannot.
Personally, I think most investors should use stock screens as the wonderful tool that they are, but they should also remember that, like Mr. Market, stock screens are there to serve you, not to guide you.
Thanks to Richard Beddard for prompting this post with his post on trusting mechanical investing, and for the several readers who have asked me why I occasionally ignore what my stock screen is “telling me” to do.