Every January, we publish our annual review of the AAII Stock Screens in the AAII Journal. Many of you have likely read the article by now. For those of you who haven’t, 12 screens bucked the stock market’s 2022 decline and posted gains as of publication time.
I’m going to complement the article today by discussing how to select a stock from a screen, including the approach I use.
A key concept to understand is that stock screens are essentially database filters. They identify stocks possessing a specific set of traits. A value screen may identify stocks trading at low price-earnings (P/E) ratios with above-average levels of return on equity (ROE). A growth screen can find stocks that consistently grow profits and are projected to continue doing so in the future. All stocks added to AAII’s model stock portfolios are found through the process of stock screening.
There are two primary approaches to following a screen.
The first is to simply buy everything passing the screen. This approach has been called mechanical investing, though it now falls under the broader arena of what is known as quantitative (or simply “quant”) investing. All stocks passing a screen are purchased, and the portfolio is then rebalanced at preset intervals or adjusted according to predefined rules.
The rebalancing involves selling the stocks that no longer pass and adding the new ones that do pass in equal-dollar amounts. We use this approach for calculating the returns of the screens. An advantage of this approach is that it takes human emotions and judgment out of the buy-and-sell decisions.
The approach will result in both transaction costs and—if done in a taxable account—taxable gains and losses. No due diligence is done. This can lead to owning stocks with problems or new information not specifically considered by a screen. For example, the stock of a company that recently agreed to be acquired could pass a screen with momentum or price gain criteria. This would occur because the stock’s price jumped on news about the merger.
The number of stocks passing the screen is another potential issue. A screen with strict criteria may result in a highly concentrated portfolio of just a few stocks; a screen with looser criteria might result in a very large portfolio in terms of the number of stocks.
The second approach is to choose among the stocks passing a screen. This approach treats stock screens as a tool for narrowing down the broad universe of stocks to a manageable list. The list is examined, and the best stocks are chosen. We use this type of approach for selecting stocks in the various AAII model portfolios. I personally use it for my own portfolio as well.
We typically start with a ranking process. For example, preference is given to the candidate with the lowest valuation when selecting stocks for the Model Shadow Stock Portfolio. The advantages of using a ranking process to decide which stock to consider first are the ability to consistently repeat it, the exclusion of biases against any single stock or company and the flexibility to exclude a company based on factors external to the screen. A passing stock ranking well on a key criterion may be skipped over because of insufficient trading volume, where it is domiciled or simply because it’s already held in the portfolio, for instance.
You could implement the process by favoring one key criterion used in the screen, such as a valuation ratio or a growth rate. Depending on your strategy, you could also overlay external criteria to rank the stocks such as technical analysis (if you use charts) or the A+ Investor Grades if you are A+ Investor or Platinum subscriber.
The downside to this approach is that the element of human judgment comes into play when deciding which stocks to invest in. This is why it’s important to have a preset process you consistently follow with repeatable rules regarding when you would be allowed to skip a stock that passes the screen and ranks high on your decision criteria.
Optimism among individual investors about the short-term direction of the stock market fell from a nine-week high according to the latest AAII Sentiment Survey. Neutral sentiment fell but stayed above its historical average, while pessimism rose.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.6 percentage points to 28.4%. Bullish sentiment remains below its historical average of 37.5% for the 56th consecutive week but is no longer at an unusually low level for the second consecutive week.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.0 percentage points to 35.0%. Neutral sentiment is above its historical average of 31.5% for the fourth consecutive week. At four weeks, this is the longest streak of above-average neutral sentiment since a five-week stretch in March and April 2022.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.6 percentage points to 36.7%. This is the first time since August 2022 that pessimism is below 40% on three consecutive weeks. Bearish sentiment is above its historical average of 31.0% for the 59th time out of the past 62 weeks.
The bull-bear spread (bullish minus bearish sentiment) is –8.3%. This is still below the historical average of 6.6%.
Concerns about the economy, inflation, corporate earnings and volatility in the stock market continue to cause many individual investors to maintain a cautious short-term outlook.