Stock Picking: Screening

This is the first in a series of posts where we discuss how to find specific company stocks to invest in. We'll filter the universe of stocks down to those that have strong financials, but are relatively undervalued.

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What is stock screening?

There are thousands of public companies around the world. While I'd love to be able to review them all individually, that's just not happening. So we need a place to start — a way to filter the thousands of companies down to tens.

That's where screening comes into play.

We setup filters to exclude companies that don't fit our criteria, and are left with just the companies that do.

How I screen stocks

To do this, we'll need access to a tool that supports filtering by financial metrics. There's a lot of them out there, but I'll be using the Finbox Screener in the examples below. It works pretty well, and I like that they have updated financials, and support markets outside the US too.

Filter categories I use

I'll spend the remainder of the post talking about the different filters I typically apply to companies, and why they make sense for me.

I filter out companies for 3 primary reasons:

1. I can't trade them. Depending on which broker you use, you may not be able to trade stocks in some countries. I limit my search to just the countries I can trade, so I don't waste my time.

2. Not halal. If it's not halal, there's no point in looking at it to begin with. I'm not investing in it.

3. Weak financials. This overlaps with the previous point about not halal companies. Companies with high debt are disproportionately impacted by interest, and are best avoided. Incidentally, this also means they are weak financially, which presents extra risk to investors — risk I'd rather avoid.

Metrics I filter by

Trading Country

I set this to the countries that my broker supports. For me, that's the United States, United Kingdom and Australia.

It may vary for you, depending on the broker you choose.

I also make sure to exclude countries that I am not comfortable trading in for ethical and religious reasons as well (e.g. Israel, China).

Quick Ratio

The quick ratio represents a company's ability to meet it's short-term obligations. It answers the question: "is the company about to die (in the next 12 months)?". It does this by comparing the current assets (assets that the company can reasonably expect to convert to cash in the next than 12 months) to the current liabilities (dues the company needs to pay in the next 12 months).¹

$$\text{Quick Ratio} = \frac{\text{Current Assets (excl Inventory)}}{\text{Current Liabilities}}$$

… and you can find Current Assets, Current Liabilities in the latest Balance Sheet of the company.

I filter by $$$\text{Quick Ratio} > 1$$$

Debt / Equity Ratio

Besides the ability to meet short-term obligations, it's also important to make sure that we focus only on companies that have little to no debt.

This matters because companies with a lot of debt have a heavy reliance on interest (specifically, paying interest to creditors) — which impacts both the halal-ness of this company, as well as it's financial health.

That's why it's best to filter out companies with lots of debt, and we can do this through the Debt / Equity ratio (which, as it's name suggests, is $$$\frac{\text{Total Debt}}{\text{Shareholder Equity}}$$$)

Higher D/E ratio's indicate higher reliance on debt to finance operations. Also, the D/E ratio can be negative for companies that have negative Shareholder Equity (which, if prolonged, would mean the company is insolvent).

I filter by $$$0 \le \frac{\text{Debt}}{\text{Equity}} < 50%$$$

Operating Income Margin CAGR (3y)

With debt out of the way, we now focus on the business operations. We want to find businesses that are getting better with time, not worse. There are a few ways to do this, but a good measure I've found is to filter for companies whose Operating Income Margin is trending up.

$$\text{Operating Income Margin} = \frac{\text{Operating Income}}{\text{Revenue}}$$

This means the business is getting more efficient over time, which is exactly what we're after. Different industries have different baseline operating margins, but by comparing the change in Operating Margin, this provides a good cross-industry metric for excluding companies that are getting worse.

The filter I use is $$$\text{Operating Income Margin CAGR (3y)} > 0%$$$

P/E Ratio

While some investors specialize in turnaround businesses

The Price / Earnings Ratio or (P/E ratio) indicates

Revenue Growth