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8 September 2017 Financial Analysts Journal Book Review

The Standard & Poor’s Guide to Selecting Stocks (a review)

  1. Murad J. Antia, CFA

This easy-to-comprehend and instructive book informs the reader about the numerous websites that provide (generally at no cost) screening capabilities for stocks, bonds, and mutual funds.

A relatively short time ago, running quantitative screens and models for equity selection was a laborious and time-consuming process. Computer code had to be written for mainframe computers, and databases such as Compustat, I/B/E/S, and Zacks Investment Research were procured, at substantial expense, on computer tapes.

How times have changed! In The Standard & Poor’s Guide to Selecting Stocks , Michael Kaye, a portfolio analyst for Standard & Poor’s (S&P) Investment Advisory Services, lists numerous websites that provide screening capabilities for stocks, bonds, and mutual funds. Within a matter of minutes, investors can create a set of screens that satisfies their security selection criteria. And in most cases, it is costless.

According to Kaye, screening helps reduce a large universe of possibilities into a smaller set and removes the emotional element from security selection. Moreover, he claims that it levels the playing field between individual and institutional investors. If individuals take the time to educate themselves, they can develop their own investment ideas as opposed to following the herd, which is a surefire means of getting average or below-average performance.

Individual chapters are devoted to presenting screening criteria for growth, value, growth at a reasonable price (GARP), momentum, and dividend-paying stocks, to the selection criteria for stocks in specific sectors, and to the criteria for identifying stocks with negative characteristics, such as illiquid stocks and stocks of companies with high debt levels and low amounts of cash on the balance sheet.

In addition to the primary screens for a particular style or sector, the author recommends screens that he considers relevant for superior stock selection. For example, when screening for GARP stocks, the primary screen is the P/E-to-growth (PEG) ratio. The secondary screens eliminate stocks with debt-to-equity ratios that are above the industry average, stocks with return on equity (ROE) that is below the industry average, and stocks covered by fewer than five analysts. His rationale for the secondary screens is that a high ROE combined with a low debt level shows that the company is profitable but that the growth has not been achieved by assuming risky leverage. In addition, requiring coverage by at least five analysts prevents the average growth estimate from being skewed by an outlier estimate.

Kaye also mentions qualitative factors that need to be incorporated in the analytical process for each of these selection criteria, although the qualitative section of the analytical process is cursory at best. The book is peppered with insights that are to be taken at face value. For instance, he states that the best overall ratio for evaluating pharmaceutical stocks is the PEG ratio. Although he provides reasons supporting PEG, he does not present empirical evidence that would substantiate his reasoning.

Kaye notes that GARP is the main style that S&P analysts use in evaluating stocks and presents impressive performance data for S&P’s star (recommendation) ratings. But he neglects to mention that S&P stock reports and their recommendations are the result of a prodigious amount of work performed by experienced and well-educated analysts who each devote their energies to only a few companies in an industry or a subindustry. In that sense, the book’s title, The Standard & Poor’s Guide to Selecting Stocks, is a misnomer because the book is limited to screening sources and techniques; it provides little insight into other aspects of S&P’s analytical process, such as the estimation and use of core earnings estimates.

S&P should be applauded for its core earnings estimates, which measure the after-tax earnings generated by a company’s principal business or businesses. They are reasonably accurate estimates of companies’ recurring earnings, and using a consistent standard for all companies makes cross-company comparisons particularly relevant.

The S&P stock reports are impressive in their level of detail. For the individual investor to replicate such analysis and achieve the same level of performance, however, would be difficult.

The chapter on reverse engineering suggests that investors can replicate performance by replicating stock or portfolio attributes. The first step in this process is to determine the financial ratios for a “highly regarded” company or fund. Subsequently, the investor should put into a stock screener the values for these ratios that are slight improvements on this company’s or fund’s ratios. The final step is to further analyze and evaluate the stocks picked by the screener to determine whether they are investment worthy.

What Kaye is suggesting is for investors to copy a stock’s attributes or a fund’s style, but to assume that such a replication will lead to similar investment performance is a leap of faith. A substantial source of a stock’s performance may be stock-specific factors, such as product innovation, that are independent of the stock’s quantitative attributes. The process might work better when copying a fund’s style because security-specific risk declines in well-diversified portfolios. But determining a fund’s attributes is not an exact science because funds do not publish this information. The author suggests that a reasonable estimate can be derived by determining the attributes of the fund’s largest holdings, which is publicly available (although dated) information.

In the chapter on screening for mutual funds, Kaye states that nearly 90 percent of all active funds with 10-year track records have underperformed the overall market and that index funds have a 350 bp advantage over the average active mutual fund because of management and other expenses. Based on these data, the book’s objective of leveling the playing field between individual and institutional investors does not set a bar high enough to benefit the individual investor. One advantage of investing one’s own assets is to avoid expenses related to actively managed funds. But can individual investors using simple screening techniques earn long-run superior risk-adjusted returns relative to individual investors using low-cost index funds?

All that being said, The Standard & Poor’s Guide to Selecting Stocks is informative about stock-screening websites and techniques. Newcomers to investing should find the material relatively easy to comprehend and instructive. The book could be particularly useful as a complementary text in a course that includes running a student-managed investment fund.


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