This article will show you how to use a stock screener, which is the best way to find stocks with your preferred characteristics.
We all know investing can be an intimidating prospect, particularly if you have never invested your own money before.
With literally tens of thousands of stocks to invest in, and what can feel like an endless stream of information to digest, where do you even start?
Well, luckily, there is a simple technique used by every hedge fund manager to address this. And I’m about to show it to you.
What is Stock Screening?
The technique is stock screening.
Stock screening is essentially a filtering process. A way of narrowing down a large list of stocks into a smaller list of stocks that meet predefined criteria.
What is a Stock Screener?
A stock screener is the tool needed to perform this filtering process. Generally speaking, stock screeners come as an online platform or downloadable software.
They work exactly the same as a search engine. The search criteria are applied to a list of stocks and return only those stocks which meet said criteria.
The screening process can be broken down into the three simple steps below:
- Input criteria into stock screener
- Stock screener applies criteria to selected list of companies (stock universe)
- Stocks that meet criteria are identified
Stock Screening Process
By performing a stock screen, you can eliminate a large swathe of companies from investment consideration. This allows you to channel your focus on only those which have the qualities you desire.
Fundamental Analysis vs. Technical Analysis
In turn, these qualities can be based on a company’s ‘fundamentals’ or ‘technicals’.
The ‘fundamentals’ of a business are the things that drive its operating performance and intrinsic value. They are the real-world variables that influence a company’s profitability, growth, or valuation. Specifically, they are measured by ratios/metrics using data from financial statements (income statement, balance sheet, cash-flow statement).
‘Technicals’, on the other hand, have nothing to do with the company as a business entity. Technical analysis gives no consideration to how a company is run, its leverage, cash position, or earnings potential. Instead, technical analysis is the study of pattern recognition and other price and volume indicators in stock charts. The belief is that these generate certain ‘signals’ that predict future price movements.
As such, fundamental stock screeners filter stocks based on performance ratios like the P/E ratio, profit margins, or market cap. Whereas technical stock screeners identify chart patterns like wedges, and technical indicators like the RSI, MACD and moving average. This article shows you how to use the MACD effectively.
Fundamental Stock Screen
For example, a fundamental screen might look for all the stocks in the US that have a P/E ratio of less than 20, a dividend ratio greater than 3%, and a market cap greater than $1bn.
Below is an example of this screen in one of the many stock screeners available, Yahoo finance. Yahoo finance is one of the best free screeners out there.
Technical Stock Screen
A technical screen might look for stocks in the FTSE 100 whose share prices are at 52-week highs – an indicator of stocks with strong momentum.
Below is an example of how you could run this screen in one of the best technical analysis software’s out there, MetaStock.
This specific criteria generated the following stock screener results:
For another example of a technical stock screen, read this article explaining how to find oversold stocks with improving RSI.
Quantitative Analysis vs. Qualitative Analysis
As you can see, stock screeners uses quantitative data (fundamental or technical) to home in on stocks that have desirable properties to you.
Unsurprisingly, this form of analysis is called quantitative analysis.
This contrasts with qualitative analysis, which focuses on the more subjective and nuanced aspects of a business, like the quality of its product pipeline, the expertise of management, and the company’s competitive position in an industry.
Qualitative analysis is more of an art than a science, but can be learnt with experience and by studying the lessons of famous investors.
While some choose to be a purely quantitative or qualitative investor, personally, I believe a good investment process must incorporate both angles.
As such, whilst screening is a great way to start the idea generation process, you should remember it is just the first step.
Blindly buying every stock that comes up in a screen tends not to be a great investment strategy. You still need to do your own research to make more informed decisions.
The only exception to this is if you have backtested a certain strategy and have chosen to employ it in a systematic way. I explain more on backtesting below.
How to Construct a Winning Stock Screener Strategy
Ok, so we’ve seen how stock screeners can quickly identify stocks with desirable properties.
But how do we know what these desirable properties are?
If we can’t answer that, then we won’t know if our stock screener is generating useful output or not.
In other words: what metrics, indicators, parameters, and thresholds should our stock screener include to ensure a promising list of stocks to analyse.
If you are new to trading, there are two good starting points for constructing an effective stock screen.
Learn From the Best
The first is to emulate the investment process of any successful investor. They’re successful for a reason, right?
The best way to familiarise yourself with these processes is to read books written by, or about, some of the all-time investment greats.
By doing this, you will build up a picture of the common traits these investors look for in companies, which you can then incorporate into your own screens.
Fortunately, most stock screening services have in-built screens that mimic the investment styles of legendary investors.
GuruFocus, for example, is a service dedicated to these so-called ‘Gurus’. Their stock screener has countless in-built screens inspired by some of the world’s most famous investors, such as Warren Buffett, Benjamin Graham, and Peter Lynch.
In addition, this website has a whole section dedicated to different Guru stock screener strategies. For example, these articles show you how to implement a Martin Zweig stock screener strategy, a Peter Lynch stock screener strategy, and a Joel Greenblatt stock screener strategy.
Backtest to Find Screens That Work
The second way to construct an effective stock screen is to mimic investment strategies that would have worked well in the past.
This is the essence of backtesting.
A backtest uses a computer programme to simulate the historical performance of some hypothetical portfolio.
How this hypothetical portfolio behaves depends on the inputs you put into the programme. In particular, it buys and sells stocks according to a set of parameters at pre-set time intervals.
Assuming the strategy works, these parameters would then form the basis of your stock screener criteria.
For example, the backtest below shows how an equal-weighted portfolio ‘buying’ the 5% of stocks in the S&P 500 with the highest R&D/sales ratio each month would have performed from January 2011 to November 2021.
The service used to perform this backtest is Portfolio 123.
As you can see, this strategy would’ve handsomely outperformed the S&P 500 over the sample period.
Now, once you’ve found a successful strategy like this, you can construct a stock screen according to the same set of rules; in the knowledge that stocks with these properties have tended to perform well historically (and hopefully in the future too).
Using the example above, your stock screener would search for the 5% of stocks in the S&P 500 (25 stocks) with the highest R&D/sales ratio.
The caveat here is that you must believe the strategy is built on sound investment principles and that these principles will remain sound in the future.
Otherwise, we can’t be sure if a tested strategy has worked because of luck and/or only for the historical period we’ve tested – a problem known as ‘data mining’.
But let’s leave that detail to one side for a moment and go back to how we should evaluate our stock screener output.
Systematic vs. Discretionary Investing
With the screener results complete, there are now two approaches you can take.
- After obtaining the stocks that meet the specified thresholds, you can then drill down into them at an individual level; using your own discretion to decide whether a company is attractive from a qualitative standpoint as well.
- Alternatively, you could follow the exact rules of the backtest. The hope here is that you will replicate its historical success in the future. This would involve buying every stock that meets the screening criteria and rebalancing the portfolio at each pre-selected time interval going forwards.
Discretionary investing follows the first approach, which involves deeper analysis of individual companies before trading in them.
Systematic investing follows the second approach, which involves buying and selling trading instruments according to a set of rules. Most important, you should not deviate from this set of rules. In other words, no further analysis or cherry-picking of individual stocks should occur.
In the example above, the systematic approach would involve buying each of the 25 stocks with the highest R&D/sales ratio. You would then need to rebalance this portfolio each month. Selling the stocks that are no longer in the top 5%, buying the ones that now are, and holding the ones that remain there.
Quantitative Stock Screener Strategies
Knowing what strategies have worked historically is an extremely useful starting point for constructing stock screens.
One of my favourite services for exploring these quantitative investment strategies is quant-investing.com.
The team at Quant Investing have backtested a whole variety of different strategies. And what’s more, they give you access to the most profitable ones through their own stock screener.
It means that anyone can implement insanely profitable strategies in just a few simple clicks.
Below is just a snippet of the different strategies they’ve backtested.
For a more a in depth look at this service, check out my Quant Investing stock screener review.
I have a whole section on this website showing you different quantitative stock screener strategies. One example, is this free cash flow yield stock screener strategy. For one that’s more earnings-oriented, check out this earnings revisions stock screener method. Both are extremely profitable.
Summary
This article has hopefully shown you the merits of stock screening. In particular, how it can improve the efficiency of your investment process.
By filtering out stocks that don’t meet your standards, you can spend more time researching the ones that do. This will not only save time but also hopefully lead to better returns.
Two approaches to constructing a stock screen have also been shown to you. Mimicking the investment processes of other investors, and backtesting screening criteria.
The rest of this website delves deeper into some specific investment strategies based around these two approaches.
Before this, I recommend studying the financial metrics and technical indicators that form the building blocks of stock screening.
Fundamental screening is generally built around financial metrics that indicate a company’s quality, value, or growth. Read these articles for more detail on value stock screener criteria, quality stock screener criteria, and growth stock screener criteria.
Technical screening, on the other hand, is built around indicators that gauge momentum in a stock chart.
By learning these basics, it will give you a greater understanding of how to construct a stock screen.
To learn more about stock scanning, read this Scanz review.