The Easiest Way to Find Great Stocks

Last week in my Back to the Basics column, I reviewed two ways to find investment ideas: examining the goods and services that you come in contact with all the time, and becoming an avid reader.

But another way to track down stocks has opened up to individual investors, thanks to the magic of the internet. It can be both quicker and easier than the two methods I talked about last week, but it also comes with pitfalls of its own. I'm talking about using stock screeners.

Think of a stock screener as an investment robot that, based on your instructions, will scour the entire stock market to find just the stocks that interest you.

Speaking investmentese
Unfortunately, this screening robot doesn't speak English. It speaks investmentese, so if you want it to bring you the goods, you need to learn its language. It may be a little overwhelming at first, but as with anything else, study and practice are the keys to success.

While I won't endeavor to cover the entire universe of investment-speak here, I can start you off with a few high points that will hopefully put you on the fast track toward taking advantage of screeners.

The free investing community at Motley Fool CAPS offers a stock screener. Let's review the categories of instructions that that screener uses. (Screeners vary in the variety of instructions they include, and sometimes in how they refer to those instructions, but most general concepts can transfer from one screener to the next.)

• Company information: Sector and industry criteria let you search with varying degrees of specificity for types of businesses -- you can search the overall health-care sector, or you can drill down to just drug companies. Market capitalization, meanwhile, refers to a company's size.
• CAPS data: This is specific to the CAPS screener, and it lets you take advantage of the wealth of information generated by the huge CAPS investment community. "CAPS Ratings" may be the most powerful criteria here, since it lets you pick out just the stocks that have earned the community's top-notch five-star seal of approval.
• Price data: Investors often look for stocks based on how the stock price has moved. In particular, many Foolish investors will look for stocks whose prices have fallen a lot in hopes of finding a bargain. This category also includes valuation metrics. This is an important topic that I'll cover in an article of its own, but in short, valuation metrics relate the stock's price relative to company data such as current profits.
• Risk data: This contains metrics that measure how risky a company may be. Insider ownership, for example, measures how much of the company executives own -- many investors see this as an extremely important measure. The debt-to-equity ratio measures the company's debt level. As with your personal balance sheet, too much debt is rarely a good thing.
• Revenue and earnings data: This covers many performance-related measures. Just as baseball fans track batting average, home runs, ERA, and strikeouts to evaluate the skill of a ballplayer, investing wonks use measures like return on equity, earnings growth, and gross margin to measure the success of a company.

Let's get some stocks!
Now that we've covered the basics of investingese, let's take a look at the screening process in action.

There's no one "right" screen, since using, or excluding, certain criteria can give a different flavor to your results and potentially uncover different types of good investing opportunities. For this example, though, I'll punch a bunch of my favorite criteria into the CAPS screener:

• Market capitalization greater than $10 billion.
• Price-to-earnings of 16 or less.
• Current dividend yield of 3% or higher.
• EPS growth rate (last three years) of 7% of higher.
• Return on equity of 15% or higher.
• CAPS rating of four or five stars.

That screen came up with six results:

Source: Motley Fool CAPS.

As with the techniques for finding investment ideas I discussed last week, the stocks that come up on screens like this are starting points for further research, not fully-baked investment opportunities.

Additionally, as I noted at the beginning, screening has some pitfalls, and one of those is that it's just as easy for anybody else to pull up the same screen that you have. So it's important to carefully consider -- particularly when valuation measures are involved -- why lots of other investors aren't rushing to buy the same stocks. A company may have something going on that's not reflected in the screening results but is set to negatively impact future profits.

Another pitfall is that screening, by its nature, is exclusionary. For that reason, it's just as important to know what you're missing out on based on your screening criteria as it is to know what you are getting. A screen like the one above is very narrow and misses significant areas of opportunity, such as small caps and growth stocks that don't pay dividends.

With that said, the screen above reveals a set of stocks that I find particularly attractive. In fact, three of the six stocks -- Abbott, Intel, and Johnson & Johnson -- are all in my personal portfolio.

Your turn
Practice makes perfect, so it's important to not just file this away under "information that might be useful someday." Start screening already! Getting some good results from your screening experiments, along with the techniques we discussed last week, will give you plenty of stocks to work with next week, when we discuss how to decide whether a stock is actually worth buying.

Until then, head down to the comments section with any questions or suggestions on what you'd like to see covered in future columns.

If you've missed out on the previous installments, catching up is easy:

• What is a Stock?
• Why Buy Stocks?
• Finding Great Stock Ideas