5 Potential Winners

As we all know, the best way to nail down a great investment is to perform solid "due diligence." But often the biggest obstacle in the entire process is finding good companies to research in the first place.

Sometimes I use a product or service so much it finally dawns on me to check out the company as a possible investment. That's what spurred me to dig into 7-Eleven, for example. But most of the time I need a push in the right direction, and that's where stock screening comes in.

Tweaking the Foolish 8
One screen we know and love is the small-cap Foolish 8. Here's a brief look at the criteria:

  1. Revenues: $500 million or less
  2. Earnings and sales growth: 25% or greater
  3. Net profit margin: 7% or greater
  4. Daily dollar volume: $1 million to $25 million
  5. Insider holdings: 10% or greater
  6. Share price: $7 or greater
  7. Relative strength: 90 or greater
  8. Operating cash flow: a positive number

While perusing some other screens generated by the American Association of Individual Investors (AAII), I felt inspired to tweak the F8 list a bit to add some elements of valuation and management effectiveness.

For starters, I wanted to expand the F8 universe to include some larger companies, so I raised the revenue cap to $900 million or less and took the $25 million limit off the daily dollar volume requirement, making it simply $1 million or greater. This allows both small and medium-sized companies to pass the screen.

I then loosened the relative strength requirement to 50 or greater. While I agree with the premise behind requiring at least a 90 -- that the market has recognized and affirmed a business' strengths -- I've always wondered if we were leaving out some good companies that didn't quite reach that lofty top decile.

I also toughened some of the requirements. First, I wanted a company to have not only positive cash flow, but also positive free cash flow. Second, in a nod toward valuation, I required a price-to-free cash flow to cash flow growth multiple of 1.00 or less. This is similar to the PEG ratio, which divides a company's P/E by its earnings growth estimate, but it substitutes the more reliable free cash flow for earnings. In the world of PEG enthusiasts, a value of 1.00 is considered fair value; anything below it indicates a stock may be undervalued.

Finally, I used a requirement in the AAII's "Hagstrom Buffett" screen. In his book The Warren Buffett Way, Robert Hagstrom Jr. wrote, "The most important management act is the allocation of the company's capital... [A]llocation of capital, over time, determines shareholder value. Deciding what to do with the company's earnings -- reinvest in the business or return money to shareholders -- is, in Buffett's mind, an exercise in logic and rationality."

Return on equity (ROE) is one of the basic measures of how well management creates value. Like the Hagstrom screen, I required an ROE above 15%... but for the past 12 months only and not the past three years.

Here are the stocks that passed my revised screen:

  • aaiPharma (Nasdaq: AAII  )
  • American Healthways (Nasdaq: AMHC  )
  • Bradley Pharmaceuticals (NYSE: BDY  )
  • Engineered Support Systems (Nasdaq: EASI  )
  • FactSet Research Systems (NYSE: FDS  )
  • Garmin (Nasdaq: GRMN  )
  • New Century Financial (Nasdaq: NCEN  )
  • Panera Bread Company (Nasdaq: PNRA  )
  • Quality Systems (Nasdaq: QSII  )
  • Stratasys (Nasdaq: SSYS  )
  • University of Phoenix Online (Nasdaq: UOPX  )
  • USANA Health Sciences (Nasdaq: USNA  )
  • WFS Financial (Nasdaq: WFSI  )

That's 13 companies, but I wanted to narrow the list down even more, so I worked in the Hagstrom screen's tougher requirement: a greater than 15% ROE over the last four quarters, and for each of the last three fiscal years.

That knocked it down to just these five companies:

  • Engineered Support System -- a holding company for nine wholly owned subsidiaries that supply electronics and support equipment to the U.S. military and some of its allies. It also manufactures industrial products for commercial businesses.

  • FactSet Research Systems -- provides online database services to the financial and investing community.

  • Garmin -- designs and manufactures handheld, portable, and fixed-mount devices for the aviation and consumer markets. Most of the products make use of the Global Positioning System (GPS) system.

  • University of Phoenix Online -- a division of the University of Phoenix, it allows users to obtain a college degree online.

  • USANA Health Sciences -- a multilevel marketing firm that distributes nutritional and personal-care items, as well as meal-replacement products.

And furthermore...
It's an interesting mix, and you probably won't have a hard time finding something here that interests you (and thus makes your research more fun). Here's a little bit more to get you started -- both from our writers and our Fool Community:

Quality Systems is a two-time Tom Gardner pick inMotley Fool Stock Advisor, and has returned 75% and 99% so far.

Rex Moore salutes another of his former schools, Lucy Reed Elementary in Austin,Texas. At press time, he owned no companies mentioned in this article. The Fool is investors writing for investors.


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