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:
- Revenues: $500 million or less
- Earnings and sales growth: 25% or greater
- Net profit margin: 7% or greater
- Daily dollar volume: $1 million to $25 million
- Insider holdings: 10% or greater
- Share price: $7 or greater
- Relative strength: 90 or greater
- 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.
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:
- FactSet Redux, by MarkMarcellus
- Garmin's Got It, by Jeff Fischer
- Showtime at the Apollo, by Rick Munarriz
- Rough Sketch of USANA by kitkatklub
Quality Systems is a two-time Tom Gardner pick inMotley Fool Stock Advisor, and has returned 75% and 99% so far.