I recently took issue with Investor's Business Daily's list of "10 Highest-Rated Stocks," objecting to what I saw as a heavy emphasis on several quantitative factors, at the expense (to some degree) of more extensive and qualitative analysis.

As is often the case when we Motley Fool writers wax provocative in an article, I received some strongly worded emails from readers:

  • "If you can't provide actual information, you shouldn't be taking up Internet space complaining about what other people provide."
  • "You obviously have no idea what you are talking about when you write about IBD's list."
  • "You apparently have been assigned to attack Investor's Business Daily."

More interestingly, and not surprisingly, I heard from the folks at IBD. As I did last time we disagreed, I'm hereby devoting an article to offering much of their response, since it seems like a fair thing to do (and because they made some good points). The response was prepared by the executive editor of IBD, Chris Gessel, and the content editor of investors.com, Ken Shreve.

The objections and clarifications
First and foremost, Chris and Ken wanted to clarify that, "[Your] premise assumes this is a buy list. It is a watch list." To my comment that, "It's usually a bad idea to invest blindly from any list, but lists can offer you ideas to investigate more closely," they replied: "Yes, that is our position also -- you must research."

In my article, I'd pointed out that their "IBD 100" list "has performed quite well, trouncing the S&P 500 both in the past year and since its inception." If anyone is wondering why that might be, they offered this interesting tidbit: "The vast majority of stocks on the list also had high annual return on equity (ROE), which is probably the best indicator of a well-managed company (it wasn't a screening parameter)."

To back this up, they included the ROE figures below:

  • Joy Global (NASDAQ:JOYG), 30.2%
  • Tenaris, 42.6%
  • TradeStation Group (NASDAQ:TRAD), 32%
  • Gilead Sciences (NASDAQ:GILD), 32.2%
  • The Pantry (NASDAQ:PTRY), 31.4%
  • Western Digital (NYSE:WDC), 36.5%
  • Ceradyne (NASDAQ:CRDN), 25.1%

Point by point
Let me now go over a few of my points and their related responses.

I said that that placing a lot of importance on earnings, especially earnings per share, is problematic, since companies can manipulate their earnings in many perfectly acceptable ways. I suggested that it's sounder to look at cash from operations, or free cash flow, to get a more dependable idea of the firm's progress. They said: "All financial numbers can be altered, including cash flow and sales. Enron and WorldCom are prime examples. Our studies for over five decades show that EPS gains correlate highly with stock appreciation."

I pointed out that "per-share numbers, in theory, can go up just because of share buybacks, reflecting no operational success." They retorted that "buybacks are a sustainable and good reason for EPS to increase. [Home builder] Ryland (NYSE:RYL) has boosted its EPS numbers for years by continually buying back shares. It's up 572% in the past five years, while its homebuilding industry group is up 347%. We'll take the extra 200%, thank you." To this, I'd just like to point out that buybacks are indeed wonderful -- except when the shares being bought are overvalued. If a stock's intrinsic value is $25 per share and the company buys back shares at the current price of $40, it's wasting shareholder capital. It would be better to pay that money out as a dividend or invest it where it will offer a bigger return.

I said, "The attention paid to the stock's price also troubles me. Although some rapidly growing stocks will continue their swift rise, others may run out of steam." They replied, "RS (Relative Strength) is the other primary indicator of a stock's future gains. Investors might not like it, but the market is not about making you feel good."

Perhaps my main objection was this: "I think there are some qualitative measures that no screen will catch -- first and foremost, quality of management. Fool co-founders David and Tom Gardner agree -- they've made quality of management a core component of their recommended companies in the Motley Fool Stock Advisor newsletter service."

Chris and Ken explained that, "We are very interested in management and the story behind a company. It is why we have New America stories, the IBD 100 Profile, and Leaders & Success features. The numbers are reflective of superior management. IBD Ratings help you efficiently screen through 8,000 stocks to find those gems."

Finally, they took issue with my advocacy of fundamental stock analysis and my mention of David and Tom's market-beating Stock Advisor service (which has averaged returns of 45% and 73%, respectively, against 21% for equal amounts invested in the S&P 500 over roughly four years). They pointed out that the newsletter was launched near the bottom of the recent bear market and opined that, "A strict fundamental approach is more likely to collapse again in the next bear market." (The market actually continued to fall for another six months after Stock Advisor's launch.)

They then referred to their proprietary stock evaluation system, "CAN SLIM," saying: "If you compare performance as a goal in determining best methods to make money in the market -- you might also review an outside group using CAN SLIM -- the CAN SLIM Select Fund. It is real money based on the same principles as the IBD 100, and so far performs very much like it. Through Friday, March 24, the CAN SLIM fund was up 10.3% in 2006, vs. 4.4% for the S&P 500 and 10.4% for the IBD 100." [In our discussion board community, we have a busy CAN SLIM board, featuring more than 20,000 posts.]

There you have it. Ponder my thoughts and theirs and make up your own mind on these issues. Having digested their response, I don't think we're as far apart as I originally expected. I encourage you to check out any of our investing newsletters to get a feel for our investment approaches. (You can do so for free, so you've got nothing to lose and everything to gain.) I also encourage you to check out IBD for yourself. It's a newspaper that you can find at many newsstands and libraries. It's also at Investors.com.

Here's to big profits in your future!

Selena Maranjian 's favorite discussion boards include Book Club , The Eclectic Library, Television Banter and Card & Board Games. She owns shares of no company mentioned in this article. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.