Let Scrooge Make You Rich

Ebenezer Scrooge is unstoppable.

For each of the past five years, I've teamed up with Hewitt Heiserman Jr., author of the excellent It's Earnings That Count, to generate a list of stocks cautiously greedy investors may wish to consider for the year ahead. We call this process the Scrooge screen, and it has crushed Mr. Market every year. Here are its 2009 returns:

Sources: Motley Fool CAPS, Yahoo! Finance.
*Adjusted for dividends and other returns of capital.

And here's a complete history of the miser at work:

Sources: Motley Fool CAPS, Yahoo! Finance.
*The Scrooge screen made no picks in 2008.

Heiserman pulled from his book to build the original screen in 2004. In 2008, we revised it to look for a below-market average P/E ratio, rather than a below-industry average P/E ratio. We did this partly due to the limitations of screening in MSN versus the more powerful Capital IQ, but mainly because we wanted to widen our search for bargains.

In either form, Scrooge has proven to be a superior bargain shopper.

Indeed, had you been lucky or prescient enough to put $10,000 into a Scrooge portfolio at the beginning of 2005, rebalancing in the years following, you'd have $32,000 today, taxes excluded. That's a 26% annualized return. A similar investment in the S&P 500 would have earned just 1% a year over the same period, giving you $10,321 pre-tax.

Heiserman attributes Scrooge's dominance to combining above-average profitability with below-average valuation, two characteristics that the Dickens' fictional miser might find pleasing were he real and investing today.

2009: a time for hoarding
So that's the overall picture. Now let's dig into the details. First, 2009's performance shed doubt on whether Scrooge is better suited to predicting large-cap winners, as we wrote in 2008. Exxon Mobil lagged as Tenaris SA soared.

Mid-caps, on the other hand, continued to be a bright spot for the screen. Continental Resources more than doubled, and TD AMERITRADE thumped the market by more than 20 percentage points.

But when it comes to small caps, Scrooge once more got stuck with suckers. GigaMedia was a bust in a year when most stocks rallied. And while KHD Humboldt Wedag enjoyed a positive return, it lagged when compared to the S&P 500. Small caps aren't Scrooge's specialty.

For this column, we define small caps as stocks worth $250 million to $2 billion in market cap. Mid caps range from $2 billion to $15 billion in market cap. We consider anything worth more than $15 billion to be a large cap.

Why not weed out the small caps from the screen, you ask? It's a good question. If we're loath to do it, it's because Scrooge has demonstrated a winning formula. Sustainable investing gains are rare enough.

How to be a Scrooge
So we're sticking with Scrooge as is. Here's what it demands:

• Average five-year revenue growth of 8% or better: Weeds out one-hit growth wonders.
• Annual earnings per share growth of 7% or better over at least the last 12 months: Spot growth while it's accelerating, rather than the reverse.
• Average five-year return on equity (ROE) of 10% or better: Good management will produce good returns.
• Debt equaling no more than half of equity: Weeds out the could-go-bankrupt-if-creditors-called-at-the-wrong-time crowd.
• Institutional ownership of 60% or less: Undiscovered firms are often the market's multibaggers in the making.
• A short interest ratio of 5% or less: High short interest could be reflective of fundamental problems.
• A low price-to-earnings ratio: We choose a P/E of less than 16, before excluding special items -- roughly equal to the trailing P/E of the S&P 500 SPDR.

Be cautiously greedy with these two stocks
Just two companies pass the latest Scrooge test, based on data from Capital IQ. We like, but don't love, both of them:

Sources: Motley Fool CAPS, Yahoo! Finance.
*Adjusted for dividends and other returns of capital.

Our hesitation has little do with the merits of the underlying businesses. Fundamentally, they're both good. What worries us is the overall environment for investing. Here's how Heiserman put it in an email to me:

Scrooge's lack of ideas means he's nervous. Me too. First, just two companies pass our screen. In a normal environment we should have lots more companies to buy, based on now five years' worth of experience running this screen. Second, at the March 2009 low of 667 for the S&P, the 10-year cyclically adjusted P/E was 11x. At prior washouts in 1920, 1932, and 1982, the 10-year P/E went down to 6x, based on my analysis of data complied by Yale's Robert Shiller. If history is a guide, earnings multiples may fall lower before the next bull market in the manner of 1982-1999 begins. Third, the S&P's dividend yield is a scant 1.9%. Dividends are important, because earnings without cash are not necessarily 'earnings.' If stock prices regress to yield 4.4% (the average dividend yield for the last 130 years), this puts the S&P at 496, a 56% loss from current levels. Fourth, the 10-year Treasury yields 3.8%, well below the 6.36% average since the early 1950s. If the cost of money increases, as the United States' subprime finances warrant, then equities will be sailing into the wind. 2009 was a bear market rally, I suspect.

Not surprisingly, I agree. I'll keep my promise to bet real money with Scrooge, as I did last year, but I'm also going to be careful. SAIC and Stepan will be minority positions in the 2010 edition of the Beyers family portfolio.

Now it's your turn to weigh in. What do you think of this year's Scrooge picks? How about the screen in general? Make your voice heard using the comments box below.