By Ann Coleman (TMF AnnC)
February 10, 2000

Our Screen Explanation page gives a complete, if cryptic, description of each of the 12 stock strategies that we are following "officially" here in the Workshop. Dozens more are followed on the message boards.

We present only a few of the most promising, stable, and well-investigated strategies here. That's mainly because the full glory of the work that is published on the Mechanical Investing board is blindingly confusing to newcomers, although well worth the effort to assimilate for those who have a mathematical or logical turn of mind.

For the rest of us, the few strategies we follow here are confusing enough!

Just in case it hasn't already been made abundantly clear, by the way, the brain trust that has developed in the Mechanical Investing community has to be one of the most unique ever. The Motley Fool provided the mechanism for the community to develop (and we're happy to take credit for that), but the research that has come out of that community has been absolutely astounding. Even more astounding, though, is the spirit of generosity that has driven these people to share their work freely, not only with those who could further the work, but the rest of us who just plain benefit from it.

Forgive the digression -- I sometimes get overwhelmed with awe and gratitude. But what I really started to discuss was the screens that many of you use to select investments. I want to make the case today for getting to know at least a couple of screens very intimately. It's not enough to say, big-cap stocks, 30% a year in the back test, yep, Keystone sounds good to me. That may be better than buying Internet IPOs on Day 2, but for sound Workshop investing over the next decade, you need to know more than that.

As an example, let's compare the PEG screen and Relative Strength-26 Weeks. If you've been following along here for a while (and if you haven't, click those links at some point), you know that most of the Workshop screens start with a high Timeliness Rating by Value Line and at some point include the RS-26 factor. In fact most of them use a relative strength (RS) factor (total return over the past x weeks) as the final determinant, and some use it as the sole determinant (other than the Timeliness Rating). RS-26 Weeks is one of the highest-performing screens we follow, and it uses only two factors: Timeliness and Total Return (or RS) over the past 26 weeks.

The PEG screens, on the other hand, include RS-26 Weeks (or 13 Weeks) as a selection criteria, but stocks are also selected by Timeliness ranking and high anticipated earnings-per-share (EPS) growth. The final determinant of rank is the PEG ratio, the ratio between the stock's P/E (price-earnings ratio) and growth rate. (That's right -- it's a ratio of ratios.)

This difference is why it pays to really know your screens intimately. Many who follow these strategies adopt a completely mechanical approach, and if a stock in the portfolio is no longer on the screen when renewal time comes along, it's outta there. Others believe that selling a stock that may have dropped from fifth to sixth place on renewal day (and thus be off of the top five stock list) may be a bit drastic -- especially for the strategies with shorter holding periods. It's not unusual for a stock to drop to sixth place one month and be "off" a monthly screen only to rise back to fourth place the next month. That's mechanical investing for you.

If you are of a mind to modify these approaches, then knowing how the screens work is essential. With a pure RS strategy, you will understand that the reason the stock dropped was because other stocks have performed better in recent weeks. As a relative strength investor, you are committed to buying the strongest-performing stocks, so perhaps strictly following the rules about selling would make sense.

But with PEG, moving down on the list can mean something very different. The final determinant of the order of the stocks is the PEG ratio, not relative strength. When a stock's PEG goes up it often means that the price has risen. (It may also mean that the earnings or growth estimates have been cut, but, at least in this current market and with Timeliness 1 and 2 stocks, a rising PEG is more likely to be a result of price growth.)

Why is price growth significant? Right -- price growth means high relative strength. So the fact that a stock has moved DOWN on the PEG list could very well mean good news, with more good news to follow.

This is where the division between strictly mechanical investing and those who would inject a bit of fundamentalism shows up. If one follows the PEG strategy strictly, especially when using a monthly renewal strategy, then one could conceivably sell a PEG stock just as it starts to move up on the RS strategies. There are ways to address that. One is to use several strategies that have somewhat different underlying philosophies -- PEG and RS-26 for example -- and follow them strictly.

PEG has proven to be a wonderful screen for identifying stocks that have the potential to turn into big winners. That's because it looks at fundamental factors as well as recent price performance. It is more likely to "catch" a big winner before it hits the relative strength screens and to drop it before the relative strength screens do. Since PEG only uses the price-to-earnings-to-growth factor as a final sort, though, a stock that has been moving up in price but whose fundamentals remain strong would not be dropped immediately, but would simply be ranked lower by the screen. So another other way to address the different ways that the screens work would be to hold stocks selected by the PEG-5 screen until they drop off the list of top 10 stocks entirely.

The nuances of a stock screen's "personality" can tell you much more than big cap vs. small cap, or earnings growth vs. relative strength. Knowing them is vital to properly designing a mechanical portfolio that works efficiently.