Wouldn't it be wonderful if there were an infallible stock screening tool that always gave investment ideas that spanked the market averages? All we as investors would have to do is take the output of the screen, buy the stocks, and not spend one nanosecond further thinking about stocks.
Unfortunately, such a magical "black box," like the Fountain of Youth, exists only in our dreams. And even if a perfect stock screening tool did exist, it certainly would not fall into our hands as average investors. With change being a constant in the stock market, it wouldn't work for long, either.
But don't despair! The reason humans still have an edge over computers in the game of investing is because quantitative attributes of a company only tell us a small part of the overall story. When considering a company for investment, the human factor is critically important to connect all of the dots and see if the picture makes sense.
It's helpful to keep this in mind when using stock screens such as the Foolish 8. Though the Foolish 8 screening tool acts as an excellent way to generate investment ideas within the small-cap arena, we still need to look much further into companies that pop up on the screen. No screen that uses numbers alone is going to be perfect, and an objective look at a company's products, competitive positioning, and management is needed before an investor should sign off on a stock put forth by a screen.
Why the Foolish 8 isn't perfect
Our own Foolish 8 screen does a good job of putting companies that are performing well on the radar. However, the screen is far from the complete decision-making tool.
The largest thing that I see missing from the Foolish 8 screen is any sort of consideration of a company's valuation. If a company is chugging along with 30% growth of both revenues and profits and also meets all the rest of the eight attributes the screen looks for, it does not automatically mean it is a "buy," especially if the stock is trading at 400-times forward earnings.
One of the lessons of the dot-com meltdown is that, yes, valuation does matter. A screen is only of so much use if it does not reconcile a company's cash-flow-generating ability with a stock's price and what investors must pay to get their proportionate share of that cash flow. The Foolish 8 on its own is totally inadequate on this accord.
There are screens and tools available that numerically take valuation into consideration -- our Foolish PEG Ratio being a powerful but easy one to use -- but it still takes a human to see that the companies up for investment consideration put forth by a screen are indeed doing well and priced attractively.
The Foolish 8 also makes little determination about a company's qualitative aspects. Is management prone to hyping or stretching the truth? Is there funny, unexplained stuff going on with the balance sheet? Is a company's business a sustainable entity or merely a flash in the pan? What sort of sustainable competitive advantages does a company possess? These are all critical questions that no screen can answer.
The fact is that some rotten companies may look great on paper, and rotten companies make for rotten long-term investments.
An example
The reason I got started thinking about this issue was because I had to recently bend the Foolish 8 "rules." While researching Foolish 8 ideas for the upcoming issue of The Motley Fool Select, I found what I thought to be an excellent investment opportunity, but it did not quite meet all the criteria required by the screen.
The company I wrote about was on the Foolish 8 for several months but was recently punted from the screen for having annual earnings growth of "only" 19%, below the 25% growth threshold the screen uses. This, even though profits are expected to grow near 80% next year. The screen didn't see that this year's earnings are hampered by one-time events and growth is about to hit turbo again. This particular company also trades at a single-digit forward PE ratio, also a fact I had to dig up on my own.
Either way, the company I wrote about came onto my radar thanks to the Foolish 8 stock screen, and I don't know if I would have found the company otherwise. Still, by looking beyond just what the raw numbers used in the screen told me, I was able to find a solid investment idea.
The bottom line is this: Before putting your hard-earned money into a company put forth by a stock screen, use your brain as well as your nose to make sure the business passes the smell test, is on solid ground, is valued reasonably with a sufficient margin for error, and that the investment opportunity just plain makes sense. The Foolish 8 will lead you near where the good water can be found within the universe of small companies, but it is still up to you to uses your senses to decide whether it's a good idea to drink.
Paul Larson has a few window screens on his house that need repairing. You can see Paul's stock holdings online. The Motley Fool has a progressive disclosure policy.
