Screening for Winners

In October, I wrote about 5 Potential Winners -- five stocks that passed a modified Foolish 8 screen. That column received a positive response, so I want to keep the idea alive by digging a little deeper. First, we'll check out the historical performance of the screen, and then perhaps consider ways to tweak it for the better.

To recap briefly, our screen took the original F8 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

...and made the following modifications:

• Raised the revenue cap to $900 million or less
• Took the $25 million limit off the daily dollar volume requirement, making it simply $1 million or greater
• Loosened the relative strength requirement to 50 or greater
• Required not only positive cash flow, but also positive free cash flow
• Required a price to free cash flow-to-cash flow growth (PFCF-to-FCF) multiple of 1.00 or less
• Required better than 15% return on equity (ROE) over the last four quarters, and for each of the last three fiscal years

The reasons behind the changes are explained in the column. The modified Foolish 8 screen (shall we call it the MF8?) passed only five companies out of the 5,963 listed on the New York, American, and Nasdaq stock exchanges:

• Engineered Support System (NASDAQ:EASI) -- 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 (NYSE:FDS) -- provides online database services to the financial and investing community.
  
  
• Garmin (NASDAQ:GRMN) -- 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 (NASDAQ:UOPX) -- a division of the University of Phoenix, it allows users to obtain a college degree online.
  
  
• USANA Health Sciences (NASDAQ:USNA) -- a multilevel marketing firm that distributes nutritional and personal-care items, as well as meal-replacement products.

History
So, the screen produced five companies. So what? While we know that such a list is only a launching point for further research, we'd at least like to know if the passing companies are strong as a whole. That's the whole idea behind screening (that, and finding the next Microsoft (NASDAQ:MSFT) or Intel (NASDAQ:INTC)). There's no point, after all, in coming up with a list of a few weak companies.

Since the day that 5 Potential Winners was published, the five stocks have been red hot as a group:

While this is certainly encouraging, we can't draw any strong conclusions after just eight weeks. Or even weak conclusions, for that matter. It will take a year, or two, or more before we can get some idea of the strength of this screen. But in the meantime, I've begun looking backward -- trying to identify companies that would have passed muster in years past.

For starters, I set up a screen to catch all companies that would have made our MF8 list on April 1, 2002. That would have allowed plenty of time for 2001 data to become available, and, of course, we have a certain affinity for that date here at The Motley Fool.

This was much easier said than done, though. I use Stock Investor Pro software (available on the American Association of Individual Investors website), and it's a powerful tool. However, it doesn't screen for certain things on a historical basis -- in particular, daily dollar volume, insider holdings, and relative strength. So, I decided to keep daily dollar volume and insider holdings as is (i.e., screen for companies currently meeting the requirements) and to leave relative strength out of the screen entirely. I don't believe these decisions had much of an effect on the final list.

Still, keep in mind this isn't an exact science, even for the current screen. For example, Stock Investor Pro's PFCF-to-FCF growth formula uses a five-year growth rate in the divisor. I think I'd a prefer a one-year growth rate -- thereby including companies that have recently turned free cash flow positive. Should I go to that in the future, the list components would likely change somewhat.

At any rate, here's the list as of April 1, 2002, with each stock's total return:

Not bad at all. The S&P 500 is down 7% in this time frame, and outperformed only Pharmaceutical Product Development. The other five handily beat the market, returning from 32% to 142%.

Next, I came up with a list of companies that would have passed the MF8 in April 2001:

Again, the results are heartening. Ten stocks made the cut, and all 10 were better off than the S&P. University of Phoenix Online -- which is still on the list -- was a monster, returning 418%. Its parent company, Apollo Group (NASDAQ:APOL), rose 240%.

The charts for some of these stocks aren't for the faint of heart. Advanced Energy Industries (NASDAQ:AEIS) (+15%) and Foundry Networks (NASDAQ:FDRY) (+278%) were quite volatile. AudioCodes (NASDAQ:AUDC) (+16%) was the scariest; at one point it had lost 80% of its value and was below $2. Since then, it has soared 450%. It's not surprising to find this screen produces some risky stocks.

Bottom line
What counts here is the big picture. So far, it seems there's a reasonable chance the MF8 screen will do what we want it to do: pass along lists of companies for further research that are likely to include some future strong investments.

One final note: As of last week, the MF8 list looks the same as the October list -- minus Garmin, which dropped off as its PFCF-to-FCF growth ratio moved above 1.00.

If you have ideas on improving the MF8 screen -- including a better name -- drop us a note on the Foolish Eight discussion board!

Rex Moore hopes the MF8 is more useful than screen doors on a submarine. He owns no companies mentioned in this column. The Motley Fool is investors writing for investors .