Be a Market Darwinist

It's impossible to know every stock. And that's one reason I'm impressed by Jim Cramer. With more than 8,000 listings floating around the New York Stock Exchange, Nasdaq, and American Stock Exchange, it's a skill to be able to comment -- however breezily -- on any combination of letters thrown at you.

But passing knowledge of 8,000 companies won't help you profit in the stock market. You'll do much better by knowing a few firms, and knowing them cold.

Ways to winnow
Screens are an investor's friend. Here at Fool HQ, we have access to a nifty one provided by the good folks at Capital IQ. And I must admit: I'm a junkie. I screen for fun, and I screen for profit.

The fun screens are the ones in which I identify all the companies with a Georgetown Hoya (my alma mater) on the board. For the record, there are 918 such companies, running the gamut from Aeropostale (NYSE:ARO) director David Vermylen to Zix (NASDAQ:ZIXI) director Antonio Sanchez. But (sadly) screening for Georgetown grads won't generate many investment ideas. So here's how I get started screening for profit:

1. Only include companies that trade on the NYSE, Nasdaq, and AMEX.
While there are lots of opportunities to profit on stocks that trade over the counter or on foreign exchanges, there is also lots of risk associated with companies that are not subject to American regulatory requirements or major exchange listing guidelines. I don't want to get burned by buying based on unreliable information (although this can also happen in the United States).

According to Capital IQ, this criterion narrows my choices down to 8,342 companies. That's too many -- I've still got work to do.

2. Only include companies capitalized over $200 million.
Again, there are plenty of opportunities among micro caps, and I even own one myself that just crossed the $200 million threshold. But as a starter screen, this step eliminates stocks that can be unduly volatile (because of low trading volume) or difficult to evaluate (because of a dearth of coverage).

Current Capital IQ count: 4,058. Still more material than I want to cover.

3. Only include companies that have net income greater than zero.
For this starter screen, I only want to deal with profitable businesses. While that will automatically eliminate many (if not all) of tomorrow's biotech wonders, I don't have the expertise to analyze those anyway. (As an aside lesson, know your limits in investing and only traffic within your circle of competence.)

Current Capital IQ count: 3,424. Onward I go.

4. Only include companies that have five-year revenue and net income compound annual growth rates (CAGR) greater than 20% and 15%, respectively.
Rather than weeding out characteristics I don't want, now I can start drilling down on characteristics I do want. These are high bars, but companies that pass this screen are worth a look (at least). The key here is taking a longer view toward history. While that means we won't get in on any turnarounds, five years is long enough for me to know that the sales and income rates I'm after aren't flashes in the pan. And you'll see from the number below that I've really narrowed down the field.

Current Capital IQ count: 336. Almost there.

5. Only include companies that have zero debt.
I don't normally fear debt. But by only including debt-free companies, our screen will likely produce a list of businesses that are in good financial health. Couple that with their size and five-year growth rates, and we've got 57 candidates worth investigating. And, thankfully, 57 is a manageable number -- at least to start looking at names, lines of businesses, and other important details such as insider ownership, valuation, and future prospects.

Of those 57 companies, here are the five I find most intriguing:

I hate my screens
Now for the shocker: The stock I selected for The Motley Fool's Stocks 2006 publication did not make the list. Why? For starters, it has debt. It also doesn't quite sneak past the five-year revenue CAGR test (coming in at 18.2%). But I'm not concerned. The company is using its debt to expand and enhance existing operations to take advantage of what should be a $30 billion health food industry by 2007. The growth rates it will get out of that investment should make for market-beating five-year returns and a strengthened operating position even further down the line. That's why investors need to use qualitative judgment in investing, even as we use quantitative criteria to narrow the field. Most great opportunities won't conform to five simple screening steps.

And while my selection did not make the list of 57, three of the 12 Stocks 2006 selections did. I can't tell you which ones they are, but I can tell you that these three companies are debt-free, profitable, and growing rapidly, and that they passed the qualitative tests of our research analysts. That's a pretty sweet combination.

If you'd like to get your hands on a copy of Stocks 2006 and learn 12 of our best investment ideas for the year ahead, click here for more information. The series has a history of beating the market, and editor Bill Mann says this may be the best edition yet.

Tim Hanson expects Roy Hibbert to put up big numbers tonight against Illinois. Hoya Saxa! Tim does not own shares of any company mentioned in this article. Bed Bath & Beyond and eBay are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.