Scrooge Strikes It Rich

I'm beginning to love Ebenezer Scrooge.

Don't get me wrong; I'm no miser. To the contrary. I believe our annual Foolanthropy campaign is one of the very best things we do at The Motley Fool.

My love for Scrooge derives not from the pearly writings of Charles Dickens, but from the more recent incisiveness of another author: Hewitt Heiserman Jr., the top-notch analyst behind It's Earnings That Count.

For three years now, I've had the good fortune of teaming with Heiserman to create what we call the "Scrooge" screen -- a series of criteria for finding stocks that meet the needs of cautiously greedy growth investors like us.

We're getting richer by the day. Here are the results for the Scrooge screen for 2007 (all dividends were reinvested):

Impressive, no? I'll say. Miners Rio Tinto (NYSE:RTP) and Compania de Minas Buenaventura (NYSE:BVN) more than compensated for huge losses at health-care software provider Streamline.

And remember: This is the third consecutive year of market-beating gains for our miserly screen. Scrooge was up 9.8% on the S&P 500 in 2005 and 10.5% in 2006. Big winners from those years include First American Financial (NYSE:FAF), Taiwan Semiconductor (NYSE:TSM), Southern Copper (NYSE:PCU), and POSCO (NYSE:PKX).

Big losers include Cantel Medical, Docucorp, and -- wait for it -- current Motley Fool Hidden Gems winner II-VI (NASDAQ:IIVI).

From these results, and the limited data they represent, I draw two preliminary conclusions:

1. Our screen is a better predictor of success for large caps than for small caps.
2. Holding for the long-term can be a market-crushing strategy with small caps (witness II-VI).

How to be a Scrooge
When it comes to large caps, Scrooge usually does an excellent job of handpicking the best. Here's what it demands. Commentary from Heiserman added for perspective:

• Average five-year revenue growth of 8% or better: "This is your indicator that the company is making a product or service that customers can use. But it's important to watch out if the number is too high. For example, 40% is likely unsustainable. On the other hand, if you've found a company growing at only 2% to 3%, it probably operates in a mature market. Low sales growth is almost always a red flag."

• Annual earnings per share growth of 7% or better over at least the last 12 months: "As with sales, you don't want 20% to 25% because that's probably not sustainable long-term, and any company that is growing that fast may be peaking. A company growing at 7%, however, may just be starting to accelerate, leaving plenty of opportunity for investors."

• Average five-year return on equity (ROE) of 10% or better: "This is simply the best way to gauge management's use of shareholders' money to fund growth. A higher number here is usually better, though it's important to remember that a highly leveraged firm can still have a high ROE."

• Debt equaling no more than half of equity: "This helps eliminate the firms who have high ROE but who are also so highly leveraged that they would be in trouble if creditors came calling at the wrong time. I think one of the great lessons of the late '90s is that investors forgot about this and the rest of the balance sheet."

• Institutional ownership of 60% or less: "John Neff gave a great quote in which he relayed some advice from his father. His father said merchandise well bought is merchandise well sold. That's a motto for the value investor, but it can also be a motto for the conservative growth investor. Low institutional ownership leaves room for mutual funds and others to come in and discover the firm and push the share price higher. On the other hand, if 98% of the stock is already owned by institutions, then the most likely decision they'll make next is to sell, and that will create downward pressure on the shares."

• A short-interest ratio of 5% or less: "Considering the way shorts make money, they have to be more dogged and more research-intensive. It's hard to imagine that you or I would know more about any individual stock than the most tenacious participants in the stock market. High short interest is always a warning sign."

• A price-to-earnings ratio lower than the industry average: "There's no substitute for getting in on a stock cheaply. A lower than average P/E increases your chances of finding a stock selling at a discount."

No more misers
Who makes Scrooge's list this year? No one. Not a single stock met our criteria.

Hey, look, I'm bummed too. Scrooge has been so good, so often, that I'd prefer to have his counsel before conducting any year-end portfolio rebalancing. Alas, no such luck.

But is this really so bad? Perhaps the lesson we're to take from our miser's misery is that sometimes the best investing decision is no decision at all. Warren Buffett has followed this advice on occasion with great success. He famously eschewed tech stocks during the dot-com era. And he liquidated the highly successful Buffett Partnership -- which had produced 13 years of 30% average annual returns -- in 1969, when the market had become so overheated as to lack bargains.

I'll not argue we're facing a market similar to the one Buffett stared down in the late '60s. But I'm lucid enough to understand that relaxing investing criteria for the sake of putting money to work is a wonderful way to destroy wealth.

Scrooge wouldn't approve. Neither does this Fool. See you in 2008!

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