Scrooge Finally Slips Up

After five years of treating Mr. Market like Bob Cratchit, Ebenezer Scrooge received his comeuppance in 2010.

Since 2004, I've been teaming with Hewitt Heiserman Jr., author of the excellent It's Earnings That Count, to generate a list of stocks that cautiously greedy investors may wish to consider for the year ahead. Last year's picks lost to index for the first time in the screen's history:

Source: Motley Fool CAPS, Yahoo! Finance.
*Adjusted for dividends and other returns of capital.

And here's a complete history of the miser at work:

Source: Motley Fool CAPS, Yahoo! Finance.
*The Scrooge screen made no picks in 2008.

Heiserman pulled from his book to build the original screen in 2004. In 2008, we revised it to look for a below market average P/E ratio, rather than a below industry average P/E ratio. We did this partly because of the limitations of screening in MSN versus the more powerful Capital IQ, but mainly because we wanted to widen our search for bargains.

In either form, Scrooge has proven to be a superior bargain shopper.

How good, you ask? Had you been lucky or prescient enough to put $10,000 into a Scrooge portfolio at the beginning of 2005, rebalancing in the years following, you'd have $30,697 today, taxes excluded. That's a 20.6% annualized return. A similar investment in the S&P 500 would have earned just 2.6% a year over the same period, giving you $11,680 pre-tax.

Heiserman attributes Scrooge's dominance to combining above-average profitability with below-average valuation, two characteristics that Dickens' fictional miser might find pleasing were he real and investing today.

2010: when Scrooge searches for scraps, scram
So that's the overall picture. Now let's dig into the details. Scrooge reversed himself in 2010. After years of getting big returns from mid-caps, the miser squeezed his best performance from small cap Stepan Co.

For this column, we define small caps as stocks worth $250 million to $2 billion in market cap. Mid caps range from $2 billion to $15 billion in market cap. We consider anything worth more than $15 billion to be a large cap. Stepan was worth less than $700 million in market value at the time of last year's picks.

Dividends played a key role in the chemical producer's outperformance, whose stock yielded 1.4% as of this writing. Management paid year-over-year dividend increases of between 8% and 9% in every quarter of 2010, as revenue grew. Outperformance followed.

Mid-cap SAIC wasn't so lucky. Valuation may have been the issue. Not even a month into its reign as a member of the Scrooge portfolio, SAIC insiders began selling shares. Institutional selling followed, and despite some subsequent buying among executives and board members, the stock has yet to recover.

And that hurt us. With only two stocks in the portfolio, we lacked the flexibility to withstand a bad pick. Since Scrooge had never been perfect -- GigaMedia was a big loser in 2009, and Compania de Minas Buenaventura lagged in 2006 -- we entered 2010 nervous about the streak. Turns out we had good reason.

How to be a Scrooge
So be it. Stock picking is an imperfect science. The best we can do is look for good, growing businesses selling at good prices. Here's what the Scrooge screen seeks:

• Average five-year revenue growth of 8% or better: Weeds out one-hit growth wonders.
• Annual earnings-per-share growth of 7% or better over at least the past 12 months: Spot growth while it's accelerating, rather than the reverse.
• Average five-year return on equity (ROE) of 10% or better: Good management will produce good returns.
• Debt equaling no more than half of equity: Weeds out the could-go-bankrupt-if-creditors-called-at-the-wrong-time crowd.
• Institutional ownership of 60% or less: Undiscovered firms are often the market's multibaggers in the making.
• A short interest ratio of 5% or less: High short interest could be reflective of fundamental problems.
• A low price-to-earnings ratio: We choose a P/E of less than 14, before excluding special items -- a bit below the trailing P/E of the S&P 500 SPDR.

Be cautiously greedy with these six stocks
Six companies pass this year's Scrooge test. We like this. Having a larger list offers protection from Scrooge's known weaknesses with picking small caps -- important since none of the 2011 qualifiers command even $1 billion in market value:

Source: Motley Fool CAPS, Yahoo! Finance.
* Adjusted for dividends and other returns of capital.

As is custom, we'll buy shares of these stocks for our personal portfolios. Scrooge may have had an off year, but we still believe in the screen and its cautiously greedy approach to picking stocks.

As Heiserman said when we began, quoting the legendary investor John Neff: "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."

Six years later, it still is.

Now it's your turn to weigh in. What do you think of this year's Scrooge picks? How about the screen in general? Make your voice heard using the comments box below.

These six stocks may be Scrooge's picks for the best stocking stuffers, but our Foolish team of analysts has identified one positioned to beat all others in 2011. Find out which stock they're betting on by checking out this free special report.