I became interested in the power of stock screening in 1997. I'd just finished The Motley Fool Investment Guide, a book that not only introduced me to the Fool (and led to my eventual employment here) but also highlighted a nifty tool called the Foolish 8 (F8) screen, which produces a list of small-cap stocks worthy of further research.

I've since developed a separate, modified version of the F8, which added some elements of valuation and management effectiveness. Even though neither screen is designed to be used in a mechanical manner, backtesting by the American Association of Individual Investors (AAII) shows total returns of 429% for the original F8 and 498% for the Modified F8 since 1998. By comparison, the S&P 500 and the S&P SmallCap 600 have returned 23% and 78%, respectively. (You can learn more about the criteria here.)

Both screens are produced every month for subscribers of our Motley Fool Hidden Gems newsletter, and today I want to highlight a few of the passing companies and introduce the beginnings of a new screen.

Crazy 8s
Four of the 24 companies that passed the two F8 screens this week tell me we're still on the right track with the criteria. Quality Systems (NASDAQ:QSII) and SS&C Technologies (NASDAQ:SSNC) appear on the original F8 screen, and Tom Gardner has recommended both in the Motley Fool Stock Advisor newsletter.

Quality Systems, which makes software to help doctors and dentists keep track of their medical records, was twice selected by Tom back in 2003, and is up an average of 345% -- compared with the S&P 500's 44% gain. Business software maker SS&C Technologies has also done very well, rising 85% since the October 2004 recommendation. That tops the S&P's 6% spike.

Another F8 stock this week is Vasco Data Security International (NASDAQ:VDSI). This company designs identity authentication hardware and software products that enable secure financial transactions over the Internet and other systems. Tom placed Vasco on his Hidden Gems Watch List last December. Since then the stock has risen 63%.

Finally, one from the Modified Foolish 8 screen: USANA Health Sciences (NASDAQ:USNA). Tom offered this network marketer of nutritional supplements as a bonus recommendation in March 2004, and it has beaten the S&P 46% to 8%.

I want to pause and emphasize a couple of things here. First, not every stock Tom has recommended does this well. Eight of his formal Hidden Gems recommendations are underwater, for example, as are 11 of his Stock Advisor picks. Still, the majority of his stocks have been winners, and his total average returns are easily beating the market.

Second, you're probably thinking: It's great that these stocks have done so well, but do these screens show me only past winners? While you'll see some stocks that have done well in the past -- especially on the original F8, which selects high-momentum companies -- rest assured that at least two of the businesses above appeared on the screens many months ago (Quality Systems and USANA Health Sciences). And remember, the AAII data show outstanding total performance for the seven-and-a-half-year backtesting period.

Screening in a different direction
Since these screens seem to be somewhat in tune with Tom Gardner's thinking, I'd like to take another shot at incorporating more of the thought processes he uses when digging for new small-cap winners. Among the things he likes to see:

  • Accelerating sales growth, which indicates a business moving in the right direction.
  • Strong insider ownership, which usually aligns the interests of those running the business with outside shareholders.
  • Little or no analyst coverage, meaning the company is still obscure and more likely to offer value through mispricing.
  • A standout company in an out-of-favor industry, which may point to a stock that has been unfairly punished by the market.

There are many more, but I'm going to stop here as I slowly build out this screen over the coming months. Thus, the screen searches for:

  1. Positive sales growth.
  2. At least 15% insider ownership.
  3. Three or fewer analysts covering the stock.

In addition, I limited the list to companies associated with the beaten-down airline, automobile, semiconductor, or discount retail sectors, as well as any industry that may be suffering because of high oil prices. Finally, I required a market cap of $200 million or greater. Twelve companies passed the screen:

Stock Ticker Industry
AB Volvo VOLVY Auto & Truck Manufacturers
ADE ADEX Semiconductors
ARM Holdings ARMHY Semiconductors
China Eastern Airlines CEA Airline
China Southern Airlines ZNH Airline
Fiat FIA Auto & Truck Manufacturers
Hayes Lemmerz HAYZ Auto & Truck Parts
Marten Transport MRTN Trucking
Republic Airways Holdings RJET Airline
Retail Ventures RVI Retail (Department & Discount)
TNT N.V. TP Trucking
World Air Holdings WLDA Air Courier

Of interest are ARM Holdings (NASDAQ:ARMHY), a two-time David Gardner Stock Advisor recommendation that is trailing the market 8% to 28%, and ADE (NASDAQ:ADEX), another Hidden Gems Watch List stock, which is beating the market 15% to 10%. There also are quite a few foreign companies on the list that trade as American Depositary Receipts in the United States.

I'm not formally recommending any of these stocks because I've not done any research on them. But then, that's the purpose of the screen ... to produce a list of companies for further research. To that, I say, dig in!

The entire list of Foolish 8 and Modified Foolish 8 stocks is available each month in Hidden Gems. Recommendations fromTom and his guest analysts have produced total average returns of 35% in the two years since the newsletter's inception, compared with 9% for the same amount invested in the S&P 500.You're invited to try a free, no-risk trial for 30 days. Click here to learn more.

Rex Moore is not allowed to operate heavy machinery or complicated microwave ovens while screening for superior stocks. He owns no companies mentioned in this article. The Motley Fool has a disclosure policy.