Scrooge Stocks Up Again

Would Scrooge have been a good investor? I'm not so sure. Charles Dickens' legendary miser hoarded money, eschewing risk. I have a hard time believing he'd have invested in anything more than a low-yield savings account.

But greed is still greed, and when it comes to investing, it can be good. Just ask Foolish friend Hewitt Heiserman Jr., author of the must-read It's Earnings That Count and administrator of an excellent discussion board here in Fooldom that's dedicated to cautiously greedy investing.

A miserly stock screen
Heiserman is an outstanding investor and member of the Boston Security Analysts Society. For the past two years, I've relied on his counsel to generate a handful of ideas for the coming year. The goal? Seek cheap stocks possessing a high degree of earnings quality.

Here's the list of criteria we plugged into our favorite screener at MSN Money, along with Heiserman's reasoning for each:

• 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."

Greed is still good
During 2005, the Scrooge screen beat the S&P 500 by 9.8 percentage points. It did even better during 2006:

Got that? Our conservative growth portfolio beat the index -- represented here by the S&P 500 SPYDR exchange traded fund -- by more than 15 percentage points. Sweet.

Don't pour the egg nog ... yet
How did it happen? Two cyclical winners propelled our gains: Korean steel producer POSCO (NYSE:PKX) and Peruvian miner Southern Copper (NYSE:PCU). We caught both as demand and commodity prices were on the rise.

But they also had excellent fundamentals. For example, Southern Copper had a 40% return on equity and a P/E equal to roughly one-third its expected growth rate. (Find out why that's a bullish sign.)

Then there were dividends. POSCO was yielding 3.3% at the time of last year's screen, while Southern Copper was yielding 9%. When reinvested, these meaty payouts contributed heavily to our market-crushing performance.

But I blew it with Florida's cheap housing specialist, Nobility Homes (NASDAQ:NOBH). I thought it would do great because it had many of the characteristics Tom Gardner and Bill Mann seek in Motley Fool Hidden Gems: a boring but profitable business model, heavy insider ownership, and accelerating owner earnings.

Unfortunately, owner earnings stopped accelerating. And following a pretty weak fourth quarter, the company said it has hired an advisor to "seek strategic alternatives" -- code-speak for shopping for a buyer.

What went wrong? Like Southern Copper and POSCO, Nobility is a cyclical, but we caught it as the real estate bubble began to deflate. Plus, at 1.38, the firm had the highest price-to-earnings-to-expected growth (PEG) ratio in last year's portfolio. I didn't think that would much matter, given the other factors working in its favor. Big mistake.

More stocking stuffers
Still, the overall market-beating performance of this screen tempts me to run it again. This time, MSN found 41 stocks that could prove worthy. But only three trade for far less than their expected growth rates:

Are any of these three worth owning? I'm inclined to hold the entire portfolio, given the last two years' worth of results. But there's a danger in doing so. This year's portfolio is much smaller than in years past. And Streamline Health, while potentially promising as a health-care software provider, is still burning cash. It's also a microcap stock.

Compania de Minas Buenaventura and Rio Tinto, on the other hand, are dividend-paying metal miners. Yet where one operates primarily in Latin America, the other owns vast interests in Australia, Africa, and Asia. And both are highly rated by the investors participating in Motley Fool CAPS. Color me intrigued.

Bah humbug
I'm not inclined to single out a stock worth owning in this year's portfolio. But that's fine. Like Scrooge, the best investors are ruthless when it comes to screening stocks. That, after all, is the surest path to the greatest of all portfolio gifts: massive returns.

Foolish best wishes for a Merry Christmas to you and yours!

Foolanthropy is celebrating its 10th year! To learn more about our five Foolish charities or to make a donation, visit www.foolanthropy.com.

Small, unloved, and ripe for multibagger gains -- that's how Tom Gardner and Bill Mann like their stocks. The Hidden Gems portfolio has beaten the S&P 500 by 24% since inception. Sound intriguing? Try it free for 30 days.

Fool contributor Tim Beyers, ranked 805 out of 18,099 in CAPS, is greedy when it comes to his family. They deserve the best, after all. Tim owns shares of Taiwan Semiconductor. Get the skinny on all the stocks in Tim's portfolio by checking his Fool profile. POSCO is an Income Investor pick. The Motley Fool's disclosure policy is in a giving mood.