Screening for Rising Stars

One of the major goals of my Rising Stars portfolio is to introduce and explain the various screens I use to find great stocks. (Another major goal is to make money. Of course.)

This article will show you how easy it is to construct a screen for almost any interesting investing ideas you come across.

The setup
This particular screen was born out of my work with Motley Fool co-founder Tom Gardner for the Hidden Gems service. Tom is always studying winning and losing stocks in order to learn how to better find the champions and avoid the dogs -- and I help him as best I can. A few years ago, we studied all of the Hidden Gems winners to find out what they had in common. We found many of them shared these seven traits:

1. Double-digit rising sales
We view this as one of the most telling indicators of a real growth company. We love earnings growth as well, but earnings are too easily manipulated. Revenue growth, however, is a pretty pure marker of rising demand and pricing power.

2. Rising free cash flow and book value
While earnings can be fudged, cash is where it's at -- and great businesses generate lots of it. A company that's growing both its free cash flow and book value is on the right track.

3. Improving margins
The ability to take in more and more profit from each dollar of sales is an indication of competitive advantages and efficient management.

4. Rising return on equity
We use ROE as a decent proxy for how well a company allocates capital -- what Warren Buffett calls the most important aspect of management.

5. Insider ownership
This one's no surprise to all you veteran Fools out there. As shareholders of a company, we are part owners of the business, and we'd like a significant portion of management to be our co-owners. That way there's more incentive for them to act in our best interests. We look for insider ownership of 5% or more.

6. Regular dividends
There's research out there that indicates dividend-paying companies tend to be better at managing capital and growing earnings. We feel that the pressure of making quarterly cash payments forces a certain discipline on managers, and deters them from such destructive habits as "empire building" -- that's when companies in search of something to do with their cash start making less-than-ideal acquisitions.

7. Out-of-the-way success
Many big winners come out of relative obscurity and are never media darlings or hot IPOs.

Armed with that information, the natural question to ask is "How can I find companies that meet these standards?" Well, by screening, of course! Armed with my awesome Capital IQ screening tool, I looked for companies larger than $200 million in market cap that met the following criteria over the past 12 months:

• Total revenue growth 10% or better
• Free cash flow growth greater than zero
• Book value growth greater than zero
• Net margin growth greater than zero
• ROE growth greater than zero
• Insider ownership 5% or better
• Dividend yield greater than zero

The only thing I couldn't screen for is out-of-the-way success, but we can do that mentally at the end.

Out of the 3,682 companies on U.S. exchanges with a market cap of $200 million or greater, only 15 companies passed the screen:

Source: Capital IQ, a division of Standard & Poor's.

If you're looking for a free screening tool, start with the Motley Fool CAPS screener. It can't do everything the industrial-strength Capital IQ is capable of, but it's a good start.

The work begins
I'll be looking through these companies to see if any are right for my multivitamin portfolio. I'm already quite familiar with Paccar; I've owned it personally since 2005, and it's more than doubled for me during a period in which the S&P 500 has gained about 10%.

I'll report back on my findings at a later date. To keep up, simply follow me on Twitter, bookmark my archive page, or check in on my discussion board. Finally, if you're interested in any of the companies I listed, add them to your very own personal watchlist!