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February 2006 9

What does it take to become What does it take to become Wa winner?

Several stock market strategists have undertaken studies to answer that question, in the belief that win-ning characteristics could be used to fi nd future winners.

The CAN SLIM stock screen ap-proach, developed by William O’Neil, was based on the analysis of the common traits of the biggest stock market winners dating back to 1953. This approach—which because of its focus is classifi ed as a growth screen—has become one of the most popular, and best performing, strategies tracked by AAII. Other studies, however, have focused on different winning characteristics.

In an article in the September 1989 issue of the AAII Journal titled “Investment Characteristics of Stock Market Winners,” Marc Reinganum examined the common traits of a group of winning stocks. Based on Reinganum’s research, AAII developed the Stock Market Winners screen, which we classify as a growth and value approach. Last year, this screen was one of the top performers (it came in fourth overall, and was the second-best growth & value screen, after the Zweig screen). It also has an impressive long-term record, although year-by-year the returns have been volatile and the long-term performance record was boosted by a phenomenal return in 2003.

Defi ning the “Winners”

Reinganum’s study examined 222 stocks highlighted in a publication by (ironically) William O’Neil & Co. titled “The Greatest Stock Market Winners: 1970 to 1983.” The goal was to establish the characteristics that were common

to these stocks prior to their rise to super prior to their rise to super priorstock status.

Reinganum then developed nine trad-ing rules to help to identify the winners:• A price-to-book-value ratio less than 1.0;• Accelerating quarterly earnings;• Positive fi ve-year growth rate;

• Positive pretax profi t margin;• Relative strength rank of at least 70;• Relative strength rank of the stock in the current quarter

is greater than the rank in the previous quarter;• O’Neil Datagraph rating of at least 70 (a weighted com-

bination of earnings, capitalization, relative strength, and other factors where 1 is the lowest and 99 is the highest rating);

• Stock selling within 15% of its two-year high;• Fewer than 20 million common shares outstanding.

Based on these trading rules, we developed our own Stock Market Winners screen, which attempts to quantify as many of these rules as possible. You can fi nd the screening criteria for this strategy at the end of this article to see how our interpretation differs from the original. Stock Investor Pro, AAII’s fundamental stock screening and research database, includes the Stock Market Winners screen.

Performance

Figure 1 shows the performance of the Stock Market Winners screen. Outside of 1998, the stocks passing this screen have been able to generate positive returns each year. Overall, the Stock Market Winners screen has managed to outperform the small-, mid-, and large-cap indexes over the

Screening for the

Future Stock Market Winners

By Wayne A. Thorp, CFA

AAII Journal10

AAII Stock Screens

screen.Because of this strict value-oriented

rule, it is probably not surprising that the companies passing have a lower price-earnings multiple, 13.8, than the typical exchange-listed stock as well as a

lower median price-to-book-value ratio (1.24 versus 2.31).

The low price-to-book screen identifi es neglected stocks, but many of those stocks deserve to be neglected. Therefore, secondary, or conditioning, screens are needed to help identify ne-glected stocks that may be poised for a turnaround.

One of these so-called condition-ing fi lters in the Stock Market Winners screen requires that earnings from continuing operations for the most two recent quarters (Q1 and Q2) be above their respective quarters a year ago (Q5 and Q6, respectively). Comparing one quarter to the same quarter last year eliminates the seasonality in earnings that many companies experience.

To capture companies with acceler-ating quarterly earnings momentum, the Stock Market Winners screen also requires that the rate of change between the re-cent quarter and its counterpart last year be greater than the increase between the previous quarter and its counterpart.

Figure 1. Stock Market Winners Screen

-100%

0%

100%

200%

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400%

500%

600%

700%

800%

1998 1999 2000 2001 2002 2003 2004 2005

S&P 500

Stock Market Winners

MonthlyStd. Dev.

1998 1999 2000 2001 2002 2003 2004 2005 Cum'l* (%)Stock Market Winners (12.0) 21.7 27.6 41.6 32.1 131.5 9.6 25.9 716.4 7.0S&P 500 26.7 19.5 (10.1) (13.0) (23.4) 26.4 9.0 3.0 28.6 4.6S&P MidCap 400 17.7 13.3 16.2 (1.6) (15.4) 34.0 15.2 11.3 121.4 5.5S&P SmallCap 600 (2.1) 11.5 11.0 5.7 (15.3) 37.8 21.4 6.7 93.6 5.8All Exchange-Listed Stocks 5.9 35.1 (14.2) 21.2 (13.3) 81.1 22.8 4.5 199.9 6.6*Price performance of hypothetical portfolio rescreened and rebalanced monthly using month-endclosing prices and no transaction costs.Data as of December 31, 2005.

Return (%)

eight-year period, gaining a cumulative 716.4% between January 1998 and the end of 2005, compared to a 28.6% increase for the S&P 500.

Profi le of PassingCompanies

The characteristics of the stocks passing the Stock Market Winners screen as of January 13, 2006, are presented in Table 1.

Eight companies passed the Stock Market Winners screen as of January 13, 2006, and are listed in Table 2 in ascending order by price-to-book-value ratio. The cur-rent group of passing companies numbers less than half of the historical average of 17. The Stock Market Winners screen has some of the highest turnover of all the strategies AAII tracks—on average, 60.4% of the portfolio is replaced each month.

Unlike the CAN SLIM ap-proach, which is focused on earn-ings and price momentum (with no value elements), the cornerstone of the Stock Market Winners screen requires a price-to-book-value ratio of less than 1.5. The maximum level is higher than the original study so that a slightly larger group of companies would pass the overall

Table 1. Stock Market Winners Portfolio Characteristics

All Stock Exchange- Market ListedPortfolio Characteristics (Median) Winners StocksPrice-earnings ratio (X) 13.8 20.6Price-to-book-value ratio (X) 1.24 2.31Price-to-sales-ratio (X) 1.47 1.94EPS 5-yr. historical growth rate (%) 24.7 9.9EPS 3-5 yr. estimated growth rate (%) na 14.7Market cap. ($ million) 30.9 449.0Relative strength vs. S&P (%) 17 –1 Monthly Observations Average no. of passing stocks 17 Highest no. of passing stocks 60 Lowest no. of passing stocks 1 Monthly turnover (%) 60.4

February 2006 11

By isolating companies with posi-tive and accelerating quarterly growth in earnings, companies passing the Stock Market Winners screen have long-term earnings growth rates greater than the typical stock: 24.7% for the passing companies as compared to 9.9% for the typical exchange-listed stock.

Another element of the Stock Market Winners strategy is to identify stocks that have already shown upward price momentum. To this end, the screen makes use of a weighted relative strength measure that emphasizes more recent price performance by giving the most recent quarterly price change relative to the S&P 500 a weight of 40% and each of the previous three quarters a 20% weighting. Stocks passing the screen must have a weighted relative

strength value that is greater than 70% of all stocks.

The stocks passing the screen as of January 13, 2006, have outperformed the S&P 500 by 17 percentage points over the last 52 weeks, while the typical exchange-listed stock lagged the S&P by one percent-age point over the same period.

Lastly, the Reinganum study found that 90% of the fi rms had fewer than 20 million shares outstanding before their main price increase, and this is the limit used in the AAII Stock Market Winners screen. Limiting the number of shares outstanding leads this screen to isolate very small companies in terms of market capitalization (shares outstanding multiplied by price per share).

The stocks currently passing the screen have a median market capitaliza-

tion of $30.9 million whereas the typical exchange-listed stock has a market cap of $449.0 million.

Conclusion

No matter how well a stock screen-ing methodology has performed (or underperformed) over the long term, it is important to realize that stock screening is only the fi rst step in the stock selection process. The stocks passing the Stock Market Winners screen do not repre-sent a “recommended” or “buy” list of stocks. It is important to perform due diligence to verify the fi nancial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before com-mitting your investment dollars.

Table 2. Companies Passing the Stock Market Winners ScreenTable 2. Companies Passing the Stock Market Winners ScreenTable 2. Companies Passing the Stock Market Winners Screen

Price Pretax Avg as % EPS Growth Marg Shares Rel 52- P/B Q5 to Q6 to 12- Out- Strgth Wk Ratio Q1 Q2 5 Yr Mo stand’g Idx Hi Company (Exchange: Ticker) (X) (%) (%) (%) (%) (Mil) (%) (%) Description

Datalex plc (ADR) (O: DLEXY) 0.46 124.4 103.4 60.0 4.4 10.34 95 91.2 info tech prods/servsACMAT Corp. (O: ACMTA) 0.89 40.7 36.4 1.2 12.2 2.32 81 96.0 insurance for constr’nMilastar Corp. (O: MILAA) 1.02 33.3 14.3 26.9 8.8 2.72 77 88.9 metallurgical engin’gAmerican Bank Hldgs. (O: ABKD) 1.17 36.4 25.8 22.4 29.3 2.10 77 93.6 bank holding companyFirstbank NW Corp. (M: FBNW) 1.30 37.5 16.7 14.3 22.0 2.93 71 100.0 bank holding companyPeoples BancTrust (M: PBTC) 1.30 9.4 3.8 2.8 21.8 5.88 71 92.4 bank holding companyCitizens First Corp. (O: CZFC) 1.37 114.3 100.0 29.5 28.2 0.89 71 94.7 bank holding companyAmer. Physicians Serv. Grp. (M: AMPH) 1.38 262.5 82.1 80.2 24.8 2.70 74 86.8 invest advisory servs

Exchange Key: M= NASDAQ National or NASDAQ Small Cap Market, O=Over the counter.Source: AAII’s Stock Investor Pro/Reuters Research Inc. Data as of 1/13/2006.

What It Takes: Stock Market Winners Screen Criteria• The price-to-book ratio is less than or equal to 1.5 • Earnings per share from continuing operations for

each of the last two fi scal quarters (Q1 and Q2) are greater than the earnings per share from continuing operations for the same quarter one year prior (Q5 and Q6)

• Same-quarter growth in earnings per share from continuing operations from Q5 to Q1 is greater than the same-quarter growth in earnings per share from continuing operations from Q6 to Q2

• The fi ve-year growth rate in earnings per share from

continuing operations is greater than zero • The weighted relative strength for the last four quarters

ranks in the top 70% of the entire database (percent rank greater than or equal to 70)

• The pretax profi t margin for the last 12 months is positive

• The current stock price is within 15% of the high-est price at which the stock has traded over the last two years

• The average number of shares outstanding for the last fi scal quarter (Q1) is no greater than 20 million

Wayne A. Thorp, CFA, is fi nancial analyst at AAII and editor of Computerized Investing.