Is a stock screener a worthwhile stock picking tool?

The hardest part of deciding which stocks to invest in is finding what criteria you need to look for in a company. I am a huge value investing fan – so I look for companies that can be purchased at a fraction of what they are really worth. One of the tools you can use to find these undervalued shares is a stock screener.

Some brokerages services offer you a screener on your online account – others don’t.

What is a stock screener, and where do you find it?

A stock screener is a tool you can use to filter stocks with certain criteria.

Most online brokers have them these days. Then there’s Yahoo and Google Finance as well as a string of international services that offer stock screeners too such as Koyfin and SimplyWall.st.

So, what you’d do with a stock screener is select a range of criteria to help you find stocks that are ‘discounted’.

Remember, a number or ratio may look good, but it is important to understand why that number looks good, or if it looks “too” good.

These key value stock criteria will help you do just that.

Your fundamental stock picking checklist

When I look for great value stocks, I typically start out with this set of FIVE fundamental criteria.
Identifying stocks with the FIVE specific metrics outlined below are your key to properly diagnosing the financial health of a stock. Of course, past results don’t guarantee future success, but they are the best tools to predict future winners.

Investment criteria #1 – Trading volumes must be sufficient

There’s no use investing in a stock that you’ll struggle to sell again. Many value stocks are penny shares and typically have low liquidity. So, it is important you include this criterion, LIQUIDITY on your list.

I typically screen for stocks with R50,000 or more daily trade volumes. Even better would be screening stocks with R100,000 trade volumes.

Adding this criterion to the list you use when picking a stock is crucial. You really don’t want to end up with R50,000 worth of shares in a stock that only trades R5,000 a day.

Investment criteria #2 – You want to pick a stock that is making money

The PE ratio (Price Earnings ratio) is a valuation ratio of a company’s earnings per share compared to its current share price. Generally, a high P/E means the market is bullish on a stock, but it can also signal a stock is overpriced. What we look for is a stock trading at a cheaper level than the industry average. This means we can get a better deal on a stock compared to its peers.

Typically, we look at investing in stocks with PEs lower than 15.

I need to stress however the PE ratio is not the most important ratio when investing in a stock – it is simply one of the ratios we consider.

Investment criteria #3 – Debt should be manageable

Debt-to-equity (D/E ratio) measures a company’s liabilities compared to its stockholders’ equity.

That means – how much the company owes compared to how much it is worth.

In general, a high debt-to-equity ratio means a company has been aggressively financing its growth with debt. As with P/E, we want to see where a company stands compared to its peers since some industries are more capital-intensive than others. But we prefer investing in companies with a D/E lower than 2.

Companies with conservative debt tend to survive tough economic times.

Investment criteria #4 – Does the company make a sufficient return on investment

Return on Equity (ROE) tells us how effective a company uses the cash it receives from investors to grow your money.
This is another metric that is useful in comparison to other companies in the same industry.

I like companies with ROEs above 8% a year. A lower ROE means a sluggish company that isn’t making the most of the money and assets it holds.

Investment criteria #5 – Does the share sell for less than it is worth?

The price to book ratio (or price to NAV ratio) compares the share price to the accounting value of a business.
The book value of a company is the company’s total tangible assets less its total liabilities.

This ratio gives you an idea of how much an investor could have if the company went bankrupt immediately or held a sale selling all its assets all at once.

A P/B Ratio of less than one can signal that a company is undervalued, or that the value of its assets minus liabilities is currently worth more than the share price. So, if the company went bankrupt immediately, you could actually make more money than by selling the share on the open market (although highly unlikely).

The important thing to remember is book value varies greatly for different industries. Also, a company in distress may have many more liabilities than assets, making this number meaningless. Finally, the book value does not include brands and intellectual property, which some companies use as their main asset. IT companies are examples of businesses where the book value isn’t a great indicator of the value of the company.

Now that you know this great fundamental recipe you can set up a ‘watchlist’ of stocks you should keep an eye on as possible buying opportunities.

And always remember – these criteria on their own just help you weed out the good shares from the bad ones.

You still have to research further before making a buying decision.

If you would rather the hard research be done for you that’s where Red Hot Penny Shares can help. Every month, I research the best value small caps buys on the JSE and publish my top selection. I also provide regular updates on existing stocks in my portfolio, dividend announcements and most importantly when to sell.