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Chapter 11

Security Screening

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity.

General George S. Patton

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Introduction Security screening involves reducing the

security universe down to a manageable size

Picking stocks is an art rather than a science• There is no single best way to choose

individual investments

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Why Screening Is Necessary Time Constraints Everyday Examples of Screens

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Time Constraints The NYSE, AMEX, and Nasdaq list

thousands of potential investments• There isn’t time to analyze every security and

process the associated information

Many people never develop a well-conceived way to deal with the information overload

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Everyday Examples of Screens University Admission Test

• More people apply for admission than are ultimately admitted

• Universities use two steps:– An initial screen

– Closer individual scrutiny for those passing the first round

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The Football Team: Another Everyday Example of Screening

More players try to join the football team than the rosters can carry

Coaches may use screens:• 40-yard dashes for running backs• Bench presses for offensive linemen

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What Constitutes A Good Screen?

Ease of Administration Relevance and Appropriateness Acceptance by the User Ordinal Ranking of Screening Criteria

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Ease of Administration The screen should be easy to administer and

implement

e.g., narrow stocks down to thinly traded stocks by using The Wall Street Journal• Thin trading refers to a security with a

relatively small number of shareholders and a lack of trading volume

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Relevance and Appropriateness Screens should logically have something to

do with the ultimate objective

For example, start at the top of the NYSE listings with your screen

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Acceptance By the User Screens lose value if people fundamentally

disagree with it

For example, people may not believe in SAT scores as a screen for admission

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Ordinal Ranking of Screening Criteria

Use a screen pecking order for multiple-stage screening:• The first screen is the one that eliminates the

most alternatives

• The second screen eliminates the next highest number of alternatives, etc.

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Screening Processes Multiple-Stage Screening Subjective Screening Screening with the Popular Press Only A Quick Risk Assessment Screen with the

Stock Report

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Multiple-Stage Screening Most investment applications require

several screening stages• e.g., earnings per share by itself is not very

useful

• e.g., in choosing a growth stock, it would not make sense to search initially for those with the highest dividend yield

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Subjective Screening Not all screens need to be quantitative

For example, socially responsible investing:• Tobacco stocks, nuclear power, animal testing,

the environment, human rights, etc.• Best of class investing recognizes that all firms

can be faulted in some way and looks for “role models” within each industry

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Screening with the Popular Press Only

Price/Earnings Ratio Dividend Yield Stock Price Exchange Listing Familiarity 52-Week Trading Range Options Availability

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Price/Earnings Ratio Low PEs are good:

• Investors pay little to get a lot

High PEs are good:• The efficient marketplace anticipates that future

earnings will be higher than those of the past

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Dividend Yield Dividends do not materially alter a

recipient’s wealth

People like to receive dividends:• Strokes the ego• Important for income or growth of income

objectives

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Stock Price Some people believe in an optimum trading

range for stock prices The cost of a share should be merely a

marker Some people prefer to avoid odd lots

• e.g., investing $2,000 means the stock price cannot be higher than $20

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Exchange Listing Some clients may want to restrict their

investments to a particular exchange:• AMEX

• NYSE

• Nasdaq

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Familiarity Invest in companies that you know

something about

Familiarity is a subjective criterion

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52-Week Trading Range “The stock is trading at the low end of its

annual high and low”

If the market is efficient, annual highs and lows are of no value in predicting future prices

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Options Availability Some people invest in equity issues that

have options available because they are versatile

Options information is contained in the financial press

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A Quick Risk Assessment Screen with the Stock Report

ROA and ROE Evaluating ROA and ROE

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ROA and ROE The Stock Report contains ten-year histories

of ROA and ROE:• Useful for a quick comparison of companies:

– ROA is net income after taxes divided by total assets

– ROE is net income after taxes divided by equity

– If the firm has debt and positive earnings, ROE will exceed ROA

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Evaluating ROA and ROE A “good, safe investment” has a history of

stable ROA and ROE figures, with ROE somewhat higher than ROA

If ROE is substantially higher than ROA, the firm is heavily leveraged (risky)

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Sources of Information Library Information

• Value Line• Standard & Poor’s• Mergent

Internet• Morningstar• Yahoo!• WSJ.com

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Value Line The Value Line Investment Survey:

• Follows 1,700 common stocks

• Rates each stock in two categories:– Timeliness: the advisability of buying a stock now– Safety: a measure of potential risk with a stock

• Many market analysts attach considerable significance to the Value Line report on a stock

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Value Line Timeliness & Safety Ranking System

RankingNumber of Stocks with This Ranking Meaning

1 100 Best

2 300 Above average

3 900 Average

4 300 Below average

5 100 Worst

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Sample Value Line Report

Source: The Value Line Investment Survey, December 10, 2004. Copyright © 2004 by Value Line Publishing, Inc.: used by permission. For subscription information to the Value Line Investment Survey, please call (800) 634-3583.

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Value Line Investment Analyzer

A 7,500-security database

Can be screened by more than 300 variables

Can be used to prepare statistical summaries and detailed tabular reports

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Standard & Poor’s Stock Report Compustat NetAdvantage

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Stock Report The S&P Stock Report is a one-page

document that:• Is updated quarterly• Contains a description of a company• Contains an estimate of what the future holds

for a company• Contains financial statement information,

dividend payment dates, beta, and other risk measures

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Sample S&P Stock Report

Source: Standard & Poor’s Stock Guide (New York: Standard & Poor’s Corporation, 2004): Reprinted with permission.

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Compustat Used by academic researchers Available for mainframe and personal

computers Hundreds of screening variables include:

• Current ratio• Retained earnings• Unfunded pension liabilities

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Mergent Mergent’s Manuals Mergent Dividend Record

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Mergent’s Manuals Mergent’s Manuals:

• Contain seven sets of volumes covering industrial firms, public utilities, over-the-counter industrials, transportation issues, and bank/finance issues

• Include the Company Archives Manual, which provides data on defunct companies since 1996

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Mergent Dividend Record Mergent Dividend Record:

• Contains information on the recent dividend history of a company, including:

– Payment dates

– Ex-dividend dates

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Internet Examples of good sources:

• http://finance.yahoo.com • http://www.smartmoney.com• http://www.morningstar.com• http://www.fool.com• http://www.bloomberg.com

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Yahoo!® Finance