Jim has generously shared numerous screens that produce high returns. Successful screening criteria include things such as ROE, revenue growth and P/E. The common denominator in all of these backtests is screening for the top few percent of stocks in the database using the given criterion. Table 7.2 in “The Little Book That Beats the Market” shows the returns by decile of 2500 stocks as ranked by the magic formula, a screen that used two criteria, one for profitability (return on invested capital) and one for cheapness (earnings yield). The returns were:
top decile, 17.9%
2nd decile, 15.6%
bottom decile, 2.5%
S&P 500, 12.4%
Simply by screening for the top 10% by the selected criteria, the return increased 5 percentage points relative to the median. If one plots these returns by decile and extrapolates to the top 5%, the implied return is 6% above the median.
I’m really just stating the obvious, but the basic trick is to select one or more criteria upon which return logically depends, and then to buy the stocks in the top 5% or 10%. In mechanical investing one generally buys all the stocks that pass the screen, but it’s not absolutely necessary to do so. One can start with a universe of, say, the largest 2000 stocks by market cap, and then screen by one or more criteria to get the top 100 stocks (5% of the universe), and then choose the 25 that one likes the most after applying other criteria such as quality of product or service, market share, debt/equity or what have you. The important thing is to stay within the top 5% to 10% by one’s primary criteria.
Three criteria that work well are (1) some measure of profitability (such as 5-year average ROE or ROA), (2) some measure of growth (such as 5-year average revenue growth) and (3) some measure of cheapness (such as normalized earnings yield), but as Jim has shown us, using a single criterion works very well.
Like I say, I’m just restating what others have already shown, but such screens are useful. They generally turn up some good companies, such as Alphabet.