How do you find new investment opportunities?
Most people probably use stock screeners as a quick way to crunch everything that is actively traded and spit out a handful of tickers meeting certain criteria that may warrant a closer look.
How quaint! 😉
My journey so far through the CFA Program – financial statement analysis in particular – has utterly destroyed any confidence I had in screeners’ abilities to either filter out the portfolio torpedoes or not filter out the gems. Engineers like to speak in terms of “signal” and “noise”. And the unadjusted financial ratios used by most screeners are signals greatly corrupted by noise. Legal noise… mostly… I hope… but noise nonetheless.
Active investors have two choices. One is to keep using screeners, but in the framework of a portfolio of 20-30+ stocks. Then, just as company-specific risk can be diversified away, so too may the noise affecting your investment decisions be “averaged out”.
I use to take comfort in this approach. Then I remembered that for noise to average out, it must be uncorrelated. I’m not so sure this is the case for financial ratios. If the dishonest companies all use roughly the same (legal) accounting tricks to put lipstick on their pigs, does that sound uncorrelated? Certainly for every company that is making their business look better than it really is, there’s not another intentionally making theirs look worse!
Sticking with the engineering aphorisms, there was another one – source long since forgotten – about a sort of Heisenberg Uncertainty Principle concerning financial ratios. The thinking was, as soon as a ratio (e.g. Return on Assets) becomes popular, with an agreed upon numerical range for what is good and what is bad, it is guaranteed that accountants will do whatever they can get away with to steer their companies’ numbers towards the attractive range. The more popular the ratio, the less reliable it may be.
The active investor’s other option is to give up on the screeners and give up on the hope of accurately judging books by their glossy covers. Any company may be a good investment at the right price, and you just don’t know until you dig through the financial statements, MD&A, footnotes, etc. to find out. This is akin to saying that your ideal screener should have no filters.
As if I really needed another distraction, I recently downloaded the iPhone SDK and coded up a simple app for no filter screening. Apple finally declared it fit for public consumption a couple days ago…
It’s designed to do one simple thing – generate random stock tickers and, if valid, load up a preview for you on either Google or Yahoo Finance. It may help you come across some low-volume value play that you otherwise would never have known existed – or revisit a well-known large cap you’d previously written off.
And since the tickers are completely random, you’re open to coming across the occasional interesting quant strategy ETF or commodity mutual fund too. Hope it’s useful – link to the iTunes page for the app is below.
Click Here for Random Ticker Generator at iTunes App Store