Today I want to share a stock-picking method with you that’s worked really well for me in recent years. Screening means using a pre-defined set of rules to narrow down your potential ‘universe’ of stocks.
In my experience, screening provides two big benefits. The first is that with about 3,500 stocks listed in the UK, there simply isn’t enough time to review every one. Even if you restrict yourself to the FTSE 100 or FTSE 350, that’s still a lot of stocks to consider. Using a screen can reduce this number dramatically. This gives you time to focus on the companies that are of most interest.
The second benefit is that screening can help you avoid stocks you shouldn’t buy. In my experience, avoiding big losses is just as important as picking winners if you want to beat the market. The reason for this is simple. If you make a 50% loss, you need a 100% gain just to get back to where you started. That’s not easy.
Get started with this simple screen
The widespread availability of financial data on the internet means that screening tools are more widely available than ever. There are a number of free services out there, as well as more sophisticated subscription services.
For this example, I’ve decided to focus on the FTSE 100. I’m looking for stocks that are affordable, offer an above-average dividend yield and don’t have any obvious financial problems, such as too much debt.
By using four simple rules, I’ve been able to reduce the FTSE 100 from 101 stocks down to just 25. Here are the rules:
Forecast price/earnings ratio < 16
Forecast dividend yield > 3.5%
Net debt < 3x after-tax profit
Price/book ratio > 0
Narrowing down the FTSE 100 in this way gives me a choice of 25 stocks from five different sectors.
What’s on offer?
These screening results include a number of stocks from my own portfolio, such as mining giant Rio Tinto and insurance firm Aviva. Both companies are performing well at the moment and offer well-supported dividend yields of more than 5%.
Other stocks that might be of interest include easyJet and British Airways owner International Consolidated Airlines. Both companies are growing strongly, despite fears that rising fuel prices could put pressure on profit margins.
This screen also flags up some potential opportunities in the financial sector. Many banking and insurance stocks are still out of favour, despite improving performances. In my view, stocks such as Royal Bank of Scotland and HSBC Holdings look good value at current levels.
Most portfolios also benefit from some defensive stocks. Many of these are too expensive to qualify for my screen, but a few choices are available. Tobacco giant British American Tobacco remains a popular income pick, while supermarket group J Sainsbury and defence group BAE Systems could also be good dividend buys.
What comes next?
I hope this has given you a taste of how useful a simple screen can be when picking stocks for your portfolio.
Once you’ve got a shortlist of stocks, I’d suggest doing further research to narrow down your options to companies you might want to buy.
One set of screen results isn’t likely to provide enough stocks for an entire portfolio. But by repeating this process every few months, you should gradually be able to build an attractive and diversified portfolio of stocks.