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  • Systematic stock screening removes the guesswork of stock picking.
  • Stock screening strategies should reflect your time horizon and investment style.
  • Screening is only the first step. You'll need to refine your list and take action too.

Historically, the biggest returns come during the first two years of a bull market move. The S&P 500’s average return in year one is 38%, but it falls to 12% in year two and just 6% annually thereafter, according to CFRA. Because bull market returns are front-end loaded, you don’t want to be caught flat-footed. Especially if you invest in individual stocks, which can move many multiples more than the market itself.

Unfortunately, finding big winners requires more than a Twitter account (more on that in a minute). Instead, it requires a systematic approach driven by rules rather than seat-of-pants decision-making.

A systematic stock-picking process is key

Systematic idea generation is a fancy way of saying that you’re following rules to find stocks worth buying. It implies an unemotional approach to idea generation that’s reliant on stocks meeting preset characteristics.

In “7 Tips for Finding Your Next Great Stock Pick,” Real Money’s James DePorre (“Rev Shark to his friends) writes:

“Hunting for your next great stock pick is one of the most rewarding and entertaining aspects of trading and investing. It is very satisfying to discover what looks like a great opportunity and watch as it blossoms into a significant winner…Most market players approach stock picking randomly. They discover a pick by reading an article, hearing about it on TV, or social media. Sometimes those picks work well, but often they don't…Like most aspects of trading, you will increase your chances of successful stock picking if you have a clear strategy and apply it systematically [emphasis mine].”

I couldn’t agree more. My first job on the sell side was working for an independent research firm whose clients included some of the biggest and most successful mutual and hedge funds on the planet. The company’s research approach was rooted in quantitatively ranking sectors, industries, and stocks using a formulaic approach. The simplicity associated with such an approach stuck with me, and in 2003, I developed my idea generation model, which I still use to find ideas.

Creating a system to find stocks requires knowing what characteristics to search for, depending on your investment style and mindset. For instance, a value investor doesn’t look for the same stocks as a growth investor, and a day trader isn’t hunting for the same things as a long-haul investor. Because of this, knowing thyself is important.

A framework for creating a systematic stock screen

In his article, DePorre provides a 7-step framework to help you develop and implement a systematic screening process. I’m including all seven of his tips, followed by my comments.

No. 1: “Identify Your Goal. The first step to great stock picking is to be clear about what you want to achieve. Are you seeking a long-term buy-and-hold investment or a day trade that you might hold for a few minutes? A great short-term pick is often a terrible long-term pick and vice versa…It is also essential to understand the context of the overall market when you start your hunt. Is this a bull market with strong positive trends that favor momentum, or a bear market where you are looking for counter-trend moves and great values that are finding support?...

Have a clear goal in mind, and that will narrow your focus as you dig deeper.”

I can’t stress enough how essential it is to have a timeframe in mind for each system you create. Not everybody can successfully shift back and forth between a short-term trader and a long-term investor. Even if you’re comfortable doing both, the characteristics you’d be looking for will be different. For example, a short-term trader may want to screen for stocks above or below their 21-day moving average price. Alternatively, a long-term investor would be more interested in screening for stocks generating revenue, earnings, or dividend growth targets.

Similarly, investors should consider the stock market’s primary trend. If it’s up (bull market), the Federal Reserve is usually friendly, suggesting a more aggressive “buy dips” in growth stocks approach will yield the biggest winners. However, if it’s down (bear market), then focusing more on GARP (growth at a reasonable price) or value characteristics could be smart. A bull market screen could search for stocks growing 25% or more, while a bear market screen may seek stocks trading near 5-year price-to-earnings ratio lows.

No. 2: “Read. The best way to find ideas is to read everything you can, but that is just a starting point. The information out there can be overwhelming, and it can be challenging to separate the quality information from the sensationalistic that is just trying to seek attention and clicks…Sites like RealMoney.com and Sharkinesting.com will provide you with new stock ideas daily, but that is just a starting point. It is up to you to determine if these stocks meet your needs, and you have to develop your strategy for trading them. Don't expect someone else to make very important decisions for you. Identifying an exciting stock is just a starting point.”

This brings us back to needing more than a Twitter account to find quality stocks worth buying. Sure, there are plenty of great investors online worth following for idea generation, but you should only follow them selectively. For instance, on Twitter, my favorite follows are folks who have been investing for decades, including through at least one – or better two – bear markets (so the lessons REALLY sink in). Often, younger, more novice investors do well in raging bull markets, but inexperience causes them to lose big when the bear bites.

DePorre also points out that you must make decisions rather than rely on others to tell you what and when to buy or sell. The only way to consistently do that is to know what you’re buying and why you’re buying it. That requires extensive studying. For example, if you’re a buy-and-hold style investor, reading the annual and quarterly SEC filings is necessary to understand a company’s risks and how it makes money. Quarterly earnings transcripts will help you gauge how management navigates during good and bad times. And tracking key information on financial reports, such as cash and debt on the balance sheet and revenue, operating margin, and earnings per share on the income statement, is critical.

No 3: “Follow the Charts. One of the best ways to find great stock ideas is to look at hundreds of charts regularly. Price action tells you more about a stock than anything else. I look daily at stocks that are making sizable moves on increased volume and then study the charts and try to discern why they are moving. Some of them may be great short-term trades, and a small number may be great long-term plays that are just starting to develop.”

Knowing if a stock is trending up or down is helpful, even if you are a fundamentals-only buyer. Using price charts to visualize trends reveals whether big funds (with deep pockets!) are buying or selling. If they’re buying, the pathway to profit once you’ve done your fundamental due diligence is easier.

Also, consider the value associated with charting fundamental data. For instance, visualizing historical revenue, profit, margin, and valuation metrics can be very informative.

If you’re a shorter-term or swing trader using charts, you’ll want to read the pros and cons of technical analysis. Real Money chart expert Bruce Kamich has been using technical analysis since the 1970s, so consider buying his book if you want to learn more about charting.

No. 4: “Scan, Scan, Scan. Most professional investors use scanning programs that allow them to enter various technical and fundamental criteria that will narrow down the selection process. MarketSmith, which Investors Business Daily produces, is favored by momentum and growth investors looking for stocks with strong relative strength and earnings. The stock-picking process is much easier to apply using the MarketSmith scanner.

Finviz.com offers a simple and very effective scanner. It allows you to enter technical and fundamental criteria and scan the entire market to find stocks that meet your standards.

The trick to using scanners is to develop search criteria that are broad enough so that you don't miss great opportunities but narrow enough so that you are not overwhelmed by the number of stocks.”

Don’t ignore your brokerage firm’s tools, either. Many brokers, including Fidelity, offer comprehensive screeners you can use to generate ideas systematically.

No 5: “Research. Once you have narrowed down your stock selection, the hard work of research begins. Review the charts carefully and identify the time frames most relevant to your trading. If your time frames are short, you will likely focus primarily on chart patterns and immediate catalysts for movement, such as news events and macro data. If you have a longer-term time frame, it is much more important to understand fundamentals and to have a thesis for what will drive the stock higher over time.”

This is pretty self-explanatory, and my follow-up is similar to what I mentioned under DePorre’s second tip.

No 6: “Prepare Your Watchlist. Many of the stocks you find may look very interesting but are not ready for entry. Put those stocks on a list and watch them closely. Learn their personalities and how they move so you can execute when the time is right.”

Agree. Knowing how a stock trades based on a characteristic, such as valuation or relative to a benchmark, can help you refine your entry or exit points, so using a watch list to see how stocks act is helpful.

No. 7: “Finally, Execute. After you've completed your work and identified what looks like an outstanding stock, execute and implement your strategy. Often the best approach is to start with a small initial position and then add to it as it develops.”

Analysis paralysis is a real problem for many investors. If you spend too much time researching stocks that meet your criteria without taking action, you could wait for a perfect moment to buy that never happens, particularly when a new bull market gets underway. Instead, using progressive exposure (buying a small amount of stock and only adding over time if it's working) is better. It gives you skin in the game without exposing you to the risk that the bear market isn’t over and lower prices remain ahead.

The Smart Play

As individual investors, we manage a limited amount of money, so we must be selective about the stocks we buy. Because there are thousands of choices vying for our hard-earned money, it’s important to focus only on stocks that meet our criteria, not those of somebody else.

A systematic screening process based on the characteristics that are important to you is the best way to do this. In his article, DePorre offered up a step-by-step framework you can use to help decide what those characteristics should be and how to implement them.

A word of caution, though. Everybody’s financial goals and style are unique, so you’ll want to consider your situation. Many companies provide pre-defined screening tools, but you won’t know which tool is right for you until you’ve analyzed your investment goals and the pros and cons of various investment styles. Once you’ve done that heavy lifting, it will be easier to avoid the risks associated with ping-ponging from screen to screen because you’ll better understand what stocks you’re most interested in owning.

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