Screening for Value: Why You Shouldn’t

Many investment articles/books, at some point, indicate how to look for good opportunities using some sort of screening technique.  I disagree.  I believe this approach is adopted to quicken the process, however, such steps distort the process.  (Quick and wrong doesn’t seem to be an appropriate substitute for slow and right.)

A key component to value investing is the idea that market prices are opportunities to buy or sell–not, however, indicators of  intrinsic value or worth of a company.  Intrinsic value is something you have to independently determine.  When the market prices and intrinsic values diverge, then you have opportunity.  However, screening reverses the process by providing you ideas which are the result of metrics tied to market pricing.  Most screening tools are based off a market price, i.e. Price to Book Value, Price to Earnings, Price to Cash Flow, etc.  After you have the name of a company with an attractive  book value (or other metric), you begin looking at the company’s financials to determine your estimation of its intrinsic value.  I believe at this point, you are at a significant disadvantage.

In behavioral finance, they would call this “anchoring”.  Having already placed this company in the mental bucket of being a “good candidate” based on your screening and potentially even peeked at the market price, you have become anchored to the idea that this is potentially a good value and, even worse, to the current price of the company.  After your research, you may agree or disagree, but there is an underlying bias towards the original anchored price.  I am not implying that an intelligent and good value investor could not, after having discovered the company through a screen and seen the market price, come up with his or her own intrinsic value calculation, but I do think it is harder.  And I like easy.

Another frequent flier on the screening technique is 52-week low lists (or some other time period, 13 week, 26 week, etc).  Once again, an investor approaches this list with the thought that something that is selling for its lowest point in a specified time period, should at least merit further review, given its apparent or potential value.  However, the market prices are once again serving as an initial screening tool.  The stocks are only cheap in relation to their market prices from an earlier time period.  The screening tool has left you nowhere closer to an intrinsic value calculation, yet has biased you towards this company because it is cheaper than it once was.

Anchoring is not the only problem with screens.  In general, I think investors who rely on them bypass the process of business investigation that is the best learning tool out there.  There are very few books or classes out there that will give you a better investment education than sitting down and reading 5 Annual Reports (10Ks) per day.  Seeing a lot of business and their financial characteristics, business competition environment and general patience is lost with screening.

The goal should be to pick up a company’s 10k  and have the ability to independently determine your own intrinsic value calculation of that company.  This may not be easy, but as Charlie Munger said, “It’s not supposed to be easy. Anyone who finds it easy is stupid.”

My next entry will describe how to search for companies without screens.

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