Wayne A. Thorp - Screening For Momentum Stocks.pdf - Wayne A. Thorp - Ryjufka

STOCK SCREENING

A LOOK AT MOMENTUM INVESTING:

SCREENING FOR STOCKS ON A ROLL

By Wayne A. Thorp

Momentum investors

purchase stocks that

are rapidly rising in

price in the belief

that the rising price

will attract other

investors, who will

drive up the price

even more. One key

is recognizing when

the momentum is

beginning to fade.

Envision a snowball rolling down a hill: As it rolls along, it picks up more

snow, which causes it to move faster, which causes it to pick up even more snow

and move even faster.

That’s the basic strategy behind momentum investing—purchasing stocks that

are rapidly rising in price in the belief that the rising price will attract other

investors, who will drive up the price even more.

Richard Driehaus is one of the champions of momentum investing, favoring

companies that are exhibiting strong growth in earnings and stock price. He is

not a household name, but his firm, Driehaus Capital Management in Chicago,

rates as one of the top small- to mid-cap money managers, and his success has

landed him a spot on Barron’s All-Century Team—a group of 25 fund managers

that includes such investment luminaries as Peter Lynch and John Templeton.

This article focuses on Driehaus’ momentum strategy, which is discussed in the

book “Investment Gurus” by Peter J. Tanous (New York Institute of Finance,

$24.95), and serves as the basis for this article.

THE MOMENTUM APPROACH

Driehaus emphasizes a disciplined approach that focuses on small- to mid-cap

companies with strong, sustained earnings growth that have had “significant”

earnings surprises. If a company’s earnings are slipping, it is eliminated. Ideally,

you would like to see improving earnings growth rates.

Driehaus uses positive earnings surprises as a “catalyst.” An earnings surprise

takes place when a company announces earnings different from what has been

estimated by analysts for that period. When the actual earnings are above the

consensus estimates, this is a positive earnings surprise; a negative earnings

surprise occurs when announced earnings are below consensus estimates.

Another factor is the range of earnings estimates—a surprise for a company

with a narrower range of estimates tends to have a greater impact than a

surprise for a company whose estimates have a greater dispersion. In general,

positive earnings surprises tend to have a positive impact on stock prices.

Another key to momentum investing is to recognize when the momentum is

beginning to fade, when sellers begin to outnumber buyers. Thus, investors need

to closely monitor the company itself, as well as the market, and it therefore is

a strategy that makes sense only for those willing to keep their fingers con-

stantly on the pulse of the stock.

Driehaus cautions investors to be mindful of events such as earnings an-

nouncement or warnings and earnings estimate revisions—anything that could

either signal the slowing of the upward trend or propel the price even higher. In

addition, investors should gauge the direction of both the industry in which the

company operates as well as the broader market environment, both of which

could affect the individual holdings.

EARNINGS GROWTH SCREENS

Table 1 presents a list of the companies that passed a screen of filters based

on the Driehaus momentum investing approach and applied to AAII’s Stock

Wayne A. Thorp is assistant financial analyst of AAII.

AAII Journal /April 2000

STOCK SCREENING

Investor Pro database.

The heart of the Driehaus method is

to identify those companies with

improving earnings growth rates. To

find those stocks that are exhibiting

sustained or increasing growth rates

in earnings per share, the screen first

filters for stocks whose year-to-year

earnings growth rate is increasing. The

screen examines the growth rates in

earnings from continuing operations

from year 4 to year 3, year 3 to year

2, year 2 to year 1, and from year 1

to the trailing 12 months, and requires

an earnings growth rate increase each

period over the rate that preceded it.

[The box below shows how these

growth rates are calculated.]

Growth over each of the last three

years is used for two reasons—first, a

longer period would exclude compa-

nies not in existence for more than

three years; second, it is long enough

to see if a pattern of sustained or

increased earnings has developed.

Another screen stipulates that, at a

minimum, a company has experienced

positive earnings growth over the

trailing 12 months compared to the

earnings in the preceding 12 months.

Many of the companies that pass the

earnings growth rate screen are not

yet profitable—they do not necessarily

have positive earnings.

Applying the four earnings growth

rate criteria narrows the Stock

Investor database down to 220

companies (out of 9,269 companies

tracked by the program).

Table 1 shows selected earnings

growth rates in continuing operations

for the companies that ultimately

passed all of the criteria: The median

growth rates over the last four

quarters compared to the preceding

four quarters (the 12-month growth

rate), from fiscal year 2 to year 1 (the

one-year growth rate), and from fiscal

year 3 to year 2 are 68.4%, 4.5%,

and –21.9%, respectively.

As these numbers show, the growth

in earnings over the last four quarters

as compared to the previous four

quarters has taken off, particularly

when compared to the median

increase of 8.5% for all the stocks in

the database. Exchange Applications

(EXAP) has seen earnings growth of

almost 126% during this period. The

“laggard” of this group, Microcell

Telecommunications (MICT), has

seen growth of 9.3%, which is only

slightly above the median growth rate

for all stocks.

Looking at the prior periods pro-

vides some insight into where many of

these companies are coming from.

Three of the eight companies that

passed this screen actually saw

earnings fall from fiscal year 2 to fiscal

year 1, while all but two had declining

earnings from fiscal year 3 to fiscal

year 2. However, companies that

experience negative earnings growth

from period to period, as long as the

negatives are getting smaller, do not

scare off Driehaus. He terms these

time periods the flexion points—where

negative earnings are declining, and

ultimately shifting to positive earnings

figures. For example, Terayon Com-

munication Systems (TERN) saw its

earnings fall over 99% from year 3 to

year 2, yet it saw positive growth of

0.2% in earnings from year 2 to year

1. This is the kind of turnaround

Driehaus is looking for.

One last point to keep in mind

about earnings growth concerns the

base earnings level used to calculate

earnings growth. For instance, two

companies with 100% growth in

earnings from year 2 to year 1 would

be considered on an equal footing at

first glance. However, upon closer

examination it turns out that Com-

pany A’s earnings have gone from

$0.01 to $0.02, while Company B’s

earnings have risen from $0.50 to

$1.00—telling a much different story.

Therefore, when you see an extremely

high growth rate for a company, you

may wish to check where the com-

pany started. Growth rates are very

helpful in identifying interesting

stocks, but you should look at the

underlying figures to gauge the true

significance of these changes.

EARNINGS SURPRISES

Once companies with improving

historical earnings growth rates have

been identified, the next step is to

select those most likely to continue

the trend. One event Driehaus sug-

DETERMINING THE GROWTH RATE

Earnings per Share (from Continuing Operations) for Intel (INTC)

Quarterly:

Annual:

Q1 25-Sep-99

$0.44

26-Dec-98

$1.82

Q2 26-Jun-99

$0.53

27-Dec-97

$2.12

Q3 27-Mar-99

$0.60

28-Dec-96

$1.57

Q4 26-Dec-98

$0.62

30-Dec-95

$1.08

Q5 26-Sep-98

$0.47

Q6 27-Jun-98

$0.35

Q7 28-Mar-98

$0.39

Q8 27-Dec-97

$0.53

12-Month Growth Rate:

Formula:

[(Q1 + Q2 + Q3 + Q4) ÷ (Q5 + Q6 + Q7 + Q8)] – 1

[(0.44+ 0.53 + 0.60 + 0.62) ÷ (0.47+ 0.35 + 0.39 + 0.53)] – 1

= 0.259 or 25.9%

One-Year Growth Rate (Y2 to Y1):

Formula:

(Y1 ÷ Y2) – 1

(1.82 ÷ 2.12) – 1

= –0.142 or –14.2%

AAII Journal /April 2000

STOCK SCREENING

gests seeking is a “significant” positive

earnings surprise, where the

company’s actual announced earnings

beat the median consensus analyst

estimates. Earnings estimates are

based on expectations of the future

performance of a company; surprises

signal that the market has underesti-

mated the company’s future prospects

in its forecast.

Driehaus does not specify what he

considers to be a “significant” earn-

ings surprise. Recent studies have

shown that analysts tend to be

pessimistic when it comes to their

quarterly earnings estimates. There-

fore, it is more likely that a company

will beat its quarterly earnings

estimates than fail to meet them.

Using data on 498 of the S&P 500

companies from the third quarter of

1999, one analyst estimate service,

First Call, found that earnings came

in, on average, 3% above analysts’

estimates. On our own Stock Investor

program with data as of January 28,

2000, the median earnings surprise for

the 4,328 companies with earnings

surprise data was 2.4%. Therefore,

ideally, an earnings surprise screen

would take into account this apparent

downward bias in analysts’ estimates.

Only 4,328 companies in the Stock

Investor database have earnings

surprises, so simply performing the

screen automatically eliminates half of

the companies. Requiring the earnings

to be at least 5% above the estimates

winnows the database down to 1,807

companies, while a 10% minimum

requirement narrows the database to

1,340. Not wanting to be too restric-

tive, yet wanting to choose a level that

was “significant,” we chose 10% for

use in this screen. Applying this

criterion to the list of companies that

passed the earnings growth require-

ments narrows the list to 59 compa-

nies.

In Table 1, the median earnings

surprise percentage for the companies

that passed all of the screens is 26.4%,

well above the 2.4% median percent-

age for the entire database. NetIQ

(NTIQ) leads the pack, with an

earnings surprise percentage of 300%.

NorthEast Optic Network (NOPT)

had the lowest earnings surprise

percentage, 11.8%.

To provide perspective, the table

also provides the announced earnings

figure. NetIQ had announced earnings

of $0.08, which was 300% above the

median expectation, meaning that the

median earnings estimate was $0.02

per share.

The earnings per share figures for

the passing companies also illustrate

that most of these companies, al-

though moving up, are not yet

profitable—only three of the final

eight companies have positive quar-

terly earnings.

The number of analysts tracking a

company is an important factor.

Coverage of a company by only one

analyst limits the usefulness of an

estimate; as the number of analysts

covering a company increases, the

consensus estimates become more

credible. Of course, requiring more

analyst coverage reduces the number

of stocks with the required estimates;

in the Stock Investor database, only

2,741 companies have at least three

analyst estimates, and only 1,737

firms have at least five. For this

screen, we required at least three

analysts, which provides a high, a

middle, and a low estimate for a given

company. Adding this requirement

reduced the number of passing

companies from 59 to 40 companies.

MOMENTUM

Like most investors, Driehaus

remains invested in a stock until he

sees a change in the overall market, in

TABLE 1. MOMENTUM COMPANIES: FIRMS PASSING ALL SCREENS

EPS Continuing Grth Announc’d 4-Wk. 26-Week

Last Y2 Y3 Earnings Qtrly Price Relative Strength Mrkt

12 Mos. to Y1 to Y2 Surprise

EPS Change Firm Industry Cap.

Company (Exchange*: Ticker)

(%)

($)

(%)

($ Mil) Description

Celgene Corp. (M: CELG)

23.5

8.8

1.8

23.8 –0.16

354

41 1,258.5 Pharmac’ls & agrochemical

Exchange Applications (M: EXAP)

125.7 73.5 –63.3

20.0

0.06

158

64 1,092.4 Customer optimiz’n software

Geoworks Corp. (M: GWRX)

47.1 –2.1

–6.7

27.3 –0.08

96 1,218

582.6 Mobile E-commerce & info

Heartport, Inc. (M: HPRT)

65.1 –4.4

–8.5

26.1 –0.17

177

178.2 Systems for heart surgeries

Microcell Telecom. (M: MICT)

9.3 –20.2 –96.3

26.6 –1.82

277

30 2,214.8 Communication servs

NetIQ Corporation (M: NTIQ)

80.2 64.9

17.3 300.0

0.08

256

64 1,030.0 Application mgmt software

NorthEast Optic Network (M: NOPT) 71.6 49.6 –35.3

11.8 –0.45

151

30 1,513.4 Fiber optic transmission

Terayon Comm. Sys. (M: TERN)

74.7

0.2 –99.2 116.7

0.12

163

72 2,293.5 Cable modem systems

Median for passing companies

68.4

4.5 –21.9

26.4

–

216

– 1,175.5

Median for all companies

8.5

5.2 11.4

2.4

–

–8

–

109.5

Source: AAII Stock Investor 3.5 Pro (currently in beta testing), Market Guide, I/B/E/S

*M = Nasdaq

Data as of 01/28/00

AAII Journal /April 2000

STOCK SCREENING

the sector, or in the individual

company. He has no qualms with

buying a stock that has already seen a

rapid rise in price if he believes that

trend will continue.

Aside from strong, sustained

earnings growth and positive earnings

surprises, there are several other

characteristics that Driehaus looks for

to identify stocks that will continue

their upward trend. These characteris-

tics primarily concern momentum.

The first momentum screen looks

for those companies whose stock price

has experienced a positive increase

over the last four weeks; the larger the

required price increase, the more strict

the momentum screen. As a stand-

alone criteria, 4,618 companies in the

Stock Investor database had a positive

percentage change in price over the

last four weeks. Adding this require-

ment to our other Driehaus screens

winnows the list of passing companies

down to 16.

Among all companies that passed

the full screen in Table 1, the winner

in this category is Geoworks Corpora-

tion (GWRX), with a four-week price

increase of 96%. This is even more

impressive when compared to the

median price increase for all stocks in

the database, which is only 1%. At the

other end of the scale in the list of

passing stocks, Celgene Corp. (CELG)

has seen a price increase of only 5%,

which is still above the median four-

week price change for the entire

database. The median for the eight

stocks that passed all the criteria is

48%, a definite illustration of the

underlying price strength of these

companies.

The second momentum screen

focuses on relative strength. Relative

strength communicates how well a

stock has performed compared to

some benchmark—usually a market or

industry index—over a given time

period. A positive relative strength

means that the stock or industry

outperformed the S&P 500 for the

period, while a negative relative

strength means it underperformed the

S&P 500 for the period.

The relative strength screens here

provide two measures—the firm

relative to the S&P 500 and the

company’s industry relative to the

S&P 500.

The first relative strength screen

seeks companies that over the past 26

weeks have had stock performance

better than that of the S&P 500. The

26-week time period allows for

patterns to develop for both the

industry and the company. Shorter

time periods tend to produce false

signals, while longer time periods may

signal a trend that has already ended.

The 26-week period provides a solid

middle ground. In the Stock Investor

database, there are 4,447 companies

with a 26-week relative strength that

is greater than zero—meaning the

price has outperformed the S&P 500

over the last 26 weeks. Applying this

criteria to the other Driehaus screens

knocks out three companies, bringing

the grand total thus far to 13.

In this relative strength screen,

Geoworks again leads the way,

towering above the market with a

relative strength figure of 1,218%.

The median for the companies that

passed all the criteria is almost 217%,

compared to the entire database,

which has underperformed the S&P

500 by 8%.

The last relative strength measure

Definitions of Terms

The following is a short description of the screens and terms used in Table 1.

EPS Continuing Grth—Last 12 Mos.: The percent-

age change in earnings per share from continuing

operations between the last four fiscal quarters

and the preceding four fiscal quarters.

Announc’d Qtrly EPS: The earnings per share figure

announced by a company for the latest fiscal quarter, but

which has not been filed with the SEC.

4-Wk. Price Change: The percentage change in stock

price over the last four weeks.

EPS Continuing Grth—Y2 to Y1: The percentage

change in earnings per share from continuing

operations from fiscal year two to fiscal year one.

26-Week Relative Strength—Firm: The percentage by which

the stock price of a company has either outperformed or

underperformed the S&P 500 over the last 26 weeks.

EPS Continuing Grth—Y3 to Y2: The percentage

change in earnings per share from continuing

operations from fiscal year three to fiscal year two.

26-Week Relative Strength—Industry: The median 26-

week relative strength figure for all companies in a given

industry.

Earnings Surprise: The percentage by which

announced earnings exceeded or fell short of the

median analysts’ estimate for the latest fiscal

quarter. Positive earnings surprises tend to have a

positive impact on stock price.

Mkrt Cap.: Market capitalization in millions of dollars.

Number of common stock shares outstanding times share

price. Provides a measure of firm size.

AAII Journal /April 2000

STOCK SCREENING

compares the prospective company’s

industry and how it has performed

relative to the S&P 500. Driehaus

would rather buy a stock in a strong

industry group even if its earnings

growth is weaker rather than a stock

with stronger earnings growth but in a

weak industry. This is because

strength or weakness in an industry as

a whole can have a strong impact on

the performance of an individual

company. While this step cannot be

automated with Stock Investor , the

industry relative strength data can be

looked up and companies failing to

meet the criteria can be manually

removed. Applying this process to the

other Driehaus criteria eliminated one

company whose industry has

underperformed the S&P 500 over the

last 26 weeks, bringing the number of

passing companies down to 12.

For the most part, the companies

that passed all of the screens are in

very strong industries, with most

outperforming the S&P 500 by at

least 30% over the last 26 weeks. The

communications equipment industry,

represented by Terayon Communica-

tion Systems, has performed best,

outperforming the S&P 500 by 72%.

The lone exception is the Medical

Equipment & Supplies industry,

represented by Heartport, which has

outperformed the S&P by only 3%.

While this stock has performed very

well when compared to the market, its

industry’s weakness could begin to

weigh on its price performance.

from $50 million to $3 billion in

market capitalization; 4,933 compa-

nies in the Stock Investor database

fit into this range. Adding this

requirement to the other Driehaus

screens reduces the number of

passing companies to nine.

In the list of companies passing all

of the criteria, the median market

capitalization is $1.176 billion—10

times larger than the median market

cap of the entire database of $109.5

million. The largest company in the

list of passing stocks is Terayon

Communication Systems. (TERN),

with a market capitalization of

$2.29 billion; the smallest company

is Heartport, Inc., weighing in at

$178.2 million.

Driehaus also prefers to deal with

domestic firms, so the screen here

eliminates American depositary

receipt firms (ADRs), which are

foreign companies that are traded on

U.S. exchanges. Adding this require-

ment to the prior screens reduces the

overall total to eight.

small- and mid-cap category in the

Stock Investor database is 97,000,

while the average is almost 288,000

shares traded. For the entire Stock

Investor database, the median daily

trading volume is 57,000 and the

average is 387,000. Our screen uses

the percent rank function in Stock

Investor , which breaks down the

entire database in percentiles for a

given data field. We required

companies to have a daily trading

volume that falls in the top 50% of

the database. As it turns out, this

criterion did not change the number

of passing companies.

The final tally of companies

passing all of the screens is eight.

Not surprisingly, all eight companies

operate in businesses that have been

performing well recently—telecom-

munications, biotechnology, and

computers. The results of any type

of momentum screen will mirror the

current sentiment of the market—

companies in the “hot” industries

will be favored over less popular

industries.

TRADING VOLUME

CONCLUSION

One difficulty that can arise when

attempting to invest in small-cap

stocks is that they may lack liquid-

ity, meaning that they have relatively

low daily trading volume. This may

not be an overriding concern for a

buy-and-hold investor, but fast-

paced momentum investors need

sufficient volume and float (number

of shares freely tradeable) to buy

and, more importantly, to sell shares

with ease.

Once again, the rules are subjec-

tive. A key factor is how many

shares will be bought and sold

during each trade; the more shares

you will be buying and selling, the

higher the daily volume that should

be required. Buying 1,000 shares of

company that typically trades on

volume of 10,000 shares a day will

most likely be more difficult than

buying 100 shares of that same

company.

The median daily volume for the

4,933 companies that fall into the

The momentum approach to stock

selection used by Richard Driehaus

identifies companies that have

strong-sustained earnings growth,

accompanied by earnings announce-

ments that exceed analysts’ estimates

and upward-moving prices. The

approach seeks the “home run” that

will provide above-normal returns.

The key is to have a system in place

that gets you out of a trade with

only a minimal loss, while allowing

the winners to run until the momen-

tum dies.

By implementing a strategy built

on discipline and careful examina-

tion of a company, its industry, and

the market, momentum may be on

your side. However, remember that

screening is just a first step. There

are qualitative elements to examine

that cannot be captured by a com-

puter-generated list. Further funda-

mental analysis is necessary for

successful investing.

THE UNIVERSE

Richard Driehaus focuses most of

his energies on small- to mid-cap

stocks. Historically, small-cap stocks

have done better than larger stocks,

with the trade-off being higher risk

and volatility. By focusing on

smaller companies with strong

earnings growth rates, he hopes to

identify the market giants of tomor-

row.

There are differing definitions of

the market capitalization categories,

but for the screen here, we defined

small- and mid-size stocks as ranging

AAII Journal /April 2000

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