Rational “do-it-yourself” stock investors will seek some degree of third party research or opinion in their investment process. That at least reduces the amount of work they need to do to reduce the size of the universe they evaluate, and it may provide them with ideas for stock selection.

Some of those independent investors pay advisors to coach them and provide a sounding board, while others use rating services to screen stocks for investment prospects.

For a large portion of do-it-yourself investors, these five rating services are stock screening sources, each of which uses a five level rating scale:

• Standard & Poor’s Outlook
• Value Line Investment Survey
• Morningstar
• Reuters street consensus
• Schwab Equity Ratings.

We think it’s important when using a screening tool to know about the overall pool of data, and not just pull a screened list from a “black box”.

The first issue is the general way the ratings are created. One way to classify the ratings could be:

• Rules-based and machine-generated (Value Line and Schwab)
• Process-based and judgement-generated (S&P and Morningstar)
• Aggregation of all reporting analysts (Reuters street consensus)

The table below shows the number of companies at each timeliness rating level from the five rating systems, and the number of companies at each financial strength rating level from S&P and Value Line (as of Aug 21, 2008):

click image to enlarge

Notice that Value Line and Schwab (rules-based, machine-generated ratings) show an approximately symmetrical distribution of ratings with the greatest number at the HOLD level, fewer at UNDERPERFORM and OUTPERFORM, and fewer still at SELL and BUY.

S&P and Morningstar (process-based, judgement-generated ratings) show non-symmetrical distribution of ratings with the largest number of companies at HOLD, and more in the OUTPERFORM and BUY levels than in the UNDERPERFORM and SELL levels.

The Reuters street consensus is seemingly euphoric about companies by comparison to the other rating systems with more OUTPERFORM and BUY than the sum of HOLD, UNDERPERFORM and SELL.

Both S&P and Value Line have similar percentages of their universes rated highly for financial strength, but Value Line has a lower percentage of companies rated as weak than S&P.

Best of Both Worlds

One way for do-it-yourself investors to play it “safe” would be to seek the best of both worlds by using both a rules-based, machine-generated system and a process-based, judgement-generated system (example: Value Line and S&P).

One way to use two systems that use different methods, would be to make a list of all stocks that are highly rated by one or the other, and then do your own research and filtering from that list to arrive at your selections.

Another way to use two systems, would be to find those highly rated stocks that are common to both rating systems, and then work from that shorter list.

For example, if you used Value Line and S&P, and if you screened for stocks rated BUY or OUTPERFORM, you would arrive at a list of 925 stock recommendations from the two systems. However, if you screened for those stocks rated BUY or OUTPERFORM by both systems, you would arrive at an intersection list of 125 stocks.

Sample of Intersecting Stocks:

Here is a sample of the lowest market-cap 10% of stocks that intersect the list of BUY or OUTPERFORM by Value Line and S&P.

We are not recommending these stocks, just presenting a sample of the intersection list. They may or may not be good ideas. Even with data services, you need to make your own judgements about what makes sense to you and for you.

Unless you have lots of time to do research, you would benefit by engaging some form of personal or subscription third party help in your do-it-yourself investing.

Richard Shaw
QVM Group LLC

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