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The Importance Of Screening And Back-Testing

Every week in this article, I will usually outline either a unique way to screen for stocks, or go over a proven, profitable trading strategy

Every week in this article, I will usually outline either a unique way to screen for stocks, or go over a proven, profitable trading strategy.

In this week’s article though, I thought I’d start at square one, and go over why screening is so important. But, even more importantly, discuss why back-testing is the most important step of all.

Why should I use a stock screener?

The short answer is: “Because there’s over 10,000 stocks out there, and you need a way to find the good ones.” The longer answer is: Other than buying the stocks that are talked about on TV, or written about in the paper (not to mention "tips" from a friend), how else are you going to find stocks that meet certain fundamental characteristics?

Even if you don’t use a screener now, most people still do their own "screening" one way or another. They may hear that a stock has a certain growth rate, or a certain P/E Ratio or sales surprise, or whatever. Then they find themselves listening for, or reading about, stocks that meet this criteria.

Well, if you want to find stocks that meet certain criteria, you can find them quickly and easily with a stock screener. But, just because you narrowed 10,000 stocks down to only a handful, doesn’t necessarily mean that you’ve picked the best stocks on the planet.
In fact, you might have picked the worst ones. But how will you know? Back-testing.
Once you’ve created a screen, you can then back-test it to see how good (or bad) your screening strategy has performed. In other words, does your screen generally find stocks that go up once they’ve been identified, or does your screen generally find stocks that get buried once they’ve been identified? This is good stuff to know.

With back-testing you can see how successful your stock-picking strategy has performed in the past, so you’ll have a better idea as to what your probability of success will be now—and in the future. Of course, past performance is no guarantee of future results, but what else do you have to go by?

Think about it. If you saw that a stock-picking strategy did nothing but lose money year after year, period after period, etc., there’s NO WAY you’d want to trade that strategy—or use that screen to pick stocks with. Why? Because it’s "proven" that it picks bad stocks. Sure, it may turn around and start picking winners, but it may also continue to pick losing stocks the way it always has.

On the other hand, what if you saw a strategy that did great year after year, period after period (you know where this is headed)? You would, of course, want to trade that strategy. Why? It’s proven to be a profitable one. And while it may start picking losers all of a sudden (now that you’re using it J), it may also continue to pick winning stocks, just like it did before. Keep in mind, a screening and back-testing program isn’t a "box of magic." But it is a great way to see what works and what doesn’t BEFORE you put your money at risk!

I’ll end this with a recollection of a conversation I had with someone a while back who was "stuck" in a losing stock: I asked him why he was still in it if it kept losing money, and he said he didn’t think it would go much lower from here. I then asked him if he thought it would go this low when he bought it. (He, of course, said no.) When I asked if he thought it’d go up from here, his answer was "probably not right away," and then he added that it could possibly still fall a bit more from here. I told him that there are plenty of stocks going straight up, and asked him, “Why don’t you get out of that one that’s losing you money, and get into a better one?” He admitted that he didn’t know of any better stocks to get into. I then asked him, “What if you did know of a better stock to get into, would you do it”? His answer, of course, was yes, but he quickly added that he didn’t know how to find "better" stocks. That last comment said it all.

He was in losing stocks because he didn’t know to pick better ones, but if he had a proven, profitable, stock-picking strategy, he could. Don’t get me wrong, just because you have a great strategy for picking winning stocks doesn't mean it will preclude you from ever having another loser. On the contrary, even some of the best strategies "only" have win ratios of 70 percent or 80 percent (NOT 100% percent). But if your strategy picks winners far more often than losers, you can feel confident that your next pick will have a high probability of success. And don’t be the guy who "accidentally" gets into one or two good stocks and thinks he’s the next Warren Buffet. If your stock account is important to you, test your stock-picking strategies out to see if your method for finding winners is a repeatable one. That’s why someone should use a screener and a back-tester.

As usual, I’ll close with a few new picks from some of my favorite back-tested screening strategies for the week of 4/29/08:

AYI Acuity Brands, Inc.
(from the Increasing cash flows screen)

CE Celanase Corp.
(from the Upgrades and Revisions2 screen)

HBI Hanesbrands, Inc.
(from the Momentum Method1 screen)

Sign up now for your two-week free trial to the Research Wizard, and take your stock screening to another level. When you’re done, back-test it to see if it works! And don’t forget to check out the winning trading strategies that come loaded with the program. Know when to buy and when sell. It’s all there. You can do it.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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