How Scrooge Could Save Your Portfolio

Ebenezer Scrooge is an evil genius.

While the rest of us plunged headlong into stocks late last year, he said no. He said there were no bargains, that growth had gone expensive, and that there was no value in value stocks. He saw the carnage coming, in other words. The S&P 500 is down roughly 40% this year.

This miser can make you rich
And he's been right before. "He," in this case, is the Scrooge stock screen, created in concert with It's Earnings That Count author and Foolish friend Hewitt Heiserman, Jr. We've beaten the market every year we've run it.

Scrooge scorched the index by more than 40 percentage points in 2007, by 10.5 points in 2006, and 9.8 points in 2005. Big winners from those years include large caps Rio Tinto (NYSE:RTP) and Southern Copper.

Scrooge hasn't done as well with very small caps. Streamline Health was a bust in 2007. Cantel Medical and II-VI underperformed in 2005. II-VI recovered, however, and was a big winner for Motley Fool Hidden Gems when sold from the portfolio this summer.

Thus, Heiserman and I have concluded that:

1. Our screen is a better predictor of success for large caps than for small caps.
2. Holding small caps for the long term can be a market-crushing strategy. (Witness II-VI.)

How to be a Scrooge

But when it comes to large caps, the Scrooge screen usually does an excellent job of picking the best. Here's what it demands, with some commentary from Heiserman added for perspective:

• Average five-year revenue growth of 8% or better: "This is your indicator that the company is making a product or service that customers can use. But it's important to watch out if the number is too high. For example, 40% is likely unsustainable. On the other hand, if you've found a company growing at only 2% to 3%, it probably operates in a mature market. Low sales growth is almost always a red flag."

• Annual earnings-per-share growth of 7% or better over at least the last 12 months: "As with sales, you don't want 20% to 25%, because that's probably not sustainable long-term, and any company that is growing that fast may be peaking. A company growing at 7%, however, may just be starting to accelerate, leaving plenty of opportunity for investors."

• Average five-year return on equity (ROE) of 10% or better: "This is simply the best way to gauge management's use of shareholders' money to fund growth. A higher number here is usually better, though it's important to remember that a highly leveraged firm can still have a high ROE."

• Debt equaling no more than half of equity: "This helps eliminate the firms who have high ROE, but which are also so highly leveraged that they would be in trouble if creditors came calling at the wrong time."

• Institutional ownership of 60% or less: "Low institutional ownership leaves room for mutual funds and others to come in and discover the firm and push the share price higher. On the other hand, if 98% of the stock is already owned by institutions, then the most likely decision they'll make next is to sell, and that will create downward pressure on the shares."

• A short interest ratio of 5% or less: "It's hard to imagine that you or I would know more about any individual stock than the most tenacious participants in the stock market. High short interest is always a warning sign."

• A low price-to-earnings ratio: This year, we choose a P/E of less than 11, before excluding special items -- roughly equal to the trailing P/E of the S&P 500 SPDR. "There's no substitute for getting in on a stock cheaply. A lower-than-average P/E increases your chances of finding a stock selling at a discount."

Be greedy for these six stocks
This year's Scrooge screen predicts six winners, every one of which we like:

Sources: Motley Fool CAPS, Yahoo! Finance.

I'll admit to being partial to KHD Humboldt Wedag, which superstar investors love. GigaMedia, too, is an enticing pick of our Global Gains and Rule Breakers services.

Nevertheless, the purpose of a mechanical screen is to offer a diversified set of ideas. I will therefore put real money on all six of these stocks when disclosure rules permit, and rebalance next year at this time, when Scrooge returns to offer more miserly advice.

Happy Holidays, Fools. May 2009 bring you all the riches you deserve.