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After my book It’s Earnings That Count (McGraw-Hill, 2004) was published, Motley Fool’s Tim Beyers (“Mile High Fool”) asked me for screening criteria to find his own earnings power-type stocks. An earnings power stock is a company that has positive and growing levels of free cash flow and Economic Value Added, a durable competitive advantage, and an attractive valuation.* With this information, Tim found several companies that got passing grades, which he called “scrooge” stocks. You can read the full article here:

(*If you want to learn more about the Earnings Power approach to stock selection, send me an e-mail at and I’ll send you a PowerPoint presentation.)

How’d the picks do? In 2005, the Scrooge stocks gained 17.5%, vs. 7.7% for the S&P 500, as Tim found

Emboldened by his success, Tim ran another screen, which he describes here: In 2006, Scrooge beat the S&P 500 by 10.5%.

Batting 2 for 2, Tim ran a third screen at the end of 2006. In 2007, Scrooge beat the S&P 500 by 41.2%.

Three for three. Pretty darn good. But what about this year? How did our Scrooge screen perform? Since the stock market was down about 40%, Scrooge must have lost money, yes? Give Tim credit; his screen did not pick any stocks! That’s right. Scrooge the mechanical screener in 2008 sat on the sidelines while us human beings got pummeled to varying degrees. You can read Tim’s column here

Let’s recap. Tim’s earnings power-inspired Scrooge screen has:

1. Beaten the S&P 500 four out of the last four years.
2. Never lost money
3. Has a four year CAGR of 21%, vs. -6% for the S&P 500.
4. A $100,000 investment in Scrooge at inception is worth $216,000, vs. $78,000 for the S&P 500.

So, what’s the secret sauce? Here is our original seven-point screen, which we haven’t changed since. The quotations are my commentary.

1. 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."

2. Annual earnings per share growth of 7% or better over at least the past 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."

3. 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."

4. Debt equaling no more than half of equity: "This helps eliminate the firms that have high ROE but are also so highly leveraged that they would be in trouble if creditors came calling at the wrong time. I think one of the great lessons of the late '90s is that investors forgot about this and the rest of the balance sheet."

5. Institutional ownership of 60% or less: "John Neff gave a great quote in which he relayed some advice from his father. His father said merchandise well bought is merchandise well sold. That's a motto for the value investor, but it can also be a motto for the conservative growth investor. 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."

6. A short interest ratio of 5% or less: "Considering the way shorts make money, they have to be more dogged and more research-intensive. 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."

7. A price-to-earnings ratio lower than the industry average: "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." (Incidentally, this is also another secret to Neff's winning approach. By investing in low-P/E companies, he generated an average return of 14.3% annually over 24 years as the head of Vanguard's Windsor fund, a truly remarkable record.)

What companies does Scrooge like in 2009? Tim’s picks for the next 12 months are here to learn more.

If you like Tim’s column please hit the “rec” button at the top of the page to encourage my friend to give us his 2010 Scrooge picks next December.

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