Why Stock Screening Can Be a Dangerous Investment Strategy

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In my screen of tech companies with PE multiples under 15x and 5-year EPS growth rates above 15%, I found several disappointing characteristics. Often, the companies have operations either in an industry that is decaying or, in contrast, in facing rising competition. Moreover, analysts tend not to believe that the value story will drive out-performance for investors. All of this goes to show that a simple screen ought not to be a substitute for fundamental analysis. Below, I review 3 tech companies to highlight my point.

Seagate Technologies (NASDAQ: STX)

Growing at a rate of 33.1%, this data storage producer trades at only 3.7x past earnings versus a 13.4x industry average. When you factor in a 5.3% dividend yield and a 48.9% return on invested capital (1,336 bps higher than the industry average), it's hard to not invest in the company. Shares have increased in value by a few percentage points after competitor Western Digital accelerated its dividend payment, and Barron's listed the company amongst its top 10 picks for 2013. Why then is the Street so bearish? 16 of 21 reporting analysts rate Seagate a "hold" or worse--one of them even recommends a "sell."

The main reason why the company has taken such a beating is because hard drive shipments have, well, been disappointing--relentlessly so. Producers have been dropping their shipment forecasts considerably in recent quarters. Furthermore, sagging PC sales don't bode well for the company's future. The stock fell 1.4% on HP's disastrous fourth quarter, which adds to the poor momentum guided for FQ2 (management expecting a 5% sequential drop in average selling prices.) After coming in 12% expectations with EPS of $0.25 despite aggressive share buybacks, investors do not want to take on the risk during this uncertain environment. The stock is, after all, 140% more volatile than the broader index.

CA (NASDAQ: CA)

CA is a producer of application software and trades at a respective 11.2x and 8.6x past and forward earnings with an also great dividend yield of 4.5%. EPS has grown by a rate of 53.8%. Like Seagate, return on invested capital is high at 14.3%. Even though the growth rate ahead is still strong at 9% and the company operates in a high multiple cloud industry, analysts are also bearish on the company. 9 of 12 reporting analysts rate CA a "hold" or worse--one of them recommends a "sell." Again, why the bearishness?

The company suffers from a competitive industry that has driven down margins.  Management has explained that "many new technology technological advancements and competing products [have] entered the marketplace" during the past few years. The enterprise segment, in particular, has become increasingly unprofitable, so management has attempted to shift towards its core mainframe business. The only problem is that the mainframe business is slower growing and is in a mature point in the cycle.

Intel (NASDAQ: INTC)

Intel has actually been one of my favorite stocks at 8.8x past earnings and a high 4.5% dividend yield. It has grown EPS by a rate of 22.8% and is even forecasted to have a rate of 10.6% over the past 5 years. This doesn't, however, create that much of a margin of safety on top of multiples expansion. Assuming Intel meets expectations, 2016 EPS will come out to $2.61. At a multiple of just 13x, the future value of the stock would be $33.93. Discounting backwards by 10% yields a present value of $21.07. 25 of 43 reporting analysts rate the stock a "hold," and one rates it a "sell."

Despite generating a strong 24.5% return on invested capital and attaining a decade high in the total chip market, there are several reasons for the bearishness. The main reason is that the company has a "late-mover disadvantage" in the LTE chip markets. Qualcomm and TI collectively control the market, and the former's stake is 240x Intel's. Margins have further eroded by 1,000 bps to 55% from greater competition in ARM-based chips. Free cash flow has also been trending down from $6 billion to $4.7 billion today. If you fear jumping into a sinking chip, this is not the stock for you. While I think that ship will be have its path corrected, there is only likely to be increased volatility over the next few days under intense fiscal cliff negations. For this reason, I recommend avoiding until greater certainty emerges, after which I recommend a "buy and hold" strategy.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Intel. Motley Fool newsletter services recommend Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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