Summary
- Have preset criteria minimums before committing time to research.
- A double digit growth rate for all non-bank companies is a standard prerequisite.
- Return on capital is an indicator of moat, thus we want to also see ROC in the double digits.
- A low debt ratio compared to a company’s corresponding industry can allow for meaningful shareholder yield and dividend growth.
- Shareholder yield, the combination of share buybacks, dividends & debt reduction, is an indicator of management alignment with shareholders.
The first thing we do when we look for stocks to invest in, is engage in a screening process that respects our 4-step investing process.
We know that aging demographics, climate change & technology advancement are the dominant secular trends. We also know that central banks and governments are extremely interventionist. Those understandings lead us finding sectors and industries that are more favorable than others.
Our fundamental screening will want to find companies that are potentially exceptional. A solid screening process will eliminate most of the “in the middle” companies, or worse, that we don’t want to commit time to studying, much less investing in.
Here are the basics for screening for stocks that can beat the stock market with less risk:
Growth Is Good
With the exception of financials and certain resource companies that are resource price dependent, you always want to search for companies with double digit growth rates that are sustainable for five years (or longer).
Companies with low, no or negative growth are unlikely to ever be good investments for the long-term. While there are certainly some turn-around candidates, we should always remember this Warren Buffett quote:
Turnarounds seldom turn.
So, while we will invest in some companies that are in transition, that is not the same as a turnaround. A turnaround is essentially a failed business trying to reinvent themselves into something worthwhile. That is a very difficult and expensive proposition in most cases, ask General Electric (GE).
Measures of growth we want to see are sustainable revenue growth, EPS growth and free cash flow growth. All should be double digits if you want to avoid the middle of the market.
Return On Capital
Return on capital is a measure of how effective the financial inputs of a company are. That is, for each dollar in, how much can we expect out. Joel Greenblatt uses ROC as described in his book: The Little Book That Still Beats The Market (a must read, you’ll want paper copy).
Greenblatt uses something he called “the magic formula,” which uses ROC and earnings yield to screen for stocks. His definition of ROC is this:
EBIT/(Net Working Capital + Net Fixed Assets)
He uses that definition to control for the differing tax rates and debt levels among companies.
EBIT is used instead of EBITDA because he [EBIT = earnings before interest and taxes] assumes that depreciation and amortization about equals maintenance capital spending which are cash expenses not charged against earnings. So, EBITDA − Maintenance Cap/Expenditures = EBIT. Think of what he did as crossing out same expressions on both sides of an equation, i.e. simplification.
Net working capital + net fixed assets is used to figure out how much capital a company actually uses to conduct business.
Ultimately, ROC above 20% is desirable.
Low Relative Debt
Having low debt is important. Having low relative debt to a peer group is very important. Greenblatt expresses his approach by using Earnings Yield, which is EBIT / Enterprise Value.
EY = EBIT/EV
EV includes market cap, total debt and cash. The formula reads:
EV = MC + TD – C
In other words, market cap minus net debt. This basic formula is essentially a measure of value in consideration of debt.
There are other methods of determining debt as well that you will see commonly: debt to equity, debt to assets and debt to EBITDA…
A thing to be very concerned with is whether or not there is hidden debt for a company. For example, pensions or off balance sheet obligations.
So, while making sure debt ratios are comparatively low to a company’s industry, we still must be diligent that nothing is hidden.
Shareholder Yield
Shareholder yield is a measure of how well management is treating shareholders. A high shareholder yield demonstrates that management is aligned with shareholder interests. It is also a clue that management is not borrowing to pay dividends or fund buybacks — which is generally a bad idea.
Shareholder Yield = dividends paid + stock buybacks + debt reduction
This measure combined with growth rates is especially important to dividend investors. Companies that borrow to pay dividends, or reduce share count, are often exposing the company and investors to large risks. This is especially true when a company has no growth or is shrinking.
Meb Faber gives a compelling case for shareholder yield in his now hard to get book “Shareholder Yield: A Better Approach To Yield Investing” (a must listen for dividend investors – find it on Kindle).
I estimate that about 100-150 S&P 500 (SPY) (VOO) are in danger of not only having to reduce dividends in the next decade, but are likely to lose at least 50% of their share value.
Shareholder yield should always be higher than a dividend rate. It is a very red flag anytime a dividend yield is higher than shareholder yield.
Essential Understandings For Considering Stocks
The most important thing to understand about stocks is that a stock represents a business. A business that cannot grow is in danger. Companies that have no growth or are shrinking are succumbing to competition, changing consumer tastes or obsolescence. None of that is good for a shareholder. Ultimately, a company has to be able to sell its goods and services to survive.
Once we find companies with growth, we need to examine the balance sheet, income and how management treats shareholders. Our goal is to always find companies on solid financial footing and a management that is aligned with shareholder interests.
While we will never find the perfect company, aiming high can help us find the better companies in the stock market. Now that we have a list to study, it is time to figure out which are truly exceptional and then look for opportunities to buy when value and price momentum are good.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
