Screen Test

I'm gonna run to you
Yeah, I'm gonna run to you
'Cause when the feeling's right, I'm gonna run all night
I'm gonna run to you
--Bryan Adams

At the RISE conference two weeks ago, many portfolio managers and analysts noted that they employed 'stock screens' to whittle the universe of possibilities into a subset more conducive to in-depth analyses. Most of the screens employed by these people are software algorithms that scour databases and identify stocks with attractive characteristics such as high return return on equity, low dividend payout ratios, or strong price momentum.

Many brokers (like Schwab) and investment info sites (like Morningstar) possess screening capability.

When looking for equity investments (not short term trades but long term investment), there is a screen that I like to employ. However, it is a low tech, non-mechanical screen--one that builds on my analytical strengths and personal taste preferences. One 'edge' that I may have over some market participants is skill in industry analysis and knowledge of factors that drive sustainable competitive advantage. I also have a taste for value, and believe that lower prices reduce risk and provide margin for error.

As such, I like to use that following criteria when looking for potential equity candidates:

Favorable industry structure. Think Porter's (1980) five forces. I like industries where the forces are favorable for industry profits over time. A pile of research suggests that choice of industry explains more variance in company profits than company-specific factors. Thus, I would rather consider stocks where the industry forces are blowing at the propsective company's back rather than in its face. It has become harder and harder, btw, to locate such favorable industry contexts.

Organizational factors. Research (e.g., Collins & Porras, 1994) suggests a number of factors that relate to sustainable competitive advantage over time, such as home grown experienced management, ideosyncratic cultures, demonstrated track records at coping with disruptive change. To evaluate these factors I need access to the inner workings of organizations. This can be obtained by personal contact, or (more frequently) by devouring what has been written about potential candidates by the media. You might be surprised at how much you can learn about organizations thru secondary sources.

Strong, dominant brands. I prefer firms that have gained mindshare with customers and marketshare from competitors. Strong brands drive higher profit margins as customers are willing to pay more for a branded goods relative to me-too generics. Moreover, large market share increases bargaining power and helps companies be a price maker rather than price taker.

High profit margins. I like enterprises that consistently produce gross profit margins north of 50% and net margins of at least 10%.

High cash/low debt. Debt reduces strategic freedom, even when the cost of credit is low. As an investor, I like my companies to have piles of cash since it is likely come back to me either directly or indirectly. As a general rule, I like to see balance sheet cash of at least 2x debt. Conceptually, I like to know that companies I own can extinguish all their debt overnight while still having a nice cash stash left over.

Free cash flow. Cash flow is the lifeblood of a business. Cash flow is also the theoretical basis for securities analysis and valuation. I am attracted to firms that generate gobs of free cash flow (FCF).

Valuation. While I review tradional valuation metrics such as P/E, I prefer valuation metrics directly employ FCF. Lots of FCF alone does not suffice--the price that you pay for the FCF is really what matters. When using my 'quick and dirty' comparison of enterprise value:FCF perpetuity, I like to see ratios of 1.0 or less. The lower the ratio, the greater the potential discount I am getting. Stated another way, cheap valuations provide higher 'margin for error' in my decisions.

Once I have a list of candidates, I can conduct more in-depth assessment. I can also overlay my macro view on candidates to more completely evaluate risk and reward.

Currently, my screen whittles down the universe of stocks into a pretty small list.

References

Collins, J.C. & Porras, J.I. 1994. Built to last. New York: Harper Business.

Porter, M.E. 1980. Competitive strategy. New York: Free Press.