As previously mentioned on this blog, one of the purposes of this site is to build and run stock screens, before discussing their outputs in order to generate some potential investment ideas. This value-driven screen that we will use today is based upon the work of pioneering investor Benjamin Graham, who earned an annual return of 17% for clients of the Graham-Newman Partnership and also authored the investment classics Security Analysis (with David Dodd) and the Intelligent Investor. Graham described this screen in chapter 14 of the Intelligent Investor, entitled Stock Selection for the Defensive Investor. Due to the vagaries of the Financial Times Stock Screen, the screen we use has been slightly modified from Graham’s original, but the key underlying factors remain the same.
The emphasis of this screen is to find large companies that have strong balance sheets and generate good profits, but can be acquired for a reasonable price. The criteria we use are as follows:
- Adequate size of the Enterprise. The purpose behind this test is to exclude small companies, which are more likely to fail in tough economic times, and to rely upon a reduced range of products and customers which can be vulnerable to competition and strategic changes. We therefore set a minimum market capitalisation of £450m.
- A Sufficiently Strong Financial Condition. Companies with more highly-leveraged balance sheets have more volatile earnings (and stock prices) and are also more vulnerable to failure. To root-out businesses with insufficient near-term liquidity we exclude companies with a current ratio of less than 1.5x, and to ensure our sample are sufficiently capitalised, we exclude those that have equity financing of less than 50%.
- A Sufficiently Profitable Enterprise. Graham uses the criteria that the company in question must have been profitable in each of the last ten years. However, because of the FT Stock Screen, we instead look at the average return on equity that has been achieved over the last five years. We exclude all those companies that have not achieved an average ROE of 15%.
- Some Current Dividend. Graham excludes from his companies with a dividend record of less than twenty years. However, because of a lower propensity of companies to pay dividends today (see Disappearing Dividends by Fama & French) and because the FT Stock Screen doesn’t allow us to test for a 20-year dividend record, we have relaxed this criteria to simply that the company currently pays a dividend.
- Earnings Growth. While strong past performance is no guarantee of positive performance in the future, recent growth earnings growth does mean there is higher likelihood of positive performance than if the company in question has recently been struggling operationally or financially. We exclude all companies that have failed to achieve EPS growth of 5% per annum over the last five years.
- Moderate Price/Earnings Ratio. Empirical academic research suggests that the returns earned from stock market investments are significantly negatively correlated to the prices paid for the investments in question (ie. that “cheap” value stocks tend to outperform more “expensive” growth stocks). See Value Versus Growth: The International Evidence by Fama & French. By excluding stocks that have a price-earnings ratio of more than 15x, we reduce our chances of overpaying for our investments.
- Moderate Ratio of Price to Assets. This is another criteria to prevent us from over-paying for our investment, a mistake that would likely lead to poor future returns. We relax this criteria slightly from that recommended by Graham (from a maximum of 1.5x to 1.75x) because of greater proportion of companies today which rely upon goodwill rather than industrial fixed assets (ie. to reflect the rise of service industries versus manufacturing).
At this stage we limit our screen to European companies (I’ll try and do US and Emerging Markets versions at a later date), which leaves us with ten companies that meet our high-level investment criteria. The companies in question are: Boliden AB; Centralschweizerische Kraftwerke AG; Endesa SA; Fred Olsen Energy ASA; Gazprom OAO; Kazakhmys PLC; KGHM Polska Miedz SA; Melker Schorling AB; Razvedka Dobycha KazMunayGaz AO; and Romande Energie Holding SA.
The output from our screen can be viewed here, and we will look in more detail at a selection of the companies at a later date.