Defining a suitable stock selection criteria is step #1 in our value investing workflow. It’s critical that we select only those stocks that will allow us to calculate a valuation with an accuracy we’re sufficiently confident in to enable proper execution of our value investment strategy.
Selected stocks firstly must be highly predictable. A highly predictable company will allow us to determine an intrinsic value with a high degree of confidence.
Secondly, we are looking for high quality stocks. Quality ties in closely with predictability and is defined by the company’s ability to meet a number of criteria with respect to consistent growth and return on capital. This stock selection criteria will seek to choose only the highest quality companies with a stellar record of consistently high growth across a number of metrics.
Finally, we will seek to limit our selection only to those sectors and industries within which we have at least a cursory understanding of the business. This will allow us to further screen our stock selection against possible red flags or opportunities that may not be present in the numbers themselves.
Recommended reading: This post forms part of a series of steps outlined in, “Value Investing Workflow: The basic concepts“.
It’s all about the Fundamentals
For this selection criteria, we will attempt to identify stocks which have consistent, predictable growth with low or (ideally) zero debt. A number of fundamental metrics will enable us to do this. Specifically, we are looking for stocks that meet the following fundamental criteria:
- Earnings per Share (EPS) growth > 15%. Earnings growth is the biggest driver of share price appreciation over the long term. Specifically we’re looking for a minimum of 15% average growth over the past five years with no individual year less than 10%.
- Sales (revenue) growth > 15%. It’s important that earnings growth is supported by growth in sales. While companies can increase earnings over the short term without a corresponding increase in sales through cost cutting or margin-increasing measures, this is not sustainable over the long term. We are looking for predictability and sustainability in our investments. Therefore, our second criteria is that sales have achieved a minimum of 15% average growth over the past five years with no individual year less than 10%.
- Book Value per Share (BVPS) growth > 10%. Benjamin Graham and subsequently Warren Buffett actually believed that equity growth was just as important, if not more important than earnings growth. It is possible for companies to manipulate earnings in the near term, but much more difficult to do so with equity. We will limit our stock selection to companies who have achieved a minimum average BVPS growth of 10% over the past five years.
- Debt / Equity ratio < 0.1. Low debt is a key requirement for predictable behavior. While it’s true that higher debt may in some instances boost growth over the near term, we are seeking out companies that are able to grow without relying on debt.
- Market capitalization > $300m. Companies larger than $300m are more predictable and better established.
- Stock price > $10. Weeds out low quality stocks.
- Volume > 100k. Ensures that there is adequate liquidity.
I call this the Predictable Growth, Low Debt stock selection criteria, PGLD for short. A screen (step #2 of our workflow) based on the above criteria using Finviz will typically result in 50 – 100 stocks that match the criteria. We are not done yet though. The next step is to filter out those stocks in industries and/or sectors of which you have no or little familiarity. It’s important that when reading the company’s quarterly and annual reports that you are able to understand the relevance of the risks and opportunities that are presented, and this is only possible with an understanding of the industry itself and the players within.
It’s likely that there will only be 10 – 20 stocks remaining after all is said and done. This is the focus list that must now be researched in depth to look for any possible red flags (workflow step #3). The ultimate goal should be to identify 5 – 7 extremely high quality, predictable companies, that meet all of the fundamental criteria above, are in an industry you are familiar with, and have not waved any red flags upon close examination. Any company that is able to meet this strict criteria should be worthy of further evaluation and purchase when the price is right.
The image, “Question Mark” is copyright © 2012 brianfallen97 and made available under a CC Attribution Attribution-No Derivative Works 3.0 License.