Whittling Methodology
My approach to investment; well that is partly given away by the name I write under, Stock Whittler, I screen the markets, whittling away until I come up with a manageable list of interesting stocks for further investigation.
Maybe it’s easier to start with a few exclusion rules or “no go areas” that I apply:
Firstly I only consider companies that actually make cash: this rigid rule totally rules out any blue sky companies and the "jam tomorrow" stocks. This may well deprive me of excitement but based on experience of these stocks it certainly greatly reduces stress and the destruction of one's wealth. For me, cash is king.
Secondly I will not consider any stock that appears in the most talked about listings on the various bulletin boards. Invariably they are highly ramped stocks with little in the way of quality or value. I have to say that I am not a fan at all of bulletin boards. Far too much dishonesty, ramping by ITK types and largely populated by “experts” that know sweet FA.
Thirdly, country of residence: I will not touch companies that are resident in Africa, Russia/ex-soviet block or China. In addition, I am dreadfully wary of Israeli companies and the same applies to India. In short I am very wary of any business resident outside of the UK or USA. I have had my fingers burnt in some such enterprises where the truth and reality often bear no relation to one another.
Fourthly, holes in the ground: I also have another no-go area: Aim-listed precious metal stocks, gemstone companies, I tend to like the extended Mark Twain quote that “a mine is a hole in the ground with a liar standing at the top”; I avoid such situations.
So what type of companies am I looking for? Well generally throughout my two portfolios that buy individual stocks, I whittle away at data and look for the following qualities:
General Value
PE: although most definitely not my favourite value measure, it’s nice to find a low PE but I do take care on two accounts. Firstly if the PE is ridiculously low e.g. 5 or less RED FLAG. Secondly with the PE I do make a comparison with its peers in a sector rather than the whole market and also if high, what it's realistic growth prospects may be. Why don't I like the ubiquitous PE? Well, sadly it's simply far too easy to manipulate with profits being claimed that night not actually be quite the truth. Sadly the success or failure of the directors, particularly the CEO & CFO, may be judged for bonus reward or even continuation of employment by rising "profits" & stock price performance; hence the temptation for the less honest types to manipulate.
Price to Free Cash Flow: Cash flow is harder to fudge than EPS and I feel much more comfortable with a reasonable PFCF that's not totally out of line with the sector.
Control of debt: by this I mean that net debt should be no more than 3 x Operating Profit; essentially a Naked Trader style in terms of acceptance of debt. Debt is fine when the economy and business is going swimmingly well but can be a killer in other circumstances.
Dividends: I rarely invest in companies that don’t pay a dividend. Historically reinvestment of dividends has a massive impact on total return so why ignore it?
Dividend cover: generally the acceptance of by what multiple is the dividend covered by profits. That's all well and good, but profits are also used for other things such as capital investment.Therefore for me a key criterion is that free cash flow per share must be greater than dividend per share which is my next criteria:
Free Cash Flow ps greater than Dividend ps: The odd year of a miss is fine, but I will investigate the reasons why. Why would you invest in a business that uses debt or sells off assets in order to fund cash dividends to its investors? Remember our buddies at Tesco!
Quick Ratio: Total Current Assets divided by Total Current Liabilities hopefully above 1.2 but if it's less then I need to feel comfortable as to why.
Pension deficit: a deficit is not always a killer for a company but overall I want to understand the magnitude of the deficit and plans for managing it.
Quality
Increasing Sales/Turnover: generally I want to see an increasing trend of sales/turnover. As a general approach, I prefer companies that are increasing their turnover even after going through a tough period and perhaps reengineering the business.
Increasing profits year on year: I will make the exception for the odd year but would investigate the reasons why and takes judgement.
A decent profit margin that is at least on a par with other business in that sector, I have absolutely no interest in a business that may make a profit at some time in the future.
Cash Flow per share greater than Earnings per share: as taught to me years ago by the great Jim Slater, this greatly reduces the chances of earnings being fudged.
ROCE: If you want to understand the importance of ROCE then have a look at the videos or articles by Terry Smith. Simply why would you invest in a business that makes a miserable return on capital? In reality, I look for a minimum of 10% but feel more comfortable with returns of over 15%. Occasionally if some step change looks likely within the business, then I will make exceptions.
CROCI: similar to ROCE in that it gives a measure of return on the average capital employed but uses Free Cash Flow rather than EBIT. I tend to look at the CROCI performance over a few years rather than a single year and am always looking for a general trend upwards.
Piotroski Score: yes I am a great fan of the Piotroski scoring system that gives an assessment of the financial health of a business. I usually set my criteria as a Piotroski of at least 6.
Growth
Trending: are the trends for profit margin, sales, ROCE, CROCI, cash flow etc at least indicating that we don’t have a business in decline and hopefully growing or in a health attractive state of recovery. I usually have a look at the PEG value but always need to be mindful that these are built with analysts estimates and, therefore, that’s all they are estimates.
Momentum
Momentum: all too often a stock can be identified that has many of the above qualities yet momentum is just not with that share. Some may have success in viewing these companies as value plays and holding for some time until the market again smiles on the company. I occasionally do invest in such companies but find it to be less risky if I wait until there is a degree of positive momentum with the share before making an investment.
Watch out for Smoke & Mirrors
Smoke & Mirrors: I am acutely aware aggressive accounting and the manipulation of costs to massage an apparent attractive set of numbers that make a business appear to be far more attractive than it actually is. In order to at least attempt to weed out the dodgy accounting culprits, I run a smoke & mirrors screen over stocks; invaluable in my opinion.
As a result of putting it all together we should hopefully have some stocks that may show and continue to show momentum but in the works of the great song “it don’t mean a thing if it ain’t got that swing” with swing being momentum in this case.
Maybe it’s easier to start with a few exclusion rules or “no go areas” that I apply:
Firstly I only consider companies that actually make cash: this rigid rule totally rules out any blue sky companies and the "jam tomorrow" stocks. This may well deprive me of excitement but based on experience of these stocks it certainly greatly reduces stress and the destruction of one's wealth. For me, cash is king.
Secondly I will not consider any stock that appears in the most talked about listings on the various bulletin boards. Invariably they are highly ramped stocks with little in the way of quality or value. I have to say that I am not a fan at all of bulletin boards. Far too much dishonesty, ramping by ITK types and largely populated by “experts” that know sweet FA.
Thirdly, country of residence: I will not touch companies that are resident in Africa, Russia/ex-soviet block or China. In addition, I am dreadfully wary of Israeli companies and the same applies to India. In short I am very wary of any business resident outside of the UK or USA. I have had my fingers burnt in some such enterprises where the truth and reality often bear no relation to one another.
Fourthly, holes in the ground: I also have another no-go area: Aim-listed precious metal stocks, gemstone companies, I tend to like the extended Mark Twain quote that “a mine is a hole in the ground with a liar standing at the top”; I avoid such situations.
So what type of companies am I looking for? Well generally throughout my two portfolios that buy individual stocks, I whittle away at data and look for the following qualities:
General Value
PE: although most definitely not my favourite value measure, it’s nice to find a low PE but I do take care on two accounts. Firstly if the PE is ridiculously low e.g. 5 or less RED FLAG. Secondly with the PE I do make a comparison with its peers in a sector rather than the whole market and also if high, what it's realistic growth prospects may be. Why don't I like the ubiquitous PE? Well, sadly it's simply far too easy to manipulate with profits being claimed that night not actually be quite the truth. Sadly the success or failure of the directors, particularly the CEO & CFO, may be judged for bonus reward or even continuation of employment by rising "profits" & stock price performance; hence the temptation for the less honest types to manipulate.
Price to Free Cash Flow: Cash flow is harder to fudge than EPS and I feel much more comfortable with a reasonable PFCF that's not totally out of line with the sector.
Control of debt: by this I mean that net debt should be no more than 3 x Operating Profit; essentially a Naked Trader style in terms of acceptance of debt. Debt is fine when the economy and business is going swimmingly well but can be a killer in other circumstances.
Dividends: I rarely invest in companies that don’t pay a dividend. Historically reinvestment of dividends has a massive impact on total return so why ignore it?
Dividend cover: generally the acceptance of by what multiple is the dividend covered by profits. That's all well and good, but profits are also used for other things such as capital investment.Therefore for me a key criterion is that free cash flow per share must be greater than dividend per share which is my next criteria:
Free Cash Flow ps greater than Dividend ps: The odd year of a miss is fine, but I will investigate the reasons why. Why would you invest in a business that uses debt or sells off assets in order to fund cash dividends to its investors? Remember our buddies at Tesco!
Quick Ratio: Total Current Assets divided by Total Current Liabilities hopefully above 1.2 but if it's less then I need to feel comfortable as to why.
Pension deficit: a deficit is not always a killer for a company but overall I want to understand the magnitude of the deficit and plans for managing it.
Quality
Increasing Sales/Turnover: generally I want to see an increasing trend of sales/turnover. As a general approach, I prefer companies that are increasing their turnover even after going through a tough period and perhaps reengineering the business.
Increasing profits year on year: I will make the exception for the odd year but would investigate the reasons why and takes judgement.
A decent profit margin that is at least on a par with other business in that sector, I have absolutely no interest in a business that may make a profit at some time in the future.
Cash Flow per share greater than Earnings per share: as taught to me years ago by the great Jim Slater, this greatly reduces the chances of earnings being fudged.
ROCE: If you want to understand the importance of ROCE then have a look at the videos or articles by Terry Smith. Simply why would you invest in a business that makes a miserable return on capital? In reality, I look for a minimum of 10% but feel more comfortable with returns of over 15%. Occasionally if some step change looks likely within the business, then I will make exceptions.
CROCI: similar to ROCE in that it gives a measure of return on the average capital employed but uses Free Cash Flow rather than EBIT. I tend to look at the CROCI performance over a few years rather than a single year and am always looking for a general trend upwards.
Piotroski Score: yes I am a great fan of the Piotroski scoring system that gives an assessment of the financial health of a business. I usually set my criteria as a Piotroski of at least 6.
Growth
Trending: are the trends for profit margin, sales, ROCE, CROCI, cash flow etc at least indicating that we don’t have a business in decline and hopefully growing or in a health attractive state of recovery. I usually have a look at the PEG value but always need to be mindful that these are built with analysts estimates and, therefore, that’s all they are estimates.
Momentum
Momentum: all too often a stock can be identified that has many of the above qualities yet momentum is just not with that share. Some may have success in viewing these companies as value plays and holding for some time until the market again smiles on the company. I occasionally do invest in such companies but find it to be less risky if I wait until there is a degree of positive momentum with the share before making an investment.
Watch out for Smoke & Mirrors
Smoke & Mirrors: I am acutely aware aggressive accounting and the manipulation of costs to massage an apparent attractive set of numbers that make a business appear to be far more attractive than it actually is. In order to at least attempt to weed out the dodgy accounting culprits, I run a smoke & mirrors screen over stocks; invaluable in my opinion.
As a result of putting it all together we should hopefully have some stocks that may show and continue to show momentum but in the works of the great song “it don’t mean a thing if it ain’t got that swing” with swing being momentum in this case.