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My problem with stock screens

M

Most of us know the problem with simple stock screens such as one’s based on low P/E ratio, low P/B ratio etc. A lot of stocks which get filtered through the screens are typically companies with poor economics. I have tried to overcome this problem by building a screen which has the following additional screening criteria

  • An ROCE/ROE of atleast 13% or more
  • No loss during the past 5 years
  • Above average growth over 5 years in NP
  • D/E < 2

Adding the above stock screens has filtered out companies in the following industries (partial list below)

  • auto components
  • bank
  • cement
  • Chemical
  • Shipping
  • Fertiliser
  • Shipping
  • Paper
  • Textile

I have started analysing one company at a time under each of the classification. Unfortunately the reason these companies have filtered out is either due to a cyclical uptick in the industry (cement, shipping, paper etc) or it is tier II company in the industry with high operating leverage and has seen a reduction in interest cost. Due these reasons , the recent PE, ROE etc of these companies is good, debt is down and these stocks look good.
My concern is how these companies would fare once the cycle turns downwards. Let me explain using the example of shipping industry which I am analysing currently.
The main companies in the shipping industry which have filtered out through the screen are

  • mercator lines : High asset addition recently through debt which has resulted in high earnings and high ROE. The risk to the business is high if the business cycle reverses as the company may be unable to service its debt
  • Varun shipping / Shreyas shipping: high operating leverage, high debt and high growth in earnings in recent times due to high shipping rates. Earnings risk is high due to operating leverage
  • Essar shipping : High earnings due high shipping rates. Also ROE is high to asset revaluations. This stock looks interesting and worth investigating further.

I guess the stock screen is throwing up a lot of companies which may be statistically cheap but not really a value stock. So essentially I am not be able to come up with a list of companies which are great value. I guess it is to a certain extent an indication of the kind valuation levels existing in the current market (The same filter in 2003 gave much better companies). So I guess I will have go through the entire list and maybe at the end (the list has 100+ companies) come up with a few good stocks. It defintely not a waste of time because it helps me to understand more companies/ industries which could be helpful in the future

any suggestions on improving the above screens ?

Comparing performance when invested capital is low

C

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

http://mckinseyquarterly.com/article_abstract.aspx?ar=1678&L2=5&L3=5

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn’t make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

The practise of giving price targets in research reports

T

I have always wondered why analysts give price targets, when it is extremely difficult to predict the price level of a security, which is dependent on a host of factors with a few of these factors related to the psychology of the market at a future date.

The typical research report ( at least the free ones which I typically read) usually starts off with a very brief background of the industry. It would then discuss the latest results with a brief analysis of the last 2-3 years. The next 2-3 years income statement and balance sheet is projected. The report would typically end with a price target with simplistic analysis which is typically based on the projected EPS and a PE no.

The more rigorous analyst would give his logic for the PE assumed(often  based on the past PE of the company ). Most don’t bother to do even that.

PE as a measure is fairly flawed measure as it does not consider the ROE of the firm, its competitive advantage, impact of industry dynamics etc. At the same time the number used in backward looking (based on past PE, earning etc).I would assume a more rigorous mode of valuation would be based on DCF, with various scenarios being considered and valuation range being arrived at (with degree of confidence for this range).

But then the analyst is giving the consumer (the investor) what he wants – A precise price target (which would be hopefully achieved in the future) , a certainty,  where none exists.

It’s not that all analyst reports are of a poor quality. Some do discuss the industry in depth and attempt to do a more thorough valuation exercise. But most are superficial and not worth reading. I have found the original source of the information – The annual reports, far more useful than the analyst reports and have never made a serious commitment of capital based on an analyst report.

Do we have any good source of analyst reports in India? If you are aware please email me.,

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