Introduction
IT IS NOT feasible for an individual investor to research every listed company in detail. A share-screening tool is therefore invaluable, as it helps filter listed companies into a more manageable list by specifying desirable fundamentals. Shortlisted companies can then be researched in detail. Through eliminating companies with poor fundamentals, you increase your odds of finding the best companies to invest in.
This chapter looks at a variety of screens that meet different strategic needs. The screens are separated into three groups: income, value and growth. Income screens are designed to find companies that provide a reliable, steady income. These companies are useful when company shares are held within a tax wrapper (such as an ISA), so income is not taxable. Value companies are companies where the fundamental value is likely to be well below the current price. Growth companies are companies that are growing earnings rapidly but are not currently overly expensive in valuation terms.
Both value and growth companies offer an opportunity for significant capital appreciation. This is useful when investments are outside tax-free wrappers and dividend income is taxable. Investing for capital gains is therefore more efficient (as taxes are not taken until the shares are sold) and it allows you to make use of capital gains allowances, which lower your overall tax bill.
In addition to these three groups of screens, an economic moat screen is provided. This screen helps identify companies with a durable competitive advantage likely to offer decent long-term returns. Income, value or growth companies appearing on this list should be prioritised for further research and investment. This screen can also be thought of as an alternative growth screen.
Income screens
Income screens are designed to look for companies that regularly pay out dividend income and are likely to continue doing so over the medium to long term.
Screen 1: Quality income screen
The quality income screen aims to identify companies with strong fundamentals and high yields. High-quality companies that have a high, sustainable dividend yield have been shown to perform well relative to the overall market, with good capital gains, low risk of loss and regular income-supporting returns.
The quality income screen criteria are as follows:
Rolling dividend yield higher than the average market yield plus 1% or 4%, whichever is lower
The dividend per share (DPS) is the amount of money paid out by a company each year per share owned in the company. The rolling DPS is a weighted average of the current year’s DPS and the forecast of the following year’s DPS, where the weight is dependent on how far into the fiscal year a company is.
For example, suppose the DPS in the current year is 10p and the next year the DPS is forecast to be 20p. Then, a quarter of the way into the fiscal year, the rolling DPS will be 12.5p (= 0.75 × 10p + 0.25 × 20p). Using rolling values allows a like-for-like comparison of ratios between companies that have different reporting dates.
The rolling dividend yield is the rolling DPS divided by the current share price. It determines the income stream paid out by a company as a percentage of the current value of the company.
The rolling dividend yield is required to be 1% above the average market dividend yield or 4%, whichever is lower. For example, if the average yield for FTSE All Share companies is 3.6%, then the required rolling dividend yield hurdle would be set to 4%, as 4.6% (= 3.6% + 1%) is greater than 4%. The average dividend yields for different markets are published each week in the Investors Chronicle in the ‘Market this week’ section.
Rolling dividend yield less than 15%
A company’s share price and dividend yield have an inverse relationship – i.e., when one goes down, the other goes up. Often when a company has a very high dividend yield it is likely to be the result of a depressed share price, rather than the company’s ability to produce generous payouts.
A high historic yield can therefore be a warning sign that the dividend payment is going to be cut or that the share price is likely to fall further. High-quality companies with solid fundamentals should not see their share prices plummet. This screen is therefore set up to rule out companies with dividend yields above 15%.
Rolling dividend cover above 1.5
The dividend cover is the number of times dividends can be paid out of earnings. The higher the number, the more likely it is that the company will be able to continue paying out the dividend in future years. For example, if a share in a company has earnings per share of £1.50 and it pays a dividend of 50p, the dividend cover is 3 (= 150 ÷ 50). This is probably a healthy situation, as the company is retaining two thirds of its earnings to reinvest in the business.
A warning sign occurs when the dividend cover is below 1, as this indicates that the company is paying out more dividends than it has earned; the company is either running down its reserves or borrowing money to cover the earnings shortfall. In general, the higher the dividend cover, the better for investors looking for continuing income.
Rolling dividend cover is defined as rolling earnings per share divided by rolling dividends and is interpreted in a similar way. The screen is set up to require the rolling dividend cover to be more than 1.5. This ensures that no more than two thirds of earnings are paid out as dividends.
Market capitalisation greater than £800m
Market capitalisation is the current value of a company as recognised by the market. Large companies are likely to be able to survive market downturns and recessions better than small companies. The likelihood of complete loss is therefore low. The screen requires that companies have a market capitalisation of more than £800m.
Improving balance sheet – Piotroski F-score is 7 or higher
The Piotroski F-score is designed to measure the financial strength of a company using available data from financial statements. It is named after a Chicago accounting professor, Joseph Piotroski, who devised nine criteria to assess the financial health of a company. A company scores a point for every criterion it meets. The points are added up to give the Piotroski score, a discrete number between 0 and 9. The higher the score, the better the financial health of the company.
The nine criteria are:
Profitability
1. Bottom line. Score 1 if net income is positive in the current year.
2. Operating cash flow is a better earnings gauge. Score 1 if cash flow from operations in the current year is positive.
3. Return on assets (ROA) is a measure of profitability, defined as net income divided by total assets. Score 1 if the ROA is higher in the current period compared to the previous year.
4. Quality of earnings warns of accounting tricks. Score 1 if the cash flow from operations exceeds net income before extraordinary items.
Leverage, liquidity and source of funds
5. Leverage is the amount of debt used to finance a company’s assets. A company with improving financial health should gradually reduce its leverage. Score 1 if there is a lower ratio of long-term debt to assets in the current period compared to the previous year.
6. The current ratio is a liquidity measure that is used to monitor a company’s ability to pay back its short-term liabilities (short-term debt and payables) with its short-term assets (such as cash, inventory and receivables). It is defined as short-term assets divided by short-term liabilities. The higher the current ratio, the more capable the company is of paying its obligations. The liquidity of a company is improving when the current ratio is rising. Score 1 if there is a higher current ratio in the current year compared to the previous year.
7. Shares outstanding is a measure of potential dilution. If the total number of shares outstanding increases, current ownership of the company is being diluted. This generally won’t happen for companies in good financial health (unless they are intent on making an acquisition). Score 1 if the company did not issue new shares in the preceding year.
Operating efficiency
8. Gross margin is a measure of competitive position. Score 1 if there is a higher gross margin compared to the previous year.
9. Asset turnover is a measure of a company’s ability to use its assets to generate sales. It is defined as sales divided by total assets. This can be interpreted as the amount of sales generated per currency unit of assets. If asset turnover improves over time it can be a signal of improving financial health. Score 1 if there is a higher asset turnover ratio year on year.
Good quality companies should have good financial health and should therefore meet most of the above criteria. A Piotroski score of 7 or higher is therefore required.
Low likelihood of going bankrupt – Altman Z-score is higher than 1.8
The Z-score was developed by finance professor Edward Altman in 1968. It is a model-based method to determine the likelihood of financial distress: the lower the score, the more likely the company will become financially distressed. (Note the Z-score is not suitable for financial companies.)
The Altman Z-score is a combination of five weighted business ratios that are used to estimate the likelihood of financial distress. The ratios are:
1. X1 = Working capital ÷ total assets. This measures the liquid assets of a company. A company experiencing financial distress will usually experience shrinking liquidity.
2. X2 = Retained earnings ÷ total assets. This ratio represents the cumulative profitability of the company. Shrinking corporate profitability is a warning sign that the company may be in trouble.
3. X3 = Earnings before interest and taxes (EBIT) ÷ total assets. This ratio shows how productive a company is at generating earnings relative to its total asset size. Weaker companies will be less efficient at earnings creation.
4. X4 = Market value of equity ÷ book value of total liabilities. This ratio offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent (i.e., its liabilities exceed its current value). A company with weakening fundamentals will become less solvent over time and the ratio will fall. This ratio is used for manufacturing companies.
X4A = Book value of equity ÷ total liabilities. This ratio also offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent (i.e., its liabilities exceed its accounting value). This ratio is used for non-manufacturing companies, as it provides greater predictive power than X4 when considering the probability of financial distress.
5. X5 = Sales ÷ total assets. Asset turnover is a measure of how effectively the company uses its assets to generate sales. Companies with weakening fundamentals will likely generate fewer sales for a given asset base.
For publicly listed manufacturing companies, the Altman Z-score is calculated as follows:
(1.2 × X1) + (1.4 × X2) + (3.3 × X3) + (0.6 × X4) + (1.0 × X5)
while the Altman Z-score for non-manufacturing companies is calculated as:
(6.56 × X1) + (3.26 × X2) + (6.72 × X3) + (1.05 × X4A)
When a company is experiencing financial distress, the above ratios should fall, producing a lower overall Z-score. A score above 3 is deemed to be a healthy company. A score between 1.8 and 3 is in a grey area. A score below 1.8 suggests that a company has a high probability of becoming distressed within the next two years.
High-quality companies should not have a high chance of bankruptcy. Consequently, the screen is set up to remove companies with an Altman Z-score of 1.8 or lower.
Company does not belong to the finance sector
Companies in the finance sector are excluded. It is harder to judge a financial company’s earnings and their ability to continue paying a dividend. Consequently, returns from companies in the financial sector tend to be more volatile than other sectors. The financial sector is therefore avoided when building a portfolio of quality companies with high dividend yield payout.
Optional: quality rank is above 80
The quality rank is a composite indicator produced by Stockopedia. It blends a range of quantitative factors pertaining to company cash flow, profitability and stability, to provide a general score of quality.
Every company in the market is ranked from 1–100 for each factor and a composite score is calculated as a weighted average of all these values. The quality rank is then calculated between zero and 100 for this composite score, where 100 is the best quality company in the market and zero is the worst company in the market. The higher the quality rank score, the better the quality of the company.
This criterion aims to identify the best quality companies by requiring a quality rank above 80.
If you are using an alternative screening tool, you can replace this criterion with an equivalent summary quality indicator or omit it altogether.
Screen 2: Growth and income screen
The growth and income screen is designed to select companies that are growing earnings while still offering above average dividend yields. The approach starts by looking for solid growth and reasonable quality in key metrics, then selects the subset of companies with the best dividend yields.
The growth and income screen criteria are:
Earnings upgrades over the next two financial years are positive
The screen first looks for companies where brokers have recently upgraded their forecasts for the next financial year. Analyst forecasts tend to trend, as they often get anchored to their previous forecasts and adjust their initial forecasts cautiously in reaction to new events; this often means that initial adjustments are insufficient and further adjustments over time are required.
The screen requires the broker forecast for the second (financial) year to have been upgraded in the past three months.
Current return on equity (ROE) is above the market median
Return on equity measures the rate of profit earned by a company for its shareholders. It is defined as net profit divided by shareholders’ equity (which is assets minus liabilities). It is therefore a measure of the underlying quality of the business as it calculates a company’s efficiency at generating profits from every unit of shareholders’ equity. The screen is set up to require a return above the market median.
Rolling PE is less than 20
The PE ratio is a commonly used valuation measure. It is defined as the share price divided by earnings per share (EPS). It measures the multiple of earnings a company’s share price is currently trading at. All other things being equal, the lower the multiple, the cheaper the company’s shares are relative to earnings.
The rolling PE ratio is the current share price divided by rolling EPS. The rolling EPS is a weighted average of the current year’s EPS and the forecast of the following year’s EPS, where the weight is dependent on how far into the fiscal year a company is. Using rolling values allows a like-for-like comparison of rolling PE ratios between companies that have different reporting dates.
Companies with a high PE above 20 are generally thought of as expensive, unless they have very high earnings growth. Growth and income companies selected using this screen typically have more modest levels of growth. For this reason, it is reasonable to exclude companies with a PE ratio above 20.
Rolling PE over the next year is below the market median
In addition, the rolling (forward) PE ratio is required to be less than the market median so that only the cheapest half of the market is considered.
Company is not overly geared (burdened by debt) – gross gearing less than 1
The gross gearing ratio shows how encumbered a company is with debt. It is defined as total debt divided by the book value of shareholders’ equity, where shareholders’ equity is the value of assets which may be regarded as owned by the shareholders. The higher the gearing ratio, the higher the amount of debt to shareholder equity.
A highly geared company is more vulnerable to adverse shocks, such as operational problems or a downturn in the economy. The screen therefore requires total debt to be less than shareholder equity by choosing companies with gross gearing less than 1.
Dividend yield is above the market median
The screen aims to find growing companies that pay out above average dividend yields. The current dividend yield is therefore required to be above the current market median dividend yield.
Company is less sensitive to market volatility – beta is less than 1
If a company is less sensitive to the ebbs and flows of the economy, its shares should be less sensitive to the ebbs and flows of the market. Beta measures the relationship between movements in the wider market and company share price. The screen selects more defensive companies by setting an upper limit of 1 to beta.
Piotroski F-score above 5
As mentioned earlier in the chapter, the Piotroski F-score is designed to measure the financial strength of a company using available data from financial statements. The screen requires the Piotroski F-score to be higher than 5, which signals that the financial strength of the company is gradually improving.
Rolling dividend cover above 1.5
The screen is set up to require that the rolling dividend cover is more than 1.5. This ensures that no more than two thirds of earnings are paid out as dividends.
Rolling dividend yield over the next year is expected to be above average
The rolling dividend yield is the rolling dividend divided by the current share price. It determines the income stream paid out by a company as a percentage of the current value of the company.
The rolling dividend yield is required to be above the average dividend yield offered by companies in the market. The average dividend yields for different markets are published each week in the Investors Chronicle. For example, if the average yield for FTSE All Share companies is 3%, the required rolling dividend yield hurdle would be set to 3%.
Note that a premium is not added on to the rolling dividend yield (as in the quality income screen), due to the added benefit of growth in earnings, which will hopefully allow companies to grow their dividends quickly. Furthermore, adding a premium of 1% would significantly reduce the number of companies listed in the screen.
Market capitalisation above £20m – illiquid companies ruled out
The screen removes companies with a market value below £20m. These companies tend to be riskier and harder (and more expensive) to trade – most investors do not want to own them. These companies are therefore excluded.
Value screens
Value screens aim to find companies that are out of favour with the market and currently have cheap valuations. These companies potentially offer significant capital gains once there is a favourable revaluation.
The value screens are based on work done by David Dreman in his book, Contrarian Investment Strategies: The Next Generation, which aims to identify companies that have low valuations with higher than average dividend yield. The dividend yield helps to ensure that there is a regular return on the investment and some insulation from falls in value while waiting for the re-rating.
Screen 3: Low PE screen
The low price to earnings (PE) screen focuses on the cheapest 40% of companies in the market with above average dividend yields, financial health and growth characteristics. The price to earnings ratio is used as the key valuation metric. The lower the PE ratio, the cheaper and the more out of favour the companies are likely to be.
The low PE screen criteria are as follows:
Cheapest 40% of the market based on the PE ratio
The screen orders all the companies in the market by their price to earnings ratio and selects the bottom 40% of companies with the lowest PE ratio. These companies are out of favour with the market.
Sales above £100m
The screen targets large- and medium-sized companies because they are less likely to suffer from damaging operational or financial setbacks. Large companies generally have a higher market profile than smaller companies, which attracts wider attention from investors in better times. Furthermore, the accounts of larger companies tend to offer more reliable growth indicators as the financial statements are higher quality and more information is readily available from investment houses and regulators. The screen requires company sales to be larger than £100m.
Low debt levels compared to the market
Debt to assets is a measure of the extent to which a company’s assets are financed by debt. It is defined as total debt divided by total assets. The higher the ratio, the greater the financial risk associated with the firm’s operation. In addition, a high debt to assets ratio may indicate low borrowing capacity, which in turn will lower the firm’s financial flexibility. The screen requires the debt to assets ratio to be less than the market average.
Liquid assets sufficient to cover current liabilities
The current ratio is a measure of short-term solvency. It is defined as current assets divided by current liabilities. Current assets include cash, cash equivalents and items that will become cash, such as money owed to the company, prepayments and stock. Current liabilities are the company’s debts or obligations that need to be paid within the next 12 months. Current liabilities appear on the company’s balance sheet and include short-term debt, accounts payable, accrued liabilities and other debts. When the current ratio is above 1, the company has sufficient income to cover upcoming liabilities.
The screen requires the current ratio to be greater than 1, which ensures that the company can continue trading over the short term and is deemed sufficiently solvent for further consideration.
Profit margins better than the market average
The net profit margin is a key measure of how efficient a company is at converting sales revenue into profit, taking into consideration all expenses of the company. The higher the net profit margin the more efficient (and profitable) the company. The screen selects companies that have net profit margins that are higher than the market average.
Return on equity (ROE) better than the market average
ROE is a useful measure of a company’s profitability as it shows the return being generated for every pound of shareholder equity on the balance sheet. It is defined as net profit divided by shareholders’ equity (which is assets minus liabilities). The higher the ROE for a company, the more value should be created for shareholders. Companies are required to have a ROE above the market average, which indicates they are more efficient at generating a profit than the average company in the market.
Earnings growth better than the market average
The screen requires that companies deliver earnings growth that outperforms the market, so that they are gradually increasing market value. Current earnings growth is therefore required to be above the market average (as measured by the median).
Above average dividend yield
The screen requires selected companies to have dividend yields that are above the market average. The dividend yield helps to ensure that there is a regular cash return, which helps to insulate from (temporary) falls in market value, while waiting for a re-rating.
Exclude companies that are collective investments
Collective investments are funds that combine the assets of various individuals and organisations to create a larger, well-diversified portfolio. The focus is on companies rather than funds. Collective investments are therefore excluded from the screen.
Piotroski F-score above 5
As mentioned, the Piotroski F-score is designed to measure the financial strength of a company using available data from financial statements. The screen requires the Piotroski F-score to be higher than 5, which signals that the financial strength of the company is likely to be improving.
Screen 4: Low PCF screen
The low price to cash flow (PCF) screen focuses on the cheapest 40% of companies in the market with above average dividend yields, financial health and growth characteristics. The price to cash flow (PCF) ratio is used as the valuation metric. The PCF ratio for a company is defined as share price divided by operating cash flow per share. The lower the PCF ratio the cheaper and the more out of favour the companies are likely to be.
The low PCF screen criteria are as follows:
Cheapest 40% of the market based on PCF ratio
The screen orders all the companies in the market by their price to cash flow ratio and selects the bottom 40% of companies with the lowest PCF ratio. These companies are out of favour with the market.
Sales above £100m
The screen targets large- and medium-sized companies because they are less likely to suffer from damaging operational or financial setbacks, tend to have a higher market profile and financial information tends to be more reliable. The screen requires the market value of the company to be larger than £100m.
Low debt levels compared to the market
The higher the debt to asset ratio, the greater the financial risk associated with the firm’s operation and the lower the firm’s financial flexibility. The screen requires the debt to assets ratio to be less than the market average.
Liquid assets sufficient to cover current liabilities
The current ratio is a measure of short-term solvency. The screen requires the current ratio to be greater than 1, which ensures that the company can continue trading over the short term and is deemed sufficiently solvent for further consideration.
Profit margins better than the market average
The net profit margin is a key measure of how efficient a company is at converting sales revenue into profit, taking into consideration all expenses of the company. The higher the net profit margin the more efficient (and profitable) the company. The screen selects companies that have net profit margins that are higher than the market average.
Earnings growth better than the market average
The screen requires that companies deliver earnings growth that outperforms the market. Current earnings growth is therefore required to be above the market average (as measured by the median).
Above average dividend yield
The screen requires selected companies to have dividend yields that are above the market average. The dividend yield helps to ensure that there is a regular cash return, which helps to insulate from (temporary) falls in market value, while waiting for a re-rating.
Exclude companies that are collective investments
Collective investments are funds that combine the assets of various individuals and organisations to create a larger, well-diversified portfolio. The focus is on companies rather than funds. Collective investments are therefore excluded from the screen.
Piotroski F-score above 5
As defined earlier in the chapter, the Piotroski F-score is designed to measure the financial strength of a company using available data from financial statements. The screen requires the Piotroski F-score to be higher than 5, which signals that the financial strength of the company is likely to be improving.
Growth screens
The growth screens are designed to find companies with high-quality, sustainable earnings growth that are still reasonably priced relative to the overall market. The focus is on buying companies that are likely to appreciate over time, rather than generate an income. As discussed in chapter 15, investing in growth companies can be advantageous if dividend income is likely to be taxed unfavourably.
The screens look for companies with high growth rates that are better than the market average, but with valuations that are below the market, giving you the best of both worlds.
Screen 5: Zulu growth
The Zulu growth screen is based on a screen outlined in Jim Slater’s books, The Zulu Principle and Beyond the Zulu Principle. It looks for small companies where brokers are forecasting high earnings growth and where this growth has not been fully priced in given expected future earnings. Small companies tend to be less well researched and there is therefore a greater chance of finding undervalued companies to invest in.
The criteria for the Zulu growth screen are as follows:
Price earnings growth (PEG) ratio less than 0.75
A lower PE ratio typically indicates that the price is cheaper. However, companies with high growth rates normally have higher PE ratios. Thus, just using the PE ratio would make many of the high growth shares look overvalued. The PEG ratio divides the PE ratio by the earnings growth rate, which allows companies with different growth rates to be compared.
The Slater PEG ratio is the forecast rolling PE ratio divided by forecast earnings growth. In addition, the Slater PEG is only quoted when there has been four consecutive years of earnings growth. The lower a company’s PEG ratio, the cheaper the company – all other things being equal. A growth company with a current PEG that is below 1 is viewed as good value, while a PEG below 0.75 is viewed as cheap. The screen selects undervalued companies with a Slater PEG of 0.75 or lower.
Rolling PE is less than 20
Companies with a high rolling PE above 20 would need to have earnings growth above 20% to justify such a high valuation. This sort of growth level is not sustainable long term and the share price is likely to be very sensitive to adverse news. For these reasons, expensive companies with a PE ratio above 20 are excluded.
Rolling earnings growing faster than 15%
One of the key contributing factors to stock price appreciation is the future rate of earnings growth. The higher the future earnings growth, the more rapid the price appreciation is likely to be. However, forecast earnings growth tends to be too optimistic at times. It is therefore useful to blend current earnings growth with next year’s forecast earnings growth. The rolling one-year earnings growth weights the current year and next year’s earnings growth depending on how far a company is through its fiscal year.
Growth companies should have high earnings growth. The screen therefore requires that companies have a one-year rolling earnings growth above 15%.
Relative share price strength over the past year is better than the market
Growth companies are growing their earnings at a faster pace than the average company in the market. This means that the share price of growth companies should be increasing at a faster rate than the price index of the market. That is, they should have positive relative (price) strength when compared to the market. This is especially true when you are selecting cheap growth companies, as they eventually benefit from an upward revaluation, which provides a tailwind to the price. The screen therefore eliminates companies that have underperformed the market.
Return on capital employed is greater than 12%
Return on capital employed (ROCE) compares earnings to the capital used to generate them. ROCE is defined as earnings before interest and tax (EBIT) divided by the net capital employed (NCE). EBIT is pre-tax profit minus net interest earned. Net capital employed is the capital available for use in the business by shareholders, long-term borrowings, company profits or revaluation. It is defined as total assets minus current liabilities.
ROCE measures the return generated by a company on the capital available. In general, a good company should have a high return on capital. A company with ROCE in high double digits is likely to have a competitive edge versus its competitors. The screen looks for companies with a ROCE above 12%.
Market value above £20m – illiquid companies ruled out
The screen removes companies with a market value below £20m. These companies tend to be hard to trade and are riskier. These companies are therefore avoided.
Market value below £1bn – small growth companies
The aim of the Zulu screen is to identify small growth companies, as these have greater scope to grow than larger companies. It is much easier to double a company’s profits from £10m to £20m, than a large company’s earnings from £1bn to £2bn, as the absolute increase required is smaller (£10m compared to £1bn).
A small growth company will also have a smaller share of the overall market, offering greater scope for organic growth. Companies with a market value below £1bn are defined as small, so those with a market valuation above £1bn are not considered.
Screen 6: Naked growth
The naked growth screen is broadly based on criteria proposed in the book, The Naked Trader: How Anyone Can Make Money Trading Shares by Robbie Burns. The aim of the screen is to find excellent companies with good fundamentals that are growing sales, earnings and dividends.
The criteria for the naked growth screen are as follows:
Market value above £20m – illiquid companies ruled out
The screen removes companies with a market value below £20m. These companies tend to be riskier and harder (and more expensive) to trade – most investors do not want to own them. These companies are therefore avoided.
Market value below £1bn – small growth companies
Small companies have greater scope to grow than larger companies. The screen therefore removes companies with a market valuation above £1bn.
Positive sales, earnings and dividend growth
A healthy growth company should be growing sales and earnings each year. Selected companies are therefore required to have rising sales and earnings over the past 12 months.
Growing companies that pay out a dividend must show greater financial discipline and manage cash flow more carefully, which often proves beneficial to the bottom line over the long term. In addition, companies that manage to grow the dividend in line with earnings send a signal that they are intent on progressively rewarding shareholders as growth is achieved. Companies are therefore required to have rising dividends.
Positive share price momentum
Growth companies that are reasonably priced should be steadily rising in value as sales and earnings growth gradually pushes up market value. The screen therefore requires that the current price is higher than the price 52 weeks ago.
More than 5% above 52-week price low
Fairly valued or cheap companies that are expected to continue growing in the future should be gradually increasing in value and prices should not be close to their 52-week lows. If a company’s share price is within 5% of its 52-week price low there is a risk that something fundamental has changed and that the growth story is unlikely to continue. The screen avoids companies that are making new lows or are close to making new lows.
Trading spreads are not too wide
If the trading spread (i.e., the difference between the price you can buy and sell at) is more than 4% there are not enough company shares to make the market for company shares liquid. Consequently, the cost of buying and selling the shares is high and it could be difficult to sell shares owned. The screen therefore excludes illiquid companies with spreads of 4% or more.
Rolling PE is less than 20
Companies with a high rolling PE above 20 would need to have earnings growth above 20% to justify such a high valuation (so that the PEG is less than one). This sort of growth level is not sustainable long term and the share price is likely to be very sensitive to adverse news. For these reasons, companies with a PE ratio above 20 are excluded.
A PE ratio above 12 is generally preferred, as this excludes companies that are potential value traps.
Low net debt compared to operating profits
Prudent use of debt increases the financial resources available to a company for growth and expansion. Conversely, a company with a high level of debt may find its freedom of action restricted by creditors or find that high interest-rate costs are starting to hurt profitability. Companies with low levels of debt are therefore preferred.
Debt is judged to be too high for a company if its net debt (which is total debt minus cash equivalents) could not be completely paid off within three years from its full-year operating profits. The screen excludes companies with high debt levels.
Exclude companies that are collective investments
The focus is on finding excellent companies rather than funds. Collective investments are therefore excluded from the screen.
Price to pre-tax profits ratio is less than 15
Price to pre-tax earnings per share (PPTE) ratio, is defined as the company’s market value divided by its pre-tax earnings (also referred to as pre-tax profit). Pre-tax profit is operating profit minus interest and any other non-operating expenses (except taxes).
Using this ratio as a measure of valuation is useful as it eliminates the distortion from different corporate tax structures on earnings. (It doesn’t eliminate the impact of capital structure though. This ratio could be replaced with price to enterprise value, which accounts for market value and debt levels. However, as enterprise value is evaluated in more detail in later chapters, this won’t make too much difference.) Companies that have a market value above 15 times pre-tax profits are judged to be expensive and are excluded by the screen.
Exclude companies listed on AIM
Companies that have a full listing are preferred as the accounting numbers are better audited and are generally more reliable than companies listed on AIM.
Piotroski F-score above 5
The screen requires the Piotroski F-score to be higher than 5, which signals that the financial strength of the company is improving.
Economic moat screen
Companies with an economic moat have a durable competitive advantage that helps protect them from competition and market pressures, just as the moat around a castle protects the castle from invaders. These competitive advantages provide pricing power or cost reductions, which allow these companies to maintain high returns on capital, leading to higher cash flows and returns for investors. The economic moats screen aims to find companies with durable competitive advantages using key metrics that often signal a company has an economic moat.
Income, value or growth companies that are judged to have an economic moat are of interest for investors and should be prioritised over other companies to research and invest in.
The criteria for the economic moat growth screen are as follows:
High free cash flow as a percentage of sales relative to the market
One signal that a company has a durable competitive advantage is the ability to generate a high rate of free cash flow. This is cash generated by the business after all capital expenditures (e.g., factory improvements, machinery repairs and replacement, etc.) have been paid off.
Free cash is cash that can be reinvested by the firm to grow their business, or paid out in dividends. The higher the rate of cash flow generation, the higher the value of the company. Companies with an economic moat are required to have free cash flow to sales in the top 20% of the market.
High operating profit margins above 20% and better than 80% of the market
The operating (profit) margin is a measure of a company’s pricing strategy and operating efficiency. The operating margin is defined as operating profit (i.e., profits earned from the company’s core business operations) divided by revenue. It measures the proportion of a company’s revenue left after paying for variable costs, such as wages or raw materials.
The operating margin is therefore an indicator of how effective the company is at converting revenue into operating profits. Operating margins are generally higher for companies with a competitive advantage as they have greater pricing power and/or cost advantages.
Companies with a strong competitive advantage should have the highest operating margins at above 20%. Consequently, only the top 20% of companies with the highest operating margins in the market are considered, with a 20% hurdle rate for the operating margin.
High returns on capital employed
Companies with a strong, durable competitive advantage can generate high sustainable returns on capital employed (ROCE) and returns on equity (ROE) compared with their peer group. Companies with returns of 15% or higher on a long-term basis may indicate a company with pricing power or cost advantages. Economic moat companies are therefore required to have averaged above 15% returns over the past five years and current returns should also be above 15%.
Companies fully listed on main stock exchange
This screen relies on accounting numbers to indicate whether a competitive advantage exists. These numbers therefore need to be reliable and fully audited. The screen therefore restricts the search to the larger fully listed companies. In the case of the UK, the search is restricted to companies listed on the FTSE 350. For the US, this could be changed to the S&P 500 index.
Summary
Screening for companies is a good place to start your research as it can save time and narrow your focus to a more manageable group of companies. The screens have been designed to select four sub-classes of company: income, value, growth and economic moat.
Income companies generate a sustainable, above-market average income, which can be invested in using tax wrappers, such as ISAs, which lower the tax on dividend income generated. (We discuss how to take advantage of tax rules in chapter 15.)
Value and growth companies aim for capital appreciation, which are suitable for investing outside of tax wrappers and allow you take advantage of capital gains tax allowances. However, our choice of value screen, which insists on some income generation, allows value companies to also sit within tax wrappers as well.
The economic moat screen is designed to provide a list of companies with a competitive advantage. Any companies that appear to overlap with other screens should be prioritised. In addition, cheap companies with an economic moat may be worth analysing, even if they don’t register on the other screens.
While share screeners are useful tools, they do have limitations. Share screeners only examine a limited number of quantitative factors – they are not exhaustive (otherwise you would quickly rule out all companies, defeating the purpose of screening for shares in the first place).
Furthermore, screens ignore important qualitative factors, such as the effectiveness of management, the drivers of competitive advantage or whether there are adverse, disruptive factors that are likely to hurt future profits, i.e., pending lawsuits, labour problems or low customer-satisfaction levels.
There are still many other quantitative and qualitative factors to keep in mind when considering whether a company is a worthwhile investment. The following chapters present additional fundamental and qualitative checks that help select the best quality companies with high return potential.