More often than not, the screens I run focus heavily on valuation metrics, but there is a school of thought that the most important thing investors should focus on for high returns over the long term is quality. A focus on valuation can actually be an impediment to such a strategy as the very best listed companies rarely look cheap on any conventional valuation metric. So avoiding premium ratings can be a mistake. My 'Big Reliable' stock screen, which I am now running for a fourth year, is an attempt to put the idea that 'quality will win out' into a screen.
While the screen has had some good runs over the year, the market has recently shown some aversion towards highly rated stocks and last year's screen underperformed the market. It produced a 3.5 per cent total return compared with the 6.7 per cent total return from the index from which the stocks were picked, the FTSE 350 (see table).
2013 stock performance
| Name | TIDM | Total Return (29 May 2013 - 9 Jun 2014) |
|---|---|---|
| MICRO FOCUS INTL. | MCRO | 20.2% |
| SERCO GROUP | SERC | -40.1% |
| HALMA | HLMA | 15.6% |
| FISHER (JAMES) & SONS | FSHR | 38.4% |
| DUNELM GROUP | DNLM | 8.0% |
| TELECITY GROUP | TCY | -21.3% |
| Average | - | 3.5% |
| FTSE 350 | - | 6.7% |
Source: Thomson Datastream
However, rather than ruing the 2013 portfolio, the disappointing result has got me questioning how to best assess this screen. Indeed, for those investors who put quality first in their investment process the act of buying a share is usually about making a long-term commitment. Indeed, sticking with underperforming high-quality stocks, and even averaging down, can often be wise. For example, there are some signs that the problems that beset Telecity last year (one of the portfolio's worst performers) could already be abating (see the stock write-up below).
What's more, investors would have done far better sticking with the 2011 or 2012 portfolio than switching from one portfolio to the next each year the screen was run. Indeed, the cumulative performance graph based on a strategy of switching from one portfolio to the next each year (ignoring all dealing costs and spread) does not look that impressive compared with the performance of the FTSE 350 (see graph).
However, the outperformance of the FTSE 350 by the 2011 and 2012 portfolios if held to the present date is undeniably impressive (see graph).
Given the nature of the screen, I think there is some validity in assessing individual portfolios over the long term rather than just on a cumulative (one-year switching) basis, which makes more sense for screens that aim to hunt out value. The screen itself looks at a number of measures of quality based on track record, returns, cash conversion and finances. Here are the criteria:
■ EPS growth in each of the past five years. ■ RoE of 12 per cent or more in each of the past five years. ■ Forecast earnings growth in the current financial year and the year after. ■ Gearing of less than 50 per cent, or net debt of less than two times cash profits. ■ Cash conversion (cash from operations as a proportion of operating profits) of 90 per cent or more. |
The nine stocks passing all the tests are ordered below based on their three-month momentum.
NINE LONG-TERM QUALITY STOCKS
