It's been a good 12 months for large high-quality stocks so it should perhaps not come as too much of a surprise that my High Quality Large Cap stock screen has significantly outperformed the wider market. The City explanation for the strong performance of shares in quality companies centres on a migration of cash from the bond market as investors, exasperated by the low yields now offered by bonds, search for better returns from equities with bond-like characteristics.
But the strong performance from the High Quality Large Cap screen is not a one off. Indeed, the screen has outperformed every year since I first ran it four years ago. What's more, in that time only two of the stocks picked have underperformed the wider market. That can, in part, be explained by the fact that this screen tends to find very few stocks that fit its criteria (only six this year), but it's none-the-less pretty impressive. But it's also worth pointing out that strong runs always come to an end at some point.
Over the past 12 months the screen has delivered a 20.1 per cent compared with a negative 7.9 per cent from the FTSE All-Share.
| Name | TIDM | Total Return (2 Sep 2014 - 25 Aug 2015) |
|---|---|---|
| Micro Focus | MCRO | 45.0% |
| Telecity | TCY | 43.2% |
| Berkeley Group | BKG | 39.2% |
| BT | BT.A | 10.5% |
| Next | NXT | 8.7% |
| Dunelm | DNLM | 2.5% |
| Ashtead | AHT | -8.8% |
| Average | - | 20.1% |
| FTSE All Share | - | -7.9% |
source: Thomson Datastream
Meanwhile, on a cumulative basis since I started running the screen in 2011 the total return has been 143 per cent compared with 39.4 per cent from the FTSE All-Share. Building in a 1.25 per cent charge to account for dealing costs, the cumulative return drops to 131 per cent.
High-quality large caps vs FTSE All-Share
The screen has also performed well on a buy-and-hold basis, although the result from switching from one portfolio to the next each year has been superior to date.
| Buy-and-hold total return | FTSE All Share | High Quality Large Caps |
|---|---|---|
| Aug-11 | 39% | 86% |
| Aug-12 | 19% | 93% |
| Aug-13 | -0.8% | 6.1% |
| Sep-14 | -7.9% | 20% |
| Cumulative | 39% | 143% |
source: Thomson Datastream
The screen looks at a reasonably broad range of measures of financial health, including interest cover and the presence of free cash flow, but its key focus is on earnings. It uses two earnings-derived measures of quality - return on equity and operating margins - and looks for companies that are both better than average on these measures and have shown an improvement over the past three years.
Part of the screen's valuation criteria is also primarily concerned with finding quality. By excluding the market's cheapest shares (based on a price-to-earnings (PE) ratio) the screen attempts to avoid any stocks that are suspiciously cheap, as this can be an indicator that fortunes are about to decline and that the quality the screen thinks it has spotted is illusory. Meanwhile, by excluding the market's most expensive shares, based on PE, the screen tries to avoid stocks that have seen their valuations get overblown, which helps avoid shares that may prove vulnerable to even the slightest disappointment.
On the valuation front, stocks selected by the screen also need to boast a lower than average genuine value (GV) ratio. This is essentially price-to-earnings-growth (PEG) ratio adjusted for cash and dividend yield. It's calculated like this:
Enterprise value (market cap minus cash plus debt)/operating profits / forecast growth rate plus dividend yield
Or
(EV/EBIT) / (Fwd EPS grth + DY)
The full criteria for the screen are:
■ PE above bottom fifth and below top fifth of all stocks screened.
■ Lower than median average GV ratio.
■ Earnings growth forecast for each of the next two years.
■ Interest cover of five times or more.
■ Positive free cash flow.
■ Market cap over £500m.
■ Higher than median average RoE in each of the past three years.
■ Higher than median average operating margin in each of the past three years.
■ RoE growth over the past three years.
■ Operating margin growth over the past three years.
■ Operating profit growth over the past three years.
Six shares for all the FTSE All-Share passed all the tests.
SIX GOOD VALUE HIGH QUALITY LARGE CAPS
