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How the experts screen

Created:
18 August 2008
Written by:
David Stevenson

We often talk about James Montier from SocGen – an inveterate value cynic and contrarian – but usually he's offering his sell side advice, identifying the shares and sectors he thinks are due a good beating. Rarely does offer his opinion on the companies investors should actually be buying, but in his July paper, "Confused contrarians and dark days for deep value", he came out and revealed his favourite screen and accompanying shares.

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Unsurprisingly, he seems to really rate a screen based on the investing ideas of value investing legend Ben Graham. This screen uses the following criteria -

1) A trailing earnings yield greater than twice the AAA bond yield

2) A P/E ratio of less than 40% of the peak P/E ratio based on five-year moving average earnings

3) A dividend yield at least equal to two-thirds of the AAA bond yield

4) A price of less than two-thirds of tangible book value

5) A price of less than two-thirds of net current assets

6) Total debt less than two-thirds of tangible book value

7) A current ratio greater than 2

8) Total debt less than (or equal to) twice net current assets

9) Compound earnings growth of at least 7% over ten years

10) Two or fewer annual earnings declines of 5% or more in the last ten years

At the heart of Graham's approach is the concept of an appropriate margin of safety – if you buy shares cheap enough you'll virtually guarantee yourself a margin of safety. It's a great theory, but there's one small hitch – companies that meet these demanding criteria are thin on the ground, even in the current depressed market.

According to Montier "at the moment I can find two globally (in large cap space) Taylor Wimpey and Barratt Developments, both UK house builders, showing perhaps that investors are pricing in the end of that industry! Indeed taking Taylor Wimpey, Barratt Developments and Persimmon together, analysts expect a 60 per cent plus decline in earnings both this year and next year, and a -17 per cent long-term growth rate! Surely this must be too pessimistic?".

Montier goes on to point out that if investors can't deploy all of the criteria above, they should at the very least use criteria one, three and six, which he rates as particularly important. "Criteria one and three are effective valuation constraints, criterion six ensures that there is likely to be some equity value even in the event of liquidation" says Montier. "Currently, I can find zero stocks in the US, fifteen stocks in Europe and twenty stocks in Japan that manage to pass these deep value restrictions (in the large cap universe)."

We've listed the current UK candidates below:

Company Earnings Yield Dividend Yield YTD performance
Bellway 11.70% 3.50% -37.10%
Home Retail Group 13.10% 5.70% -26.20%
Persimmon 17.20% 6.40% -54%
Royal Dutch Shell 12.60% 3.60% -17.60%
Tomkins 11.50% 7.70% -20%

Richard Bernstein is chief investment analyst at US giant Merrill Lynch and a most respected equity analysts. Back in January, he wrote of how financial markets would eventually be shaken from their complacency: "We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe that nothing is happening. The initial pop seems like a random event until a second occurs. A third. A fourth. Then the popping goes wild."

Spot on! No wonder that Bernstein has been consistently rated one of Wall Street's top analysts. In his latest monthly review, he featured a fascinating European screen that I think is worth researching . Called the International high quality & dividend yield screen, it selects high quality and high dividend yield stocks from the MSCI AC World ex-USA index that are covered by Merrill Lynch. According to Bernstein, the screen uses a number of key criteria, some of which should be familiar to any classic value investor - he's focussing in on high quality companies with secure dividend yields:

• S&P Common Stock Rank (quality rank) of A+, A, or A- for our global ex-US model. The Asia Pacific screen includes stocks with B+ or better rankings. The S&P Common Stock rankings are the main measure of quality. These rankings are based on the stability and growth in earnings and dividends over a seven-year period for non-US companies.

• Return on Equity (ROE) greater than the MSCI index.

• Debt/Equity lower than the MSCI index.

• Dividend yield greater than the MSCI index.

• Merrill Lynch Investment Opinion indicates the likelihood that the dividend will remain the same or be increased (i.e., a dividend rating of “7”).

• The ratio of the past 12 months' free cash flow to dividends is greater than 1.0

Just four companies make the grade - they're in the table below:

Company Quality (S&P) Dividend Yield
Sage A- 4.20%
Barclays A 10.10%
AstraZeneca A 3.80%
ICAP A- 3.10%

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