Elephants that canter

Indeed, over the two years I've run my 'quality large-cap' stock screen not a single stock out of the 10 picked has underperformed the FTSE All-Share (see table below). What's more, the aggregate outperformance of the market has been extremely strong, with the two portfolios (which are admittedly very concentrated), producing a cumulative total return of 88 per cent since August 2011, compared with 40 per cent from the FTSE All-Share. So to append an adage from small-cap expert Jim Slater, while "elephants" may not be able to "gallop", they certainly can canter at times.

Source: Datastream

My "quality large-cap" screen focuses on two classic gauges of quality: return on equity and operating margin. As a ratio that is partly generated from the numbers in companies' balance sheets, return on equity (ROE) is far from perfect. The story the twice yearly balance-sheet snapshot tells of a company's history sometimes has little relevance to the current state of play. However, for the purpose of a stock screen, return on equity is a broadly effective measure of what return a company can be expected to generate from each extra pound given to it by shareholders.

High operating margins, meanwhile, are generally regarded as indicating that a company has some particular advantage that allows it to make a good profit on the goods or services it sells. This could be because it is in a particular industry where businesses are built on technical knowledge or scarce skills, such as software, or due to some strategic advantage peculiar to that individual company, such as strong branding.

As well as obsessing about quality, the screen is price aware. I've refined the screen's approach to value over the three years I've run it, but the basic principle is broadly similar to the valuation approach favoured by famed US value investor John Neff. I start by looking at the ubiquitous PE ratio and eliminate the cheapest quarter of stocks in the FTSE All-Share to try to avoid suspiciously cheap situations and also get rid of the most expensive quarter of stocks to try to avoid anything overvalued. I then look at a broader-based measure of value: my 'genuine value' (GV) ratio. Stocks are only selected if they are priced below the median average GV ratio, which was 1.03 in the case of this screen.

Four stocks pass the screen. I've ordered them below from lowest to highest forward PE:

Aberdeen Asset Management

If there is one stock from this year's screen that I'd finger as the most likely to break the record of all-stock outperformance - and it is a record that one would expect to be broken soon - then Aberdeen Asset Management (ADN) is it. Indeed, from many perspectives it looks like one of those stocks that is likely to be highlighted over coming months by a lot of value and quality-orientated screens, but possibly for the wrong reasons. That's because it may be experiencing a fundamental external change, which due to its nature can only slowly be reflected in forecasts and historic fundamentals.

Aberdeen Asset Management has built up an excellent business in emerging market equities and enjoyed meteoric growth while the asset class was in the ascendant. However, now those markets have started to falter the company has experienced outflows from its funds. Even before this, to management's credit, the company was trying to diversify to reduce its reliance on this single investment area and was using fees to discourage excessive inflow. If emerging market equities continue to lose their lustre, then the shares could become locked in a spiral of downgrades. And even if emerging market performance revives, recent events could prove a salient reminder to investors of the risks associated with having such a large dependence on a single part of the investment market, meaning the shares may struggle to re-rate to past levels. So, while there may be value here based on the forecasts fed into our GV ratio, and there's a definite possibility that the shares could bounce back, we nevertheless feel rather cautious about Aberdeen (last IC view: Buy, 456.5p, 29 Apr 2013).

*Based on EPS forecast for the next 12 months. **Based on companies' financial years.

Source: S&P CapitalIQ

Micro Focus International

The strategy pursued by software company Micro Focus International (MCRO) of generating strong shareholder returns may lack the excitement of some of the more growth-focused companies in the sector, but in terms of 'total return' it has certainly delivered for a number of years, with the shares rising 238 per cent from a 2011 low of 240p. The shares have also paid handsome dividends, and there are strong expectations of a return of capital over coming years - broker Numis has pencilled in 160p per share over the next two. The company may also be about to become a little bit more exciting, for a couple of reasons.

For one thing, improving macro economic conditions in the US will, should they prove substantive, boost demand. Having done an excellent job at stabilising the business, the company should be in a strong position to benefit from this. In addition, the company is increasing its focus on growth by investing in sales and marketing. A recent refinancing has also boosted the amount the company has to spend at the same time as lowering its financing costs. While a return of capital is a strong possibility given management's commitment to generating shareholder value with the company's balance sheet, there could also be significant acquisitions. So, all in all, this stock, which frequently makes appearances in our screens, could have some positive surprises in store (last IC view: Buy, 673p, 19 Jun 2013).

*Based on EPS forecast for the next 12 months. **Based on companies' financial years.

British American Tobacco

The quality of British American Tobacco's (BATS) business was clearly displayed with its interim results last month, which demonstrated its ability to add value at pretty much every line of its profit-and-loss statement. From the starting point of a 3.4 per cent drop in the volume of cigarettes sold, the company managed to produce an 8 per cent increase in underlying EPS. And that result was achieved despite weakness in Europe, which has resulted in smokers trading down to cheaper brands.

The first contributor to the half-year corporate alchemy was the role played by its brands in enabling the company to charge high prices. Indeed, improved pricing and sales mix meant that revenues actually rose 2 per cent despite the fall in volumes. Then came the contribution from a 70 basis point underlying operating margin improvement to 38.9 per cent, which meant underlying operating profit came in 4 per cent higher. Lower interest payments and tax helped boost after-tax profits further. This was amplified by the fact that BAT has recently been using strong cash generation to buy back shares, which was the final contributor to helping EPS growth reach that 8 per cent figure. Whether or not one is a fan of the product being peddled, it has to be admitted that's impressive stuff. A strong focus on brands and smokers trading up in emerging markets helps underpin the group's long-term prospects. Meanwhile, the cash generation also funds an attractive yield (last IC view: Hold, 3,483p, 31 Jul 2013).

*Based on EPS forecast for the next 12 months. **Based on companies' financial years.

International Personal Finance

Doorstep lending in Romania and Mexico may not be everyone's first idea of what makes a quality business. However, it is hard not to be impressed by the performance of International Personal Finance (IPF). First-half results published at the end of July smashed the City's expectations with a 35 per cent leap in underlying profit and flat bad loan rates of 26.8 per cent of revenue. Mexico was a particularly bright spot, recording 80 per cent growth in profit to £5m. Despite accounting for just 10 per cent of profit - Poland is the biggest contributor at 47 per cent - Mexico is considered to have major potential due to its 20m population. Management is expanding into the country's capital and has a target of earning £33 per customer by 2015, compared with £17 at the half-year stage. The current expansion in Mexico should also help customer number growth, which was only 3 per cent in the first half, although, this didn't prevent a 14 per cent increase in credit volume. The results were impressive across all the countries in which the company operates - including Romania, where the operation moved into profit for the first time. There are now plans to start lending in Bulgaria in the third quarter.

Having made substantial increases to forecasts following the interims, broker Numis now expects IPF to achieve 87 per cent EPS growth to 2015. So while the forward PE ratio in the table below, which is based on forecasts for the next 12 months, may look lofty, the shares are valued at a not unreasonable 11.5 times Numis' 2015 forecasts. The group's dividend, while not much in yield terms, is growing fast, and the interim payment was hiked 17.5 per cent. And the company's cash generation has been put to further use with the announcement of a £60m share buyback (last IC view: Hold, 646p, 30 Jul 2013).

*Based on EPS forecast for the next 12 months. ** Based on companies' financial years.

NB: Regular readers of this column may notice a stylistic change as I am now writing in the first person. While the column was originally shared by several writers, I have been the sole writer for over a year-and-a-half and the main writer for much longer. So editorially the decision has been made to switch to writing in the first person to reflect this. Other writers will continue to run stock screens and write about them on an ad hoc basis on other pages of the magazine, as they already do. That brings me on to something else, which is that this column will not run next week as I am away on holiday.