A new era for our most successful stock screen

In one sense, stock screens are simply time-saving devices. By distilling the investment process into a set of rules, and then applying those rules (via a computer) to a long list of options, screening helps us do a job that would otherwise take a small team of people several days.

Ultimately, however, it is the rules and the process that matter most. Screening is about speed, but it is mainly about the hunt for superior assets that will deliver a higher rate of return per unit of risk.

Identifying these assets – “the Holy Grail of finance” in the words of JP Morgan long-term strategist Jan Loeys – has been the goal of both investors and academic finance types for decades. And a by-product of this hunt is an evangelist for every method, and cogent reasons for why every individual source of market edge is the most enduring or important in risk-adjusted terms.

For Loeys, who shifted focus to long-term asset allocation “five or six years ago”, the search for alpha was initially promising. “I really felt good about this, until I started looking at the data, and found that almost all of [these sources of alpha] were performing quite well quite a while ago – 10, 20 years ago,” he recounted in a recent video for the investment bank. “In the last five, 10 years a lot of this stuff started peaking out and wasn’t really performing anymore.”

Loeys’ theory is that to achieve alpha, you need market inefficiencies. But in a world of PhD-packed multi-strategy hedge funds in which “everybody knows everything”, every inefficiency is already arbitraged away. To most investors, the response should therefore be to either hug the market via a passive approach or take an active, non-consensus view.

There’s a great deal of wisdom in Loeys’ view. In a world of algorithmic trading, every investor should recognise the asymmetries in alpha-hunting and the limitations of their own ability.

But I’m not entirely sure how to square his observations with the general success of our stock screens, which follow a range of well-understood (too well-understood, in Loeys’ eyes’) factor-based methodologies.

This may be because I’m not quite sure where our stock screens sit on an asset allocation timeline. The average screen that appears in these pages has been tracked for a decade, which would likely meet most investors’ definition of ‘long term’. Then again, annual refreshes mean their collective hunt for alpha is probably closer in spirit to the arbitrageurs.

On another reading, the fact that our methodologies are doggedly repeated and part-automated could be a source of their strength. Those annual refreshes, combined with staying fully invested year after year, is in its way a discipline that is largely free of emotion and judgment.

By a couple of measures, our High-Quality Large Cap screen is the most successful of these methods. Since we started running it in 2011, it has returned 477 per cent on a total return basis, compared with 137 per cent from the FTSE All-Share. On an annualised basis, that equates to 15.5 per cent, more than double the 7.4 per cent from the benchmark.            

In practical terms, the stock screens in these pages are intended as a prompt for further research rather than off-the-shelf portfolios. But if one were to factor in a 1.25 per cent annual charge to account for the real-life costs of trading, the screen’s overall return would decline to 389 per cent over 11 years. By any measure, that’s still very handy.

Recently, however, there may be signs that the method may have peaked – or that it has struggled to identify a sufficiently diverse array of stocks.

By the screen’s heady standards, last year’s batch was another disappointment. In part, this was due to an oversight via the inclusion of antivirus software developer Avast, which delisted following its acquisition by US competitor NortonLifeLock (US:NLOK) as our last screen was being published. Exclude Avast from the equally weighted total return calculation, and the gains from 2022’s selections would have climbed from 3.2 to 3.7 per cent.

This is still 10 percentage points below the long-term record, however. That’s because while the remaining picks included three solid performers – price comparison site Moneysupermarket.com (MONY), analytics group Relx (REL) and pharma giant GSK (GSK) – they also comprised two deadweights in Auto Trader (AUTO) and Experian (EXPN), and one massive detractor in Dr Martens (DOCS).

Although the boot maker appeared to have some of the high-margin, high-return hallmarks of a quality stock following its 2021 listing, its trajectory as a public company has instead vindicated those who were waiting for the shoe to drop following its return from private equity ownership to the market. Sharpest of the pinch points this year have been marketing and distribution issues, and a much-needed boost to capital expenditure – a combo that has hurt margins and earnings forecasts.

On reflection, the shares’ 43 per cent price decline in the 12 months prior to their 2022 inclusion might also have been seen as a red flag. Although highly valued stocks do occasionally take a beating, it is rare for consistent ‘quality stocks’ to enter such a period of freefall without catching a bid.

Then again, the recovery in 2021’s worst laggards has been less than consistent. Although the year’s worst performer – fantasy model maker Games Workshop (GAW) – rebounded strongly in the past 12 months, both Croda (CRDA) and Rightmove (RMV) continued their slumps. And while the High-Quality Large Cap screen would have delivered a stronger return than the 2022 selections had it stuck with the previous year’s picks, the bounce was not enough to have beaten the FTSE All-Share.

Methodology

Our large-cap version of the high-quality screen is interested in many of the same qualities as its smaller counterpart, which we ran towards the end of August. These include positive free cash flow, forecast earnings growth, a history of margin expansion, improving returns on equity and manageable interest payments.

Where it differs is in its approach to value criteria. Rather than looking to balance quality with cheapness, the large-cap screen now takes a much more ambivalent view of a stock’s valuation, and instead focuses on companies with best-in-class returns on equity and margins.

In 2021, we tweaked some of these criteria to adjust for the metric-pummelling effects of the pandemic. This year, as with 2022, I am using the old tests for top-quartile returns on equity and operating margins, but only require that companies show relative (rather than consecutive) growth on each of these measures over three years. The tests, which are used to screen every constituent in the FTSE All-Share index, are as follows:

■ Return on equity (RoE) in the top quarter of all stocks screened in each of the past three years.

■ Operating margin in the top quarter of all stocks screened in each of the past three years.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ Market cap over £1bn.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

This year, five stocks passed all tests.

Because our quality tests are share price agnostic and tend to focus on consistent performers with strong economic moats, it’s not a huge surprise that two of the five – specialist distributor Diploma (DPLM) and drinks giant Diageo (DGE) – also appeared in the 2021 cohort, although I half-expected at least one of last year’s selections to have made the cut again.

As it stands, it’s a concentrated portfolio. While this magnifies the risk of a Dr Martens-style blow-up, the screen’s focus on consistency provides some reassurance that our best source of alpha can return to its market-beating ways in the year ahead.