Monday, April 30, 2012


Although this has been refined over the years, this is the general framework that I typically follow, and is the product of multiple years of back-testing work that I have done, combined with ideas that I have “borrowed” and weaved together from various studies published by investment guru's that have been highly influential in the formation of my investment discipline. In my opinion these collective bodies of work empirically demonstrate which metrics/factors work best in various market environments, and identify investment strategies that, when applied systemically, challenge the theory of efficient markets, and illustrate opportunities for investors to consistently “beat the market”. Most notably, Benjamin Graham’s Intelligent Investor, the Fama & French Multi-Factor Approach, the annual “Black Book Study” published by Sanford Bernstein, as well as some lesser known, but similarly convincing studies done by Jim O’Shaughnessy "What Works on Wall Street" (Multi-Factor), Mebane Faber (Momentum Approach) “Earnings Quality & the Accruals Anomaly”, (Sloan& Richardson), CSFB-HOLT (CFROI), and Joel Greenblatt’s “Magic Formula” (Value). -

I’ll try and summarize my approach which I have found to be a successful, robust starting point to identify opportunities. I generally run 3 filters:

1) Primary Universe Screen, followed by a more in-depth,
2) Fundamental Screen, and finally a
3)Technical/Momentum Overlay.

The primary universe screen I think is a very simple screen that I use across all core strategies (value, growth, dividend) and is just a very basic filter of stock characteristics that prudent investors should demand from any stock they own:

1. Market Cap minimum of $2 Billion.2. Stock trading at earnings yield > than yield earned on 10yr Investment Grade Corporate Bonds. If corporate's yield 3%, this suggests we pay a forward P/E no higher than < 33X. 3. Earnings expected to grow at a rate higher than inflation over market cycle. 
4. Company generates Return on Invested Capital exceeding cost of capital (also normalized, 5yr) (I use 6% if WACC is unavailable) 
5. Company generates cash internally – positive free cash flow. 6. Earnings Quality > Ranks above bottom quartile

Next, the most comprehensive screen is the fundamental and earnings quality screen. I will typically break out 3 Core Equity Strategies (Core Value, High Quality Dividend, and Core Growth)and if possible, break out by sector in order to make more meaningful comparisons (Financials, Cyclicals, etc.)

Core Value – More emphasis on free cash flow, EV/EBITDA, and price/earnings multiples, especially relative to its historic multiple. Less concerned about ranking within sector, more concerned about ranking vs. market averages.
1. FCF Yield > Market Average
2. EV/EBITDA < Market Average 3. Forward P/E < 1.0X Historic Relative Multiple* 4. P/EG Ratio < 2.0X 5. Historic EPS Growth > 8%
6. Historic 5YR ROIC > 10%
7. Earnings Quality > Sector Average Ranking
*(use P/B, P/S, P/CF if more appropriate)

Growth/Momentum - More emphasis on expected earnings and ROIC growth vs. sector averages. Also, demand higher EPS consistency, and top quartile rankings. Only valuation filter is P/EG
1. Expected LT EPS Growth > 12%
2. Expected LT EPS Growth > Top Quartile of Sector
3. EPS Growth Trend > Accelerating faster than Sector Average
4. EPS Consistency > Market Average
5. ROIC > 15%
7. ROIC Trend > Positive
8. Earnings Quality > Sector Average Ranking
9. P/EG Ratio < 3.0X High Quality Dividend - More focused on historic trends (indicating a willingness to pay), financial strength and consistency (indicating a capacity to pay dividend (FCF & Payout), and expected growth trends 1. Dividend Yield > 1%
2. Expected LT EPS Growth > 10%
3. FCF Yield > Market Average
4. Payout Ratio < 80% 5. EPS (DPS if Possible) Consistency > Market & Sector Average
6. ROIC > 12%
7. Earnings Quality > Market Average Ranking

The last set of screens would be technical (earnings and price momentum screens), which I use as a “trading” overlay as they can provide good insight as to the timing of stock purchase. My personal approach, is to use a somewhat contrarian strategy here, buying value when it moves and buying momentum when it is weak.

Within the value stock candidates, identify weak long term performance coupled with strong near term performance, or a relative performance reversal. Similarly, we want to identify stocks that have been taken to the "woodshed" with negative EPS revisions, and are seeing a reversal in EPS revision trends. This way we avoid “value traps”. Having followed this approach at the beginning of the year, we would have been seeing attractive entry points for homebuilding stocks, which had finally, after 5 years of price and earnings declines, were finally showing strong signs of a price reversal coupled with estimates that had been overly pessimistic. The group is now up over 80%.

Among growth, finding just the opposite, strong LT performance, with weaker short term performance, may provide attractive entry point for a high quality company taking a breather. In this way we are avoiding buying a “top”. If recent YOY EPS trends remain solid, we should be less concerned with sentiment trends, unless there is a dramatic or structural change in the company's future growth prospects. If we were to have followed this approach, high quality, high growth stocks that were in simply in a consolidation phase, such as AAPL would have looked attractive 6 months ago, penetrating its lower bollinger band, on low volume, for no particular fundamental reasons.