Growth portfolio initial screen

The passive approach

If the thought of analytical work to decide which individual companies to invest in is not for you, then one can either hand over your hard earned money to the institutions by way of an investment fund, incurring 1-2% in charges per annum, or follow a passive system such as described in Joel Greenblatt’s excellent book - “The Little Book that Still Beats the Market”.  This explains how investors can outperform the market averages by simply and systematically applying a formula that seeks out good businesses, when they are available at bargain prices.

Growth Investing

Here we are looking to screen for companies that have a proven track record of growth and the market is expecting more growth in the future. This needs to be combined with a reasonable price, low financing risk and quality.  To achieve this I run the following screen:

An EPS 3 year CAGR of 10% or greater – this gives me confidence that the company has a track record of growth and knows how to manage and sustain it.

An EPS 1 Yr rolling growth rate of 15% or greater – this shows that the market is expecting further growth and, since forecasts are often optimistic, there is a built-in margin of safety in the hurdle rate of 15%.

A maximum 1 year rolling P/E ratio of 20 – growth, especially established growth, can come at a high price, so we are looking for a reasonable valuation based on a rolling 12 months P/E (share price/earnings per share) ratio.  This can also be described in the reciprocal form as an earnings yield.  So a P/E of 20 would equate to an earnings yield of 5%, a P/E of 15 an earnings yield of 6.67%.

A PEG of less than 1 – this divides the 1 year rolling P/E ratio above by the 1 year rolling growth rate above.  The price earnings growth rate was made popular by Jim Slater in his book “The Zulu Principle”, although this is a derivative of Peter Lynch’s PEG, defined in his book “One up on Wall Street” where the numerator is the historic P/E ratio.  The PEG is an attempt to ensure that you are not overpaying for growth and that you receive good value for the price you pay.

An operating margin of at least 5% - This is the percentage of profit that is left after all costs except interest and tax costs have been deducted.  Companies with high margins are able to weather economic storms better than low margin companies.  Companies with very low margins are a price cut or minor over expenditure away from losses.  Growth rates for high operating margin companies have a greater effect on earnings.

A return on equity (ROE) of at least 15% - since your share that you have in the business, represents a partial ownership in the equity, it makes sense that you would want the earnings on that which you own, to be as high as possible.

Gearing of 75% or less - this is the ratio of debt to equity within the business. For example if you were to buy a coffee shop with £100,000 of your own money and £25,000 from a bank loan, your gearing would be 25% (£25,000 divided by £100,000 x 100).  A highly geared company is at more risk during a downturn in business or a bank liquidity crisis, than a lowly geared company.  It should be borne in mind though that debt is much cheaper than equity, so some debt is a good thing and companies with reasonable levels of debt are referred to as having an efficient balance sheet.

Interest cover of at least 4 times – this is the amount of times that the operating profit, remember that is the number that is left after all costs except interest and tax costs have been deducted, covers net interest costs.  Net interest costs are the costs of having loans and overdrafts, less any interest received from cash balances.  This interest cover shows whether the company can service the debt with a good margin of safety, that allows for operating profit declines and interest rate rises.

Finally 1 year’s relative strength greater than 0 – this demonstrates that the share price of the company over one year has performed as well as the overall market (greater than 0 would be better).  This eliminates companies that are currently out of favour with the market with strong selling pressure and includes companies that have reasonable momentum and demand for their shares.  Shorter periods of relative strength are less meaningful, as Benjamin Graham explained in simple terms in his book "The Intelligent Investor": 

“…in the short run, the market is like a voting machine …but in the long run like a weighing machine…”  

A more conservative approach might be to replace the 1 year rolling P/E ratio of 20, with a trailing twelve months P/E ratio of 20, or since we have a return on equity (ROE) of at least 15% hurdle, we could use a share price to NBV of 3 or less, since ROE divided by P/NBV is the earnings yield. Remember the earnings yield is just the reciprocal of the P/E ratio. 

If you wanted to be sure that short-term cost cutters were not being picked up by this screen, you could add a hurdle for sales growth over a specific period.  Remember though, this will just be a list of companies that warrant further analysis, so you can filter further during the analytical process, the important point is that you are looking for a manageable list of no more than 20 or so companies.  Over time you will develop your own style and requirements, but once established be brutal in your consistency and application.