Quality
Strong profitability metrics, most importantly high returns on capital employed, such as ROCE and CROIC are a key ingredient of the screen. The aim is to identify companies with high operational gearing i.e. companies which are able to convert a high percentage of sales into profit, and profit into free cash flow. This means EBIT margin is an important factor, as is the ability to efficiently generate free cash flow without needing to spend a huge amount on capital expenditure. So, by definition the screen is looking for capital light businesses. The quality rules are:
1. ROCE (5 year average) > 20%
2. CROIC (TTM) > 10%
3. EBIT margin (5 year average) > 10%
4. Free Cash Flow (TTM) > 0.8 x EPS (TTM)
5. Capital Expenditure (TTM) < 0.3 x Operating Cash Flow (TTM)
Valuation
There are several basic valuation metrics (most notably Price to Earnings Ratio) that can be used but for screening purposes, however I prefer to use those that avoid Earnings per Share and concentrate on Free cash flow yield (FCF/Price as %) and earnings yield (EBIT/EV as %). The reason for this is some companies generate earnings that never convert into free cash flow, and that is not really the sign of a high quality company. There are also myriad accounting tricks to artificially boost EPS and reported and adjusted earnings can be very different. Earnings yield is based on the Enterprise Value which handicaps companies carrying excessive debt relative to profit and benefits companies with net cash. The valuation rules used are:
6. FCF yield (TTM) > 5%
7. Earnings yield (TTM) > 5%
Dividend
I like companies to at least have some history of paying a dividend, it's a sound financial discipline. What's more, a history of 5 years dividend payment means the company was strong enough to at least maintain dividends through the Covid period. Preferably the dividend should be growing but I don’t want to rule anything out automatically, so I don’t screen for a progressive dividend which can be checked manually. For me, this is the weakest of the metrics and I’m happy to drop it to see which companies are excluded only by this rule and consider them if they stack up on all other metrics. The dividend rules are:
8. Dividend payment history >= 5 years
9. Dividend yield (Rolling 1 year) > 2%
Growth
There’s no point having strong profitability if sales and earnings are not forecast to grow in the near term. This inevitably means we are in the hands of broker forecasts, so I don’t want to set the bar too high. Some nominal sales growth with EPS growth in line roughly with inflation is good enough, although I appreciate it is a low bar. The growth rules are:
10. Forecast Sales Growth (Rolling 1 year) > 2%
11. Forecast EPS growth (next FY) > 5%
Debt
It’s OK for a company to have some debt, indeed leverage works well for companies with strong profitability because in principle debt can generate returns that greatly exceed the cost of debt. However, the debt level should not be excessive in case operational gearing should ever go into reverse. The debt has to be affordable, so the screen requires strong interest cover and long-term debt that is a reasonable multiple of free cash flow. The debt limitation rules are:
12. Interest cover (EBIT/interest expense) TTM > 10x
13. Free Cash Flow to Long-term Debt (TTM) > 10%
14. Net Debt/EBITDA (TTM) < 2x
Screen Results
The current output from the screen is shown in the table below with 9 companies currently making the cut.
Ticker | Name | Mkt Cap (£m) | P / E | FCF Yld (%) | Earnings Yld (%) | ROCE Avg (%) | EBIT Mgn Avg (%) | CROIC (%) | Sales Growth (%) | EPS Growth Y2 (%) | Div Yld (%) | FCF / LT Debt (%) | Sector
ULVR | Unilever | 95,549.95 | 16.27 | 5.31% | 8.3 | 21.2 | 18.5 | 11.2 | 2.6 | 5.4 | 4.1 | 19.3 | Consumer Defensives
ITRK | Intertek | 7,194.91 | 19.02 | 5.87% | 5.4 | 21.6 | 15.0 | 18.8 | 4.0 | 7.1 | 2.7 | 31.8 | Industrials
GAW | Games Workshop | 3,273.49 | 21.72 | 5.52% | 5.6 | 62.7 | 36.4 | 77.6 | 7.7 | 6.3 | 4.3 | 372.0 | Consumer Cyclicals
MONY | Moneysupermarket.Com | 1,389.59 | 15.17 | 6.34% | 7.0 | 37.3 | 26.4 | 31.5 | 5.4 | 8.0 | 4.8 | 139.8 | Technology
IPX | Impax Asset Management | 716.02 | 15.54 | 5.28% | 8.7 | 34.3 | 29.3 | 83.5 | 4.5 | 15.7 | 4.7 | 432.8 | Financials
SLP | Sylvania Platinum | 159.48 | 5.05 | 23.93% | 79.9 | 32.0 | 49.9 | 35.5 | 8.1 | 19.0 | 4.6 | 6813.3 | Basic Materials
REC | Record | 140.93 | 12.47 | 8.15% | 10.3 | 33.5 | 29.7 | 65.5 | 7.3 | 11.6 | 6.9 | 1365.6 | Financials
TPFG | Property Franchise | 107.25 | 11.83 | 7.38% | 8.9 | 20.0 | 35.8 | 19.2 | 5.7 | 7.3 | 4.5 | 171.2 | Financials
CBOX | Cake Box Holdings | 66.00 | 13.74 | 8.21% | 9.5 | 33.3 | 20.4 | 25.0 | 9.8 | 11.7 | 5.6 | 144.3 | Consumer Defensives
Of the 9 companies passing the screen, quite unsurprisingly to me, I currently hold 5 - Unilever, Intertek, Games Workshop, Moneysupermarket.com and Record. Another company I own (Belvoir) will soon be merging with Property Franchise, so that will make it 6. FWIW Belvoir only just misses the cut itself and passes 13 of the 14 rules, just missing out with a ROCE of 18.3%.
Any thoughts welcome. Hopefully some discussion and further analysis of quality companies can follow. If not, at least I can say I tried!
All the best, Si