Quality at a Reasonable Price

[simoan]

In an effort to stimulate some discussion of individual companies listed on the UK stock market, I thought I’d share one of the screens I run occasionally to identify quality companies that may be on reasonable valuations. Of course, this is just a start in terms of deciding whether a particular company is worthy of investment. The screen has a total of 14 rules which makes it quite strict in order to limit the number of companies passing the screen. Lots of equally good companies will be excluded, maybe due to some temporary factor, so I often loosen the rules to find companies that only just miss the cut by passing 12 or 13 of the 14 rules and which may be worthy of further investigation. The rules I use for the screen are as follows:

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

[doug2500]

Thanks for applying some stimulus.

While this is not a reason not to use a screen like that I've found that it can 'miss' some quality stocks like CCC who look like they have smaller margins than they do, or you could argue that at least.

Saying miss is possibly harsh because no screen will include everything quality, there will always be some idiosyncrasies that don't hit the criteria.

Do you know how the 9 stocks showing up now compares to history?

[simoan]

Thanks for applying some stimulus.

While this is not a reason not to use a screen like that I've found that it can 'miss' some quality stocks like CCC who look like they have smaller margins than they do, or you could argue that at least.

Saying miss is possibly harsh because no screen will include everything quality, there will always be some idiosyncrasies that don't hit the criteria.

Do you know how the 9 stocks showing up now compares to history?

Yes, you're going to miss a few good companies with any screen, which is why I often play around with the criteria to see what other companies are near misses. There's quite a few companies I own that pass 10 or more of the rules, and your example of CCC currently passes 11 out of 14. As you say, the main one is EBIT margin which is well below 10% and always has been to my knowledge.

Sorry, I don't keep any history of the screen results, but I do manually check ROCE and EBIT Margin to ensure they are not in a long term downtrend which would rule out any company as I don't like signs of decreasing profitability.

[simoan]

Apologies. I've just noticed a typo in the OP. The 5 year average EBIT Margin used in rule 3 should be 15%, not 10%. Out of interest, if you drop the EBIT Margin requirement to 10% two more companies appear - Dunelm and Wilmington.

All the best, Si

[Gerry557]

Just out of interest which screener do you use.

I like to look at ROCE but many don't include this or you need to subscribe.

Of your list, I have recently topped up ULVR. Obviously the SP has taken a dip. One hopes that this is temporary and some sort of average normality will return. I would like a growing trend in dividends and note that ULVR's is in euros so there is an FX aspect to take into account.

I note banks had poor ROCE but then set targets to increase it to greater than 10%. Hopefully this should make things better than the 1% or 2% that they were running at.

Might have to look a little bit more at some of the others.

[monabri]

Just out of interest which screener do you use.

I think Simoan is using Stockopedia ...possibly filtering further in a spreadsheet.

In a similar vein, does the screening tool allow for other markets ( eg US)?

[simoan]

Just out of interest which screener do you use.

I like to look at ROCE but many don't include this or you need to subscribe.

Of your list, I have recently topped up ULVR. Obviously the SP has taken a dip. One hopes that this is temporary and some sort of average normality will return. I would like a growing trend in dividends and note that ULVR's is in euros so there is an FX aspect to take into account.

I note banks had poor ROCE but then set targets to increase it to greater than 10%. Hopefully this should make things better than the 1% or 2% that they were running at.

Might have to look a little bit more at some of the others.

I'm currently using Stockopedia which is a paid for service using data supplied by Refinitiv. To be honest, I was surprised Unilever passed the screen. It just shows that there may be an opportunity if the new management can turn things around. However, I suspect Unilever may disappear from the screen once the data for FY23 is updated in a couple of weeks time

ROCE is not really applicable to banks, simply because they do not have capital in the traditional sense i.e. by use of fixed or intangible assets. ROE is more applicable but even then you'd have to set the bar very low. I don't really want this thread to start discussing banks if that's OK. They are low quality companies IMHO, so let's leave it there.

[monabri]

Whilst browsing...I came across this website. The first 3 companies per month are "'Free to view". Interesting....

I suspect that ULVR is marginal on a ROCE (5yr average test). Current ROCE are <20%. So, unless they turn around.

https://www.alphaspread.com/security/lse/ulvr/summary

[simoan]

Whilst browsing...I came across this website. The first 3 companies per month are "'Free to view". Interesting....

I suspect that ULVR is marginal on a ROCE (5yr average test). Current ROCE are <20%. So, unless they turn around.

Stockopedia shows the TTM ROCE for Unilever is 21.9% i.e. as of the last interims. This is in-line with the historic average. We'll see what it is for FY23 next week. Either way, ROCE will vary with EBIT but there is no sign that Unilever's ROCE is in long term decline. I suspect this is one of the few things stopping Terry Smith from selling out. BTW what is the source of data used by this website?

[monabri]

Whilst browsing...I came across this website. The first 3 companies per month are "'Free to view". Interesting....

I suspect that ULVR is marginal on a ROCE (5yr average test). Current ROCE are <20%. So, unless they turn around.

Stockopedia shows the TTM ROCE for Unilever is 21.9% i.e. as of the last interims. This is in-line with the historic average. We'll see what it is for FY23 next week. Either way, ROCE will vary with EBIT but there is no sign that Unilever's ROCE is in long term decline. I suspect this is one of the few things stopping Terry Smith from selling out. BTW what is the source of data used by this website?

I don't know the source ( can't find a link on the website)...so, one should treat with caution, especially as ( in the example of ULVR ) there's a discrepancy w.r.t Return on Capital Employed figures. I think I will email them!

[Gerry557]

Just out of interest which screener do you use.

I like to look at ROCE but many don't include this or you need to subscribe.

Of your list, I have recently topped up ULVR. Obviously the SP has taken a dip. One hopes that this is temporary and some sort of average normality will return. I would like a growing trend in dividends and note that ULVR's is in euros so there is an FX aspect to take into account.

I note banks had poor ROCE but then set targets to increase it to greater than 10%. Hopefully this should make things better than the 1% or 2% that they were running at.

Might have to look a little bit more at some of the others.

I'm currently using Stockopedia which is a paid for service using data supplied by Refinitiv. To be honest, I was surprised Unilever passed the screen. It just shows that there may be an opportunity if the new management can turn things around. However, I suspect Unilever may disappear from the screen once the data for FY23 is updated in a couple of weeks time

ROCE is not really applicable to banks, simply because they do not have capital in the traditional sense i.e. by use of fixed or intangible assets. ROE is more applicable but even then you'd have to set the bar very low. I don't really want this thread to start discussing banks if that's OK. They are low quality companies IMHO, so let's leave it there.

Thanks for the info. I have received some emails for a free trial with them. Not sure if it's worth the money or how good the info is. Yes ULVR management have had a hard time. The update might give further insight on a direction even if its pointing in the wrong direction currently.

I'm happy to talk more about ROCE and just used the banks as examples of poor ROCE with a target to improve it. You don't seem to come across it much in reports. Maybe because it's not great either.

Does anyone know of companies reporting ROCE in their filings.

[monabri]

I'm currently using Stockopedia which is a paid for service using data supplied by Refinitiv. To be honest, I was surprised Unilever passed the screen. It just shows that there may be an opportunity if the new management can turn things around. However, I suspect Unilever may disappear from the screen once the data for FY23 is updated in a couple of weeks time

ROCE is not really applicable to banks, simply because they do not have capital in the traditional sense i.e. by use of fixed or intangible assets. ROE is more applicable but even then you'd have to set the bar very low. I don't really want this thread to start discussing banks if that's OK. They are low quality companies IMHO, so let's leave it there.

Thanks for the info. I have received some emails for a free trial with them. Not sure if it's worth the money or how good the info is. Yes ULVR management have had a hard time. The update might give further insight on a direction even if its pointing in the wrong direction currently.

I'm happy to talk more about ROCE and just used the banks as examples of poor ROCE with a target to improve it. You don't seem to come across it much in reports. Maybe because it's not great either.

Does anyone know of companies reporting ROCE in their filings.

If you elect to take out a Stockopedia sub...there's a 25% discount on offer here

https://why.stockopedia.com/pensioncraf ... m-text-614

[Lootman]

Sylvana (SLP) has been a disaster. Down 50% in the last year or so, and its dividend yield screams danger.

Not that other platinum miners have done better. My Sibaye Stillwater (SBSW) is down even more.

[ReformedCharacter]

I've been tempted by Games Workshop. Quite an impressive rate of dividend growth from a cursory glance. One of my sons works in the games industry and seems to think they have a good business model and product. I used to think that the games industry was a bit niche but read recently that it is worth 3 x the music industry and 4 x the film industry.

RC

[Whatsitworth]

Just like there’s more than one way to skin a cat, there’s multiple ways to make money in the market.
One of my favourite screens to run is ‘turn arounds’.
I set the search for debt > market cap + operating cash flow is positive.

Usually the share price is bombed out and nobody wants to own it. The earnings are suppressed/non existent from finance costs and sometimes from non cash charges such as restructuring.
The cash flow statement is the most important part though. The company must be able to pay the debt and interest so as not to raise equity. The management must be making it a priority to pay down the debt. This is usually done by minimising cap ex without effecting the business.

Two good examples where Iv doubled my money GMS and MTL which I still both hold.

In terms of quality metrics I like rising trends in capital turnover and ebit margins both correlated with ROCE

[simoan]

Does anyone know of companies reporting ROCE in their filings.

Some companies do, but it’s easy to calculate ROCE yourself from the accounts. Go to the balance sheet to get the figures for Total Assets and Current Liabilities. Subtract the latter from the former and take the reciprocal. Go to the Income Statement and multiply by the Operating profit or EBIT figure. Multiply by 100 to get ROCE as a percentage. It takes two minutes.

[simoan]

Sylvana (SLP) has been a disaster. Down 50% in the last year or so, and its dividend yield screams danger.

Not that other platinum miners have done better. My Sibaye Stillwater (SBSW) is down even more.

I personally don’t invest in small resource companies so I don’t bother screening out Mining and Energy sectors, which I could do. Normally one of the factors will take out miners anyway, in particular heavy capex, but Sylvania gets through. My understanding is it produces Platinum group metals from other miners detritus in South Africa. It doesn’t get much worse than that. And of course, profits will be geared to the underlying commodity prices, which in the case of PGMs have tanked taking the share price of PGM miners with it. Bargepole deployed.

[simoan]

I've been tempted by Games Workshop. Quite an impressive rate of dividend growth from a cursory glance. One of my sons works in the games industry and seems to think they have a good business model and product. I used to think that the games industry was a bit niche but read recently that it is worth 3 x the music industry and 4 x the film industry.

RC

Games Workshop is so cash generative it just hands out truly surplus cash as dividends. It doesn’t have a progressive dividend policy to my knowledge, so if times get tough I’ve no doubt the dividend payout would decrease. Quite rightly they put the cash needs of the business first. The management are a breath of fresh air IMHO.

[Gerry557]

Does anyone know of companies reporting ROCE in their filings.

Some companies do, but it’s easy to calculate ROCE yourself from the accounts. Go to the balance sheet to get the figures for Total Assets and Current Liabilities. Subtract the latter from the former and take the reciprocal. Go to the Income Statement and multiply by the Operating profit or EBIT figure. Multiply by 100 to get ROCE as a percentage. It takes two minutes.

It takes a lot more than two mins. Just finding the info can take a while to go through. I was looking for those that put out a headline page and include it. Its rare from my observations. Whilst I might invest more time in those I own or am thinking about buying I think it's a bit much for everyday reading. Hence the idea of a screener.

Obviously you think it's worth paying Stockpedia and I'm on the fence.

[simoan]

Some companies do, but it’s easy to calculate ROCE yourself from the accounts. Go to the balance sheet to get the figures for Total Assets and Current Liabilities. Subtract the latter from the former and take the reciprocal. Go to the Income Statement and multiply by the Operating profit or EBIT figure. Multiply by 100 to get ROCE as a percentage. It takes two minutes.

It takes a lot more than two mins. Just finding the info can take a while to go through. I was looking for those that put out a headline page and include it. Its rare from my observations. Whilst I might invest more time in those I own or am thinking about buying I think it's a bit much for everyday reading. Hence the idea of a screener.

Obviously you think it's worth paying Stockpedia and I'm on the fence.

With a bit of practice you can do it in two minutes. You need to find three line items and do the calculation on your phone. That’s what I do. The problem with relying on any number provided by the company is that you can guarantee it will show their profitability in the best possible light. The issue here is adjustments to EBIT which means they may use “underlying” or “adjusted” numbers instead of the reported figure i.e. they may exclude operating costs that they consider exceptional but which sometimes are not. Diageo did just that this morning in their interim results with £154m of “exceptional operating items”.

All the best, Si