We like quality UK stocks here at The Storied Investor. Finding them can be tricky. Many investors turn to a screen to find stocks they might want to consider investing in. A screen will usually combine a bunch of metics that are though to help weed out particular stocks.
For example, a value investor might look at price-to-sales, price-to-earnings and price to book ratios and screen out any stocks that are above 15, 2, and 4. Anything that is left might be considered a good value stock candidate, worthy of further investigation and possible inclusion in a portfolio. The selection of stocks here is based on their relative cheapness compared to the rest of the market
What makes a quality stock
How about a quality screen then? Well, what are quality investors looking for? A stellar management team who have demonstrated an ability to allocate capital spectacularly, who continuously innovate and grow their companies and have established a strong and defendable competitive position and have a track record of delivering outsized returns to shareholders. Is that too much to ask for? Maybe it is. But, we can certainly try.
So we have a bunch of qualitative factors. Not easy to screen for those. So, how about some quantitative ones? We could use the following:
- Return of capital employed
- Return on Equity
- Gross margin
- Operating margin
- Free cash flow per share growth
- Revenue growth
- Debt to equity
These metrics could be calculated over the last year perhaps, or an average of the last five years for example. And they do have associations with those qualitative factors. High margins suggest competitive advantages. High returns on capital employed suggest smart capital allocation, especially if that’s been the case for years. A historically high return on equity is usually a good sign for shareholder value creation, especially if we combine it with low debt to equity. Revenues and free cash flows that are steadily ticking higher are positive signs.
But, here’s the thing. High margins tend to be associated with high returns on capital employed. Low debt to equity tends to be associated with high return on equity. High revenue growth, with high margins tends to be associated with high free cash flow per share growth, especially if the company is asset light (low capital intensity), and we could add that into the screen as well, as it can be a quality characteristic.
One metric to rule them all
A screen might have multiple, maybe 10’s of metrics. A handfuls of stocks might come out the other side. Some metrics might be relaxed to allow a few more to sift through, so there is a chance of building a portfolio that isn’t all in on just a couple of names.
But what if the best screen was not to screen at all. If all value metrics are correlated with each other, as are all quality metrics, what is gained by screening stocks based n a bunch of them. Maybe a better approach is to pick just one metric (maybe at a push two), and rank stocks by it, instead of screening them in or out. Now, what this metric is will depend on what an investor is looking for.
An income investor might pick dividend yield. They could start by looking at the top 20 stocks ordered by dividend yield, and work down the list seeing if they like each stock or not. The object is to find the biggest dividend payers for the cheapest price, adjusted for risk, right? Well, why not start with the highest dividend yield stocks and work down the list.
And for quality, I like return on capital employed (ROCE). I want to see a firm using all its sources of capital to buy productive operating assets that generate high returns on the capital employed. High ROCE tends to be associated with high margins and other measures of quality.
Return on capital employed = net operating profit after tax / capital employed
Net operating profit after tax is also called earnings before interest and taxes after tax.
Capital employed is the sum of a company’s fixed assets and its working capital, the sum of which are the company’s operating assets. Capital employed is financed by two main types of funds, shareholders’ equity and net debt,
Corporate Finance: Theory and Practice Paperback – 17 Feb. 2022 by Pierre Vernimmen, Pascal Quiry, Yann Le Fur.
If I could pick just one quality metric it would be ROCE. So why not rank stocks by it, start at the top and work my way down, rejecting or accepting I go? Now, there might be some anomalous results. Some companies might report absurdly high ROCE’s in the short term. So a five year average might be better, and even then I might end up rejecting clear outliers. But I can make it work.
To sum up then. If I am after quality, and I lean towards ROCE as the best measure of quality (when its high) then why not look for stocks with the highest ROCE. I could screen for stocks including ROCE and a bunch of other metrics, but then I might screen out high ROCE stocks because they narrowly fail to get through the other filters. And besides, quality metrics tend to be correlated with other quality metrics, so maybe I am not really gaining much by adding a bunch of them together, and losing potentially high quality stocks anyways.
The Storied Investor 