A guide to how you can screen for high quality companies with stock screeners
Investing in high quality compounders can be good for your wealth. The key is to find them, save them in a watchlist and wait to buy them until they are sold at an attractive price.
I will explain my process on how I search for these types of stocks and how I organize them into a watchlist. The reasons why I like to focus on high quality stocks vs cheap mediocre stocks when screening are these:
High quality stocks:
They’re quality is more likely to be of a permanent or sustainable nature vs a cheap stock which might be attractive only because it cheap. When the mediocre stock is not cheap anymore you need to sell it. So cheap mediocre stocks are not compounders for the long term. A stocks cheapness can be very fluctuating (Just look at 52 week high/low), but the fundamental data and history of a high quality does not change or fluctuate much.
If the watchlist contains only stocks with the “quality” of being cheap, you would need to frequently update and change this watchlist, but a watchlist of high quality stocks regardless of price is more permanent, and you will not need to change it frequently.
To find these types of stocks I use stock screeners. My favourite stock screener at the moment is Unclestock Screener. It contains a lot of great metrics to screen for to find high quality stocks. The registration is free and you can use it for a few weeks before the free trial is over. Still that does not matter much as we just want to make a database of the highest quality stocks that has permanent qualities, so you don’t need to screen frequently for changes in stock prices. You can also export you screening results to Excel, so that you can save your results and do you analysis of the stocks at a later time.
When you screen for a high quality stock you want to use:
– As few variables as possible – You want to keep things simple and not too complicated
– The most important variables for assessing the quality of a company
– Factors that determine how much stability there is in the profits of the company. – You want this because a stable company is also a company that is easier to predict what is going to earn in the future, and you are also able to put a intrinsic value on the stock.
So in Uncle stock Screener I use these variables because I think they are the most important for determining the quality of the company. They also make logical sense.
You want to screen so that you rule out companies with cyclical earnings, so the focus is on stability in the financial numbers.
I always look at the longest financial history that is available in the stock screeners. Usually that is 10 years of data.
Metrics and targets that is indications of a high quality company:
-Revenue increases: Number of years of increase in revenue past 10 years.
Target: 10/10 years with YoY increase.
-Revenue 10y CAGR: How much the compounded growth of revenue has been the past 10 years. You want to see the company grows it’s revenue over time.
Target: Above 5%
-Free cash flow positive years: You want a company to have positive free cash flow most years.
Target 10/10 years
-ROIC 10y average: (return on invested capital). This is a good metric too see if the company is a compounder.
Target is above 15%
-ROIC 10 year weakest: This is a metric that will show how much stability there is in ROIC.
Target the lowest year should not be below 10 %
-EPS positive years: You want the company to have no years of negative EPS.
Target: 10/10 past years with a positive EPS
-EPS 10 year CAGR: How much the compounded growth of EPS has been the past 10 years. You want to see the company grows it’s EPS over time.
-Free cash flow 10y CAGR: A high quality company can grow its free cash flow over time
Target above 5%
-Cash flow coverage ratio: How much cash flow from operation is in relation to total liabilities. You want a company that can pay down it’s total debt in short time if they wanted to. Target CFC more than 30% of total liabilities.
The reason I don’t use other solvency and liquidity ratios than the Cash flow coverage ratio is that there are different capital structures between industries. Strong companies can have a high debt/equity ratio, but still be in great financial shape, because their strong cash flow can easily cover their interest payments as an example.
Also notice that I don’t use any valuation metrics for cheapness like P/E etc at this stage, because my goal is just to make a list of the highest quality stocks regardless of today’s valuation. I don’t want to exclude great companies just because they are currently not cheap!
And here is an Excel file with the results from the screening:
Here is a screenshot from Uncle Stock Screener with the variables used:
As you can see in the Excel file:
– Only 31 companies made the cut out of 8201 companies in the screeners coverage of USA and Canada.
– Some companies might be familiar to you: Microsoft, Monster Beverage, Factset, Intuit and Tencent e.g. They are familiar because they have proven to be strong sustainable businesses and have become famous because of a long history of superior financial performance.
Average numbers for the stocks that was found using the screener (See Excel sheet)
-Revenue increases: 96%
-Revenue 10y CAGR: 17.3%
-Free cash flow positive years: 98.4%
-ROIC 10y average: 55.4%
-ROIC 10 year weakest: 22.3%
-EPS positive years: 99.2
-EPS 10 year CAGR: 20.3%
-Free cash flow 10y CAGR: 20.2%
-Cash flow coverage ratio: 65.9%
As you can see the numbers are high and strong. Companies with these numbers are high quality companies.
You can play with the screener and change the numbers slightly to get a different set of stocks. However I would advise you to keep rather strict criterias so that you will only get a list of great companies.
So now that you have a database of high quality companies the next step is to do a short initial analysis of the stocks in you list.
For this purpose I use the great service QuickFS.net. Here you can look at a companies 10 years of financial history in a fast and efficient way.
I go through my list of stocks that i gathered from the screening process and I look at the business description to understand what the company does. I also look at stability in the numbers like operating margin and ROIC. I also make sure that the company has no years of EPS losses and that they have a positive free cash flow most of the past 10 years. If everything looks good and confirm that this is a quality company I will continue to Gurufocus.com
Here I will first look at the longest range chart for the stock to see if the stock has “worked out” over the long term. Remember that in the short term the market is a voting machine, in the long term the market is a weighing machine. So if the stocks has performed great over the a long period like 10-30 years this actually show the quality of the company. Over the long term the market will give the valuation the company “deserve”. In almost all cases the company’s that that I have screened for using metrics to identify quality is also confirmed by the long chart that it is a high quality company.
If the long term chart 10+ years shows an steady uptrend then its good and I take a quick look at the debt metrics like cash to debt and interest coverage to see if everything looks fine.
Example from the stock Monster Beverage that was found in the initial Uncle stock screening:
Since the stock has passed all the “filters” for a quality stock I will then include the stock in the watchlist in Gurufocus portfolio tool. The tool is free to use, but you need to register with Gurufocus first.
This is the watchlist I use to keep track of my favourite stocks. You can make a big watchlist of high quality stocks and make different “views” that shows different metrics. I like to include similar quality metrics like I used on the Uncle Stock screener, but I will also include things like insider ownership and different valuation metrics.
Now you have a watchlist of quality stocks and you have saved them and can track them. The next step is to probably to get more familiar with the company, understand what their business model is and if they have a sustainable moat. There are no guarantees that the companies in your watchlist will continue to be great the next 10 years, but at least the history shows that the company has proven itself, and make it more probable that it will continue with performing well in the future. This make it also easier to assume and predict growth rates for the company for the future which is vital for having confidence in the valuation of the company.
You can go through your list and learn as much as you can about the company if you are willing to do the work.
The final step is figuring out what you are willing to pay for the stock. It’s all about price in relation to quality. The highest quality company in the list might be the company that you might be willing to pay the highest price for and it will still be a great long term investment. Still you want to pay an low price in relation to the quality since you want to have large margin of safety in case your assumption of the company’s future quality is wrong.
There are many ways to value a company but a shortcut can be to look at valuation metrics like: P/E, EV/EBIT, EV/FCF.
You can also use a tool like The Warren Buffett Spreadsheet which uses more advanced valuation models to calculate intrinsic value for stocks.
When you have figured out a price or valuation metrics that will make you want to buy the company the last and final thing you want to do is to make an price alarm with e-mail alert in Gurufocus. The e-mail alert in Gurufocus lets you set up an price alarm for price and also for whatever metric you want to. Like for example when the company is sold for a EV/EBIT below 8 as an example.
So for each stock in your watchlist you can make an email alert on price or the metric you want. In this way you don’t need to constantly check these stocks for their price and valuation, but you will automatically get notified when they reach your desired buying price.
The purpose of this watchlist is to be prepared to buy high quality stocks the next time there is a crisis with similar magnitude like the financial crisis, Corona crisis or whatever crisis that will come in the future. It will come more of them in the future and you should be prepared by knowing which stocks to buy and at what price.