Monday, March 25, 2013

How do I screen for stocks?

Somebody asked, "Hey Kevin, I wanted to know if you use certain screening tools to screen out stocks? For example, p/e less than 10, debt to equity less than 0.5 and so forth. If you do, which ones to you use and what criteria do you input?"

I guess I should start by saying that I don't generally screen for stocks.  When I do I generally start with Price to Book (P/B) value.  From there I want to invest in a business that generates a high Return On Equity (ROE).   An investor needs to be especially careful with looking at ROE's because it can be easily manipulated by the leveraging the balance sheet (adding more debt).

Book Value

If you read the annual letter to shareholders by either Warren Buffett or Prem Watsa, you will find something in common.  Both legendary investors focus on book value and discuss that metric extensively in their letters.  The book value of any company acts as an anchor or financial gravity with respect to business value.  That is why both Buffet and Watsa use book value as an understated proxy for intrinsic value. 

Recently in Canada, a number of so called investors learned this lesson the hard way in Poseidon Concepts (TSE:PSN).  How a commodity type business could trade a such a high P/B ratio almost escapes logic.  The company had zero competitive advantages and no patents.  I wonder how many investors in PSN even knew what the P/B ratio for the company even was?  I would bet not that many.  Now the stock is a zero.  It would makes an interesting case study for those interested. 

Return On Equity

Now, in general, I really only want one thing when I make an investment.  I want to earn 15% on my money, preferably on day one or as close to day one as possible.  If I cannot achieve 15% on my capital then I am not interested in that investment.  By this I mean I want to see a clear, rational argument for how I can earn 15% on my purchase price. 

What I regularly observe in reading about investments is that many people do this exercise in the precisely the reverse order.  They find an investment that they think is cheap then attempt to justify the investment by "rationalizing" some non essential metric.  What they are really doing is "irrationalizing" the investment.  I am amazed how often some investments are justified, when I know full well the math doesn't add up.  PSN would be an example. 

The trouble with stocks is that valuations are nothing more than people's expectations.  Beyond that, many people look to others to determine what the value is.  This means that every time you look at a stock quote to determine what something is worth, you are really asking someone else what the value is.  It is best to determine the business value first (unbiased by the opinions of others) and then go search out the market price. 

One last thing.  If a company doesn't have any earnings it's ROE is zero.  Let me say that again.  If a company doesn't have any earnings it's ROE is zero.  That company is in the business of consuming capital and that is not a good business to be in, unless you're generous.  I find it funny how when a company's earnings are non existent (like in the oilpatch or the dotcom bubble), investors run to other metrics such as cashflow.  While the words "cash" and "flow" both have a good ring to it, if a company doesn't have any earnings, the cash is flowing in the wrong direction... out the door. 

Business Ownership

I look at businesses a little different than most others because of my experience (working in a small business) and my fundamental understanding of capitalism.  I don't really know how else to say it.  Every business lays out money (capital) in attempt to earn a return on that money (capital).  Money is just a easy way of converting one form of capital into another. 

So every company lays out capital in an attempt to earn a return on that capital.  Beyond that, I want the return on capital to be stable and easily predictable from year to year. 

From this I just want to buy at a price point that will give me a 15% return on my investment.  This means that almost every business is a potential investment, even if it is a dull boring investment, so long as the price is acceptable. 

Now from this I would add that there are a number of other variables that are at play.  Every company has different investment merits.  Each balance sheet has to be analyzed individually for the assets and what those assets can earn for the business owner.  Sometimes there are hidden assets or undervalued assets that may potentially be very valuable. 

So my golden rule of thumb is this: How can I earn 15% on my money.  I don't care if it's an apartment, a bond, a piece of land, or a stock (part ownership in a business).  I just want to earn 15% on my capital. 

This may sound simplistic because it really is simplistic.  Staying disciplined (rational) and actually finding investments that meet the above criteria is the hard part. 

Best Regards,

Kevin Graham

P.S. - I have been extremely busy lately and thus haven't been able to write on this blog.  Early this year I was given more responsibilities at work that required more of my attention.  Beyond that, I was away on vacation for the first two weeks of February and then was in Ireland for the first 10 days of March (for work).  Only recently have I gotten back into my normal routine.