Ariston Advisors: All Style Portfolio
Rationale for this Screen:
Quality? Value? Growth? How do you decide which way you want to invest? What if aspects of all of these styles appeal to you?
Many investors prefer to focus on one specific style. Some are ardent value hunters, seeking cheap stocks, however they may decide to define the word "cheap." Other investors are lured by the thrill of fast growing sales or earnings, and avidly pursue growth-oriented opportunities. Yet, other investors prefer to focus on companies with strong management.
Which style of investing you choose to use depends on many factors. For instance, you want to consider the time horizon of your investment: How long is the money going to be working for you before you plan on using it? Another factor to consider is your tolerance toward risk.
After some introspection, some investors find that value is the best approach for them; others believe that growth best fits them. Others, still, have decided that they want to focus on companies with solid management that generates strong returns. Some investors, though, are attracted to elements of these three styles. This screen is an amalgam of quality, value, and growth.
Specific Screen Criteria
It is difficult to accurately gauge the quality of a management team. Still, there are some key statistics that shed some light on this subject. Here, we look at management's effectiveness at generating profit by using that amount of capital that is owned by the shareholders. Specifically, we focus on Return on Equity (ROE). Briefly, ROE is calculated as net profit divided by average common equity. We seek companies where ROE is not only above the industry average but is also improving over time. To accomplish this, the screen requires companies have ROE that is better than the industry average over two time periods: the trailing twelve months (TTM) and the last five years, and it also requires that a company's ROE for the last twelve months must be better than its own five-year average.
If you want to see how fast a company is growing, start by taking a look at its top line. Specifically, look for companies where the pace of revenue growth is faster than some long-term trend. We screen for companies where the revenue growth rate in the trailing twelve months is faster than its three-year average.
It is also important to be careful not to get caught up on companies that are doing well simply because their entire industry is doing well. If the entire industry exhibited recession-like conditions two or three years ago, but is booming now, it is easy for companies to meet our revenue growth requirement above. We need to be mindful of the idea of a 'rising tide lifting all boats.' In fact, we want companies that are growing their revenue faster than the average growth rate for their respective industries. The screen focuses on companies that have grown 20% faster than the industry norm in the trailing twelve-month period.
Improving Cash Flows
Stocks are theoretically valued on the basis of a stream of discounted future cash flows. While past performance is no guarantee of future performance, we use history as a guide and screen for companies that have been growing their cash flow per share. Specifically, we require that a company's annual cash flow per share is higher than its level from a year ago. We also require that the year-ago figure is better than the number from two years prior, and that number must be superior to the number from three years ago.
When examining stocks, it is often useful to compare typical valuation metrics, such as price to earnings (P/E) or P/Sales. We mentioned above that stocks are valued on the basis of discounted future cash flows. It would be too cumbersome to analyze every company and forecast cash flows. Instead, we take a cue from P/E and P/Sales metrics and look at the current price of a share divided by cash flow for the trailing twelve months. But we don't look just at cash flow, we strip out all non-operating cash outlays, such as dividend payments and capital spending, and focus on price/free cash flow. Because free cash flow omits the non-operating cash payments, it is a superior measure to gauge a company's ability to generate cash than simply cash flow. We screen for companies with P/FCF less than the industry average.
It is also useful to take into consideration analyst estimates for future performance. Instead of calculating P/E ratios based on a company's earnings for the last 12 months, we use analyst EPS estimates for the current fiscal year. We also calculate P/E using the consensus of analyst estimates for the next fiscal year. Next, divide both of these forward P/E ratios by the analyst estimate rate for long-term earnings growth. Taking these steps yields PEG ratios for the current year and next year. As with P/E ratios, lower PEG ratios indicate 'better' valuations. There is no magic number with PEG ratios, but a general rule of thumb is that any figure over 2 suggests that the stock is highly priced. On the other hand, die-hard value hunters prefer to focus on stocks with PEG ratios below unity. We don't put any such restriction on a stock's current-year PEG ratio; we simply screen for stocks where the current year reading is higher than next year's figure. But, when it comes to the PEG ratio for next year, we focus on stocks that have readings of 1.5 or less.
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