There are many indicators on Uncle Stock and this can be too overwhelming for a beginning, or even an experienced investor. But it is possible to keep it simple. You just have to apply the 20/80 (Pareto principle) thinking: with 20% of the effort or knowledge, you get 80% of return. In fact, I’m trying to describe in 2 pages what I would explain to somebody new in stock investing of what I learned in the last 10 years.
In fact there are 2 factors that are important: how cheap is the stock, and how good is the company. For that, you just need one or two indicators.
How cheap is the stock?
To measure how cheap the stock is, indicators compare earnings, or assets with the stock price. In fact, just taking one will already be good. The choice of the perfect indicator will not have that much impact on your total return. You can, for instance, just take EBIT yield, which compares EBIT (Earnings before Interest and Taxes, or Operating Income) with Enterprise Value.
The enterprise value is a more global ‘variant’ of the stock price that measures the market price of the equity plus the debt. If you make the analogy to holding a house, the enterprise value is what someone buying the house would have to pay for it. He would have to pay for what it’s worth on the housing market. Part of the money would go to me (as equity holder), part would go to the bank (as debt holder). The EBIT yield is the income before taxes that the house generates on renting income, relative to what the buyer would pay for buying the house. So it is a measure of how cheap the house is on the market (enterprise value), related to its return. Somebody deciding to buy the house would want to know this. If the house becomes more expensive, the return for a potential buyer would decrease, unless the rent increases as well.
It does not make much difference whether you use EBIT yield, EBITDA yield, FCF yield or EPS yield. Some indicators relate to stock price (like EPS yield), some to enterprise value (like EBIT yield). It does not matter too much whether you use price or enterprise value, as long as it is compared with the correct type of income. Some say the Acquirers’ multiple (Adjusted operating income yield) of Tobias Carlisle is all you need. But It will not make a lot of difference for your actual return. You can keep it simple and just use one.
Some indicators compare stock price to assets or book value to measure how cheap a stock is. But if you want to make it simple, there is no need for them. I think this is only good if you are looking for specific strategies. You can just ignore them.
Uncle Stock also has a value score which combines several indicators that compare price to several income and assets measures. So value score might also be used to assess whether a stock is cheap.
Value investors focus on cheap stocks.
Here is an example of a basic pure value screen.
Backtesting it gives a yearly return of 8%. This return is not huge, but it will be quite resistant during neutral of bear markets.
How good is the company?
Or more precise.. Does the company have the potential to grow?
For measuring how good a company is, there are indicators that are independent of price, like ROE, ROA, ROIC, ROCE or margin. They measure how efficient a company is in generating profits, using its assets. They look at the company itself, and ignore its price on the market. If you build a house, you make an investment. ROCE (return on capital employed) tells how much rent the house returns on that investment. It does not matter how the housing prices evolve. The investor has invested or employed some capital, and the performance of that investment or capital is its return on investment. So it is a measure on how efficient the company uses the invested or employed capital to generate profits. It is an indicator of how well a company transforms capital to cash.
It does not make much difference whether you use ROCE, ROIC, CROIC, ROE or ROA. They can be based on the equity, capital invested, capital employed or total assets, which are all accounting measures instead of market measures. You can keep it simple and just use one, like ROCE.
So these indicators are independent of the market value of the equity.
A second aspect of a good company is growth of income or assets. Did the revenues of the company increase over time?
Historical growth and efficiency indicators are used to predict future growth. Future growth will make the price increase over time.
Uncle Stock provides a growth score which combines historical growth with some ROCE variants. So the growth score might also be used to assess whether a company is good.
Growth investors focus on good stocks that have the potential to grow, because they are efficient in producing return or their income grows over the years.
Here is an example of a basic pure growth screen.
Backtesting it gives a yearly return of 20%. Remark that is significantly better than the performance of the value screen, but this is because the backtest period started in 2008, and the last decade was favoring growth investing.
Which is most important?
Both are important. But if I would pick one, I would go for cheap stocks, or value stocks. Over a long period of time, value has outperformed growth on average. However on the last 10 years, growth has outperformed value. Many good value investors had poor returns in the last decade. Typically, growth investing performs better in a bull market, and value investing performs better in a neutral or bear market. Perhaps now is a good moment to shift to value investing.
Also, value investing holds less risks, so you might invest more money in value stocks. If you are a bit more risk reverse, value investing might be better.
Buffett and Lynch are rather growth investors, Buffett says it is important to buy good stocks, even if they are not that cheap. Graham is more a value investor. So there are many ways to get rich. I think it is a good diversification to combine them in a portfolio. At least you should be aware of a specific stock how it looks from both perspectives.
So, if using only one indicator, something like EBIT yield will already do great.
Combine them in one indicator?
An indicator that combines value and growth is Price to Intrinsic value. It uses the current income, then estimates the future income based on the historical growth to measure the present value of this future equity value. When comparing this fair value to the stock price, you get an indicator of how cheap the stock is. There are many ways to estimate the intrinsic value, which Uncle Stock combines into an average.
So the price to intrinsic value indicates how cheap the stock is, based on the growth of the company.
The only disadvantage of this indicator is that it is not always stable. Certainly if there is not much historical depth or a lot of variability in results. It is easy to get a reliable estimate of the intrinsic value of Apple, but it is difficult to get it for a stock with just 2 years of history. All models take some assumptions (like discount rate and growth rate) that could be wrong. So it is just an estimate.
The Uncle Stock score combines the price to intrinsic value, the growth score and the value score (in that order of importance). As such, it tries to identify good stocks at a reasonable price. Although this is a very good tool to screen for stocks, it combines things that are in fact not comparable. So using it should not prevent you from asking: how cheap is the stock and how good is the company?
Here is an example of a basic screen combining value and growth indicators:
Backtesting it gives a yearly return of 12%. It is normal that this return is in between the return of the pure value screen and the pure growth screen, because it combines value and growth.
Note: All sample screens were created on www.unclestock.com.
