Category: Articles

3 Top ranked dividend aristocrats now

This is a guest contribution from Bob Ciura of Sure Dividend.

Income investors have long sought out the stocks with the best long-term prospects for rising income. The idea is simple: find the companies with the highest likelihood of being able to perform well in any economic climate, affording those companies the ability to rising dividends.

There are 65 such companies on the list of Dividend Aristocrats, a group of S&P 500 stocks that have at least 25 consecutive years of dividend increases. These companies have stood the test of time when it comes to earnings and dividends to shareholders, and below, we’ve selected three we believe are top buys today.

AT&T (T)

AT&T is a telecommunications giant that traces its history back to the late-1880s. The current company is the result of several large mergers and today, AT&T trades for a $190 billion market capitalization, and generates about $170 billion in annual revenue.

AT&T has built a highly diversified telecommunications business over time with acquisitions such as DirecTV and Time Warner, moves which were outside of its core areas of competency. AT&T still derives much of its revenue and profit from its core Communications segment, which provides wireless, broadband, and video services to ~100 million US consumers, a business which is stable over time. This allows AT&T to invest in growth via acquisition, which it has made full use of in recent years.

We believe AT&T’s model will continue to work in variety of economic climates because it is highly entrenched among consumers, where switching costs tend to be high. AT&T is the sole provider of broadband and video services in certain areas, and switching wireless providers is costly for consumers in many cases. This leads to very low rates of churn, so AT&T should be able to weather whatever storm comes its way.

AT&T’s yield is enormous currently because of a huge selloff in the stock this year. However, despite this massive yield, AT&T’s dividend still appears safe. The payout ratio for 2020 is currently forecast to be just 64%, meaning there is significant room for continued increases in the years to come.

With stable earnings, the opportunity for modest growth, and a relatively low payout ratio, AT&T should be able to continue to grow its dividend for many years to come. We see payout growth as somewhat muted given the already-high yield and AT&T’s desire to deleverage, but over time, AT&T should remain a dividend growth stock.

Chevron Corporation (CVX)

The next stock in our list is energy behemoth Chevron Corporation. Chevron traces its lineage back to Standard Oil, before it was broken up in the famous antitrust action from more than a century ago. Today, the company is one of the largest oil companies in the world based on its current market capitalization of $136 billion. Chevron, like AT&T, has had a tough 2020, but should still produce more than $100 billion in revenue this year.

We see Chevron’s model as sustainable in the long-term because it has enormous scale in supplying current energy needs globally, as well as an eye toward the future. In other words, Chevron continues to produce vast quantities of oil and natural gas products, as those are highly profitable today. It also has a sizable chemicals business that helps diversify revenue away from direct energy usage for gasoline, heating, etc.

Chevron is also investing in clean energy technology that will, hopefully, one day power the company’s revenue and profits as the use of fossil fuels declines over time. Chevron is keenly aware of this issue, but has the willingness and cash to do something about it before it is too late. Given all of this, we believe Chevron’s model can succeed for many years to come.

Massive swings in oil prices have caused Chevron’s earnings to be quite volatile over time, thereby driving the payout ratio quite high. This year is a good example of that as earnings are expected to plummet on extremely weak demand due to COVID-19. With negative earnings expected, Chevron’s payout ratio isn’t meaningful. However, the company has proven it has the cash flow to continue to pay the dividend during very tough times, as it has for more than three decades. Thus, while Chevron’s payout ratio may not inspire confidence, we see the opportunity for long-term dividend growth as earnings and cash flow normalize.

Walgreens Boots Alliance (WBA)

Our final stock is Walgreens Boots Alliance, the largest retail pharmacy in the US and in Europe. The company operates in 25 countries around the world and has in excess of 400,000 employees, making it one of the largest companies in the world by that measure.

Walgreens operates nearly 19,000 stores globally, which have front-end retail operations as well as lucrative pharmacies within. Walgreens should produce about $143 billion in revenue this year, and it has a market capitalization of $32 billion.

Walgreens should be able to produce strong earnings for the foreseeable future because of its leverage to the pharmacy business, which has experienced enormous growth in recent years. Healthcare costs continue to rise, including prescriptions, and volumes for Walgreens have risen over time as well, creating a virtuous upward revenue cycle. The retail business has been much weaker, and we don’t expect that to necessarily contribute to earnings performance over time. However, Walgreens has proven its model can work in a variety of conditions, which is exactly what investors need for long-term dividend growth.

Walgreens’ dividend payout ratio is just 40% for this year, meaning there is a very long runway for not only dividend safety, but growth as well. Walgreens easily has the most sustainable payout of the three stocks in this list, and has the most opportunity to grow the payout of the three. Thus, we see Walgreens as a very strong dividend growth stock for the years to come, extending Walgreens’ already-impressive 45-year dividend increase streak.

Final Thoughts

These three stocks all have business models we find to be quite resilient, which should afford them the ability to not only maintain, but grow their payouts over time. Chevron and AT&T both have 7%+ current yields after nasty selloffs for each stock in 2020, and Walgreens has the safest payout, while also having the most room to growth the dividend over time. However, all three offer dividend and income-focused investors the chance to buy and hold for rising income over time.

Indicator paralysis: Keep it simple!

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. 

Value: How cheap is the company?

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.

Basic value screen using Uncle Stock

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? 

Growth: How good is the company?

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.

Basic growth screen using Uncle Stock

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.

Combining value and growth

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:

Basic Price to Intrinsic Value screen using Uncle Stock

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.

Uncle Stock interview

Peter got interviewed by daytradingz.com.

Daytradingz gives valuable information about trading and about general financial topics. For example, the website includes a finance blog, online brokerage account reviews, trading ​course reviews and trading tool reviews.

The interview is about the features and creation of Uncle Stock, moreover he speaks a bit about himself and investing.

Advanced Growth Calculations In Uncle Stock: CAGR, rCAGR and rCAGR 67

Investors Extrapolate Historic Growth Towards The Future

In the valuation of a company, investors often extrapolate historic growth towards the future. The reason is that growth in the past is a predictor of a good sector, capable management or a competitively strong position. This is especially the case if this growth remains consistent over time. Uncle Stock offers different ways of extrapolating past growth towards the future, some methods being more sophisticated as others. This article gives some deeper understanding on the more advanced growth calculations Uncle Stock uses to deal with growth.

Growth Calculations In Uncle Stock

To give a first impression on the growth calculations  offered by Uncle Stock, take a look at the image taken from the revenue of Apple over past 6 years. We see a lot of growth calculations in the evolution tab, and we will discuss the following three: CAGR, rCAGR and rCAGR 67.

CAGR: Compound Annual Growth Rate

CAGR Compound Annual Growth Rate (CAGR), calculated by taking the geometric mean annual growth rate over a multi-year period

The most basic growth calculation in Uncle Stock is the CAGR (Compound Annual Growth Rate). This growth calculation method is widely used for tracking growth of a financial number (e.g. revenue ) or the return of an asset portfolio that reinvests profits and does not replenish losses. It takes the geometric mean annual growth rate over the past X years.  To determine CAGR, one needs a start value, and end value and the amount of time between these values and can be calculated as follows: “To calculate compound annual growth rate, divide the value of an investment at the end of the period in question by its value at the beginning of that period, raise the result to the power of one divided by the period length, and subtract one from the subsequent result.”

By taking CAGR instead of arithmetic mean (just counting the growth rates and divide that sum by the number of points in time), we make sure the effect of compounding gets included. For example if the revenue of a company drops 50 percent between year 1 and year 2 and increases 50 percent between year 2 and year 3,  the revenue in year 3 will be lower than the revenue in year 1. The reason is that the principal grows 50 percent in the first period and only half the principal drops 50 percent in the second period. arithmetic growth would give a mean growth of 0 percent in this situation, whereas CAGR would give a negative growth being in line with reality.

But CAGR has some serious disadvantages. The main problem is that it only looks at two values: the start value and the end value. This means that a lot of information gets lost, leading into two main problems with extrapolating CAGR towards the future:

1) What if a boundary point of your measurements is exceptional?

2) Can we come up with a growth estimate that is reliable in case growth numbers deviating a lot from the mean (punishing volatility)?

Both problems caused by CAGR are solved in Uncle Stock by using more advanced measurements of growth: rCAGR and rCAGR 67

rCAGR: Compound Annual Growth Rate Using Regression

rCAGR Compound Annual Growth Rate (CAGR) over a maximum multi-year period, calculated using the slope as result of log-linear regression.

1) What if a boundary point of your measurements is exceptional?

As CAGR only looks at two points, an exceptionality in one of these points would have a huge impact and lead towards wrong conclusions. To solve this issue, Uncle Stock has defined rCAGR, which uses logarithmic linear regression of a financial number. Technically a log linear regression is created by taking the logarithm of all values, drawing the linear regression, and taking the exponent of the slope. As we can only take the logarithm of positive numbers, Uncle Stock makes some transformations to make this algorithm possible. This growth metric can be found by drawing the regression line with the best fit between all the yearly values over a time period. The most important reason for using regression is that it takes into account all the points between the first point and the last point, which protects us from those boundary points being exceptional. We can define rCAGR as the expected yearly growth taking into account all past observantion points. rCAGR equals the slope of the regression that we have created. We have solved the problem of not taking into account all the observations between the first and last one.

rCAGR is a great growth estimate, but it gives no punishment for volatility. It does not benefit companies with a very stable growth over companies that have minor reliability of results.

 

rCAGR 67: Conservative Compound Annual Growth Rate

 

rCAGR 67% Conservative Compound Annual Growth Rate, based on rCAGR and GSD, with 67% probability to be better.
GSD% Geometric Standard Deviation is a measure of spread of yearly growth numbers (using geometric mean).

2) Can we come up with a growth estimate that is reliable in case growth numbers deviating a lot from the mean (punishing volatility)?

Most investors try to avoid volatility and even rCAGR does not take this into account. If a company has a growth that fluctuates all the time, it becomes much more dangerous extrapolating this growth towards the future. To deal with this problem, Uncle Stock has introduced rCAGR 67 (Conservative Compound Annual Growth Rate) based on rCAGR, a student T distribution and GSD, with 67% probability to be better.

A student T distribution is chosen over a standard normal distribution because it remain accurate even if only a small sample of input values are available, which is often the case for one financial number on one specific company. For rCAGR 67, Uncle Stock takes the growth rate for which the distribution gives statistically a 67 percent chance of outperforming.  This technique is more conservative than rCAGR, as we need that 67 percent chance. The more volatile yearly growth numbers we find, the more conservative rCAGR 67 becomes as the T distribution gets flattened out. That is why I think this is the best way of extrapolating growth into the future.

Acknowledgement

We thank Philip Kurtin for his meaningful input on the creation of these concepts.

If you need additional information on our financial numbers in general, our Glossary could help.

How would Warren Buffett screen with Uncle Stock?

Warren Buffett Investment Style

One of the best investors alive

Would Warren Buffett use a stock screener? And if so, how would a Warren Buffett screen look? Last week, I wrote an article on how I think Peter Lynch would use Uncle Stock. Now an even more well-known investor is discussed: Warren Buffett. He is the third most rich person in the world and controls Berkshire Hathaway, a multibillion dollar fund that outperformed the market for many years. Buffett is considered as one of the best investors alive. The super investor is inspired by the mentorship of Benjamin Graham, considered by many as the founder of value investing.

Warren Buffett compared with Peter Lynch

Buffett and Lynch have their similarities. They are both long term investors looking for undervalued companies with a strong business. But where Lynch is looking for small institutional ownership, Buffett is analyzing more senior companies in a quest for certainty. Where Lynch is being known for owning many different stocks, Buffett only buys a few stocks in which he has complete trust. This Buffett style of “betting high on high chance probabilities” is explained well in the book “The Warren Buffett Way” from Hagstrom, Robert. Given the enormous amount of money Buffett is able to invest, he often buys a position that is large enough to have a strategic impact on the companies in which he owns a stake.

Buffet is looking for great companies

The most important factor for Buffett is whether a company is strong and adds significant value. This includes long term good management performance, profitability of the sector and healthy financials. He would rather buy a great company at a reasonable price, than a weak company that is cheap. But when choosing from two great companies, he will pick the one that is most undervalued. Buffett wants his companies to have a long term purpose of maximizing shareholder value. This can be through generating dividends or reinvesting their excess returns to obtain growth.

Related to his limited amount of different companies, Buffett thinks it is important to buy shares of companies that he understands. So he would prefer a shoe manufacturer over a company that creates high tech microchips.

Now that we have covered briefly how Warren Buffett invests, we can try to answer the question how he would screen on Uncle Stock. In the next section, I create a Warren Buffett screen based on his investment philosophy.

Warren Buffett Screen

Countries

First, the Warren Buffett screen looks for some specific countries that are undervalued as a whole. To measure overvaluation of a country, Buffett has defined “the Buffett Indicator”. The indicator divides Market cap by Gross Domestic Product to give a signal on the valuation of a market. If the ratio is above its historical mean, the market is overvalued and vice-versa. An historically average value for these ratio is around 80 percent. According to Buffett indicator, most European countries and the United States are overvalued, were BRIC countries ( Brazil, Russia, India and China ) and Australia are cheap. My first Warren Buffett screen filters on these five countries. When this Buffett indicator would change, for example due to a crash in US equities, the markets that Warren Buffett screens on would rotates as well.

We also know Warren Buffett for saying even when US stocks have a high valuation, they are still a great investment in the long term. So my second Warren Buffet screen filters on the United States stock market.

Sectors and Industries

Sectors and industries are important for Warren Buffett. He is looking at businesses he understands, with high and predictable profit margins. He would exclude the Technology sector, as he finds the technology business too complex. Also, it is known to have very fluctuating profit margins. Buffett has avoided the Technology sector almost for his entire career. Some exceptions is that Berkshire Hathaway recently bought a stake in Apple and a 8 percent interest in IBM in the year 2014, Buffett points for this exception at their strong management and promising financial situation. In general, a more understandable sector with predictable profit margins is the Consumer Goods industry. However, if you have a strong technological background, investing like Buffett could mean for you that you screen for technology stocks. It is not just about the complexity of an industry, your ability to understand the industry that you are investing in is more important. Although, more complex industries like Technology will be understood by the minority of investors.  I run two screens: one that only excludes the Technology industry, another that only filters for companies that are in consumer goods.

 

 

Screening criteria

Return On Equity > 15 percent

One of Buffett’s most important criteria is the ability to make profits that can go to the shareholders. A high profit margin means a company is in a good business. Also this is a sign of efficiency, especially when ROE is growing. Buffett takes ROE as an indicator for his profit margins, as he wants to look at companies from the view of the shareholder. ROE is calculated in Uncle Stock by dividing net income over equity. We will put a filter that ROE should be over 15 percent.

Debt Ratio < 50 percent

Similar to Peter Lynch, the Warren Buffett screen tries to avoid highly indebted companies. This is a signal of weak management in the past. Also for the future, this means that future profits will go towards debt issuers instead of shareholders, so this will limit shareholder value. The Debt ratio is calculated in Uncle Stock by dividing total debt by equity. We set the limit on a debt ratio under 50 percent.

Discounted Cash Flow using Owner Earnings

A second intrinsic value method that would be used by Buffett uses owner earnings. For this valuation method, the value of a company equals all future net cash flows minus reinvestment of earnings to maintain the company’s competitive position and scale. Uncle Stock defines owner earnings as “Net income + Depreciation and Amortization + Non-cash charges + Changes in working capital – Maintenance Capex” and for the IV calculation net debt and preferred stock are subtracted as common shareholders only have the residual claim. Buffett is looking for undervalued stocks, so he would filter on price/IV <1.

Discounted Cash Flow using Book Value + Dividends

Buffett Intrinsic value Buffett tries to allocate shares that are undervalued and below their intrinsic value. Uncle Stock has a built-in Intrinsic value calculation based on Warren Buffett. Buffett will certainly like the fact that he can use his own IV calculation in his screens. The Buffett IV is discounted book value + discounted dividends. The logic for this IV is that on a possible liquidation day in the future, the value for the shareholders equals all future dividends and the net value of the balance as this remains over when everything is sold and all obligations are fulfilled. Uncle Stock only uses the provisioned cash flows that can be subtracted over the next ten years. Buffett is looking for undervalued stocks, so he would filter on price/IV <1.

 

Descending Sort On Internal Rate of Return

From the intrinsic value that is calculated by taking the sum of discounted dividends and book value, Uncle Stock derives the internal rate of return which is the growth an investment is expected to generate that would make stock price equal to that Intrinsic Value. The benefit of this inverse DCF is that you get a concrete expected return, which can be compared with the return you are expecting for the volatility risk of equity. As the purpose of investing is to maximize shareholder value, we will use the sort function on the descending internal rate of return to complete the Warren Buffett screen.

Extra filters

Buffet would put some extra filters that increase certainty. He would exclude OTC, minor exchanges, missing values and stocks that are not traded.

Results

I created four versions of the Warren Buffett screen, all using the same financial criteria but covering different sectors and markets.

Version 1: US market and all industries except Technology

We are getting 31 results that match all our criteria. The stocks that come on top are PSA-PZ and ARLP with extremely high internal rates of return. The backtest gives a yearly return of 7 percent, which is not that impressive.

Version 2: US market and only the Consumer Goods industry

This is our most restrictive screen, so we are only getting 2 stocks that match all our criteria: KORS and SAFM. This stock screen is too restrictive for backtesting.

Version 3: BRIC + Australian market and all industries except Technology

We get 40 results with two Australian companies on top: VTG.AX and FMG.AX. This Buffett stock screen gives an strong backtested return of 18 percent.

Version 4: BRIC + Australian market and only the Consumer Goods industry

This screen gives us seven results, with SAIC Motor Corporation and Shiro Holdings Limited on top. The backtest gives an average yearly return of 29 percent, but it can only find 60 data points because the screen is very restrictive, so I would not give this too much attention.

Conclusion

We can conclude that Warren Buffett would find use in a stock screener and Uncle Stock would be a fitting tool. Our stock screener offers some ratios that would help him identify stocks in line with his investment style. We can see that the screen for American stocks gives an historically average performance, whereas the BRIC countries and Australia perform much better. We should consider this difference being partly caused by the strong performance of the second group of stocks in general. We were also able to identify some true Buffett stocks in the consumer goods industry, they are certainly worth taking a closer look.

Furthermore, these quantitative criteria would be just a start. Once Warren Buffett has found a profitable company in the right sector that is not heavily indebted and still undervalued, he will look at the management, read the annual report considering whether their future plans make sense. And as he always takes huge positions, he can have a physical conversation with the management.

How would Peter Lynch use Uncle Stock?

Peter Lynch investment style

What if Peter Lynch would use Uncle Stock? How would he use it? Most of you know Peter Lynch as the successful funds manager at Fidelity Management with at his maximum a 14 billion dollar asset base under his management. Or you might know him as the writer of some great books such as “One Up on Wall Street” or “Beating the Street” to convince the retail or young investor that he can beat the institutional professional. He argues that buying what you know combined with the right financial checks, might lead to the discovery of so called “ten- baggers”, investments that lead to profits over 1000 percent. A ten bagger is mostly a stock that is already growing and will continue his growth to the sky. This growth in the past is important, as this indicates a good company. His “buy what you know strategy” can be taken very literally: if your wife loves a famous new designer brand and she tells you that all her friends love it too, you have a potential stock investment. The word new is important, indicating that you could be one step ahead of the institutional investor.  Lynch is also convinced that your investment attitude is crucial for beating the market, even more than the most advanced quantitative metrics. Of course, you should also check the financials as you do not want to pay too much for your great discovery.

Peter Lynch

Based on his story, I do not think Peter lynch would simply combine a set of financial criteria to make a screen and buy the eight stocks that come out on top. He prefers to work in the other direction, use your personal edge to find upcoming companies and then check the financials. However, there is a way to reproduce this strategy to a certain degree. Uncle Stock has a built- in Peter Lynch screen that combines his view on investing with the financial criteria that he finds important. On top of that screen we should select companies about which we know a lot. That second step is crucial and is not a built- in functionality, as this is different for every individual. For example if you have worked for 10 years at a mobile phone store. Try to screen for companies in that business, so that can use that knowledge there. But you should not be experienced in a professional way, I you are 22 years old and spend two weeks of your summer on finding the best price/quality phone you might also be able to use that knowledge. Every market can be profitable, but only for someone with specific knowledge.

Screening

Uncle Stock Peter Lynch Screen

Limited Institutional ownership

To stay in line with Lynch view on investing, institutional ownership in a company we consider should be small. Peter Lynch thinks a retail investor should be able to beat Wall Street, but it is difficult to do this if Wall Street already owns the companies that you are considering. That is why my Peter Lynch screen filters on stocks that only have less than 50 percent of their shares held by institutions.

Small market cap

A second indicator of a company not being explored by wall street is market cap. A company can be known by Wall Street, but they can chose not to own it because it is a bad company. This is why our screen contains a filter that market cap should be under 2 billion euros, as all the stocks above this level are certainly known by the famous institutions.

PEGY ratio < 1

Third, Lynch is looking for good companies that can become ten baggers. To be a ten bagger, a company needs to grow strongly and we do not want to pay too much for it. To check this, Lynch popularized a ratio that we all know very well: the PEG ratio (price earnings to growth). In “One up on wall street” he states that “The P/E ratio of any company that’s fairly priced will equal its growth rate”. In my screen, I added the PEGY ratio. The PEGY ratio is a variant of the PEG ratio and takes into account dividends. We state that this ratio should be smaller than one.

Decent growth of earnings per share

As growth is so important for Lynch, we add a second indicator to measure this. We for a compound annual growth rate of earnings per share from over 15 percent. The companies that have the best chance of becoming successful one day, are the ones that had a good start. They need to have a strong growth in the beginning and already be able to produce more value for the shareholder. This is why growth in earnings per share is so important.

Low dept to equity

Lynch also states that we should look at the debt ratio, as we are lending a firm our money. And if the debt ratio is high, we are less likely to get our money back when things go wrong. That is why we also add a final filter that selects companies with a debt to equity ratio under 50 percent.

Sort on Lynch intrinsic value

I will sort the results on the intrinsic value calculation based on price earnings and growth. On Uncle Stock this IV is defined as: “The value of a security which is fair (intrinsic) to or contained in the security itself, based on Peter Lynch’s famous rule of thumb: He is willing to buy a growth company at a P/E multiple that is equal to its growth rate. Based on this, we can derive an intrinsic value formula that goes as follows: “IV = EPS rCAGR * Net income”. For example if a company grows for 16 percent a year, I would be willing to pay for a price earnings ratio under 16.

Screening results

These five filter conditions already excludes most of the companies. From the 50 000+ stocks in the Uncle Stock database, only 162 stocks match all the criteria. Every screen need a sort function, but I do not think Lynch would really use this function. As he would state that from the stocks that match your criteria, an investor should now look at the companies, sectors or markets that he knows. That is why he would probably use the sectors and industries filter, the markets filter or even the business summary filter in addition to the five previous criteria.

Backtest

Uncle Stock backtest Lynch

When backtesting this screen, we get an annual return of 9 percent over the past 10 years. It is interesting to see that the S&P500 almost exactly had the same return. But we see on the Peter Lynch screen very large beta values and we also see that the yearly returns fluctuate a lot. So if we would blindly buy stocks coming out of the Peter Lynch screen, we would not beat the market. We would have the same return with more risk, which is not a good result. But Lynch would not see this backtesting result as a problem, he would consider this screen just as a first step.

Conclusion

Lynch would consider stock screening as a first step to find possible ten-baggers that are not known by Wall Street and have a lot of potential. This potential goes upward and downward, if one just blindly picks stocks from this list. But this first step is crucial, there is no use in finding a great company if it is already famous on Wall Street and heavily overvalued. The second step would be to take this list of 162 stocks and use your specific local domain knowledge to separate the winners from the losers. There is no backtest that can prove this second part of his strategy, except for this own track record. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world.

As a conclusion, I think Peter Lynch would use Uncle Stock by doing a screen as described in the article, but he would complete this quantitively analysis with specific business knowledge.

You can reproduce the screen from this article by using the following link:
unclestock.com/top/Peter-Lynch-Screen-Sort-on-Lynch-IV

Evaluating banks using Uncle Stock

Evaluating Banks

The banking sector is something special, with its core product being money. Banks take deposits and redistribute them through credits. Evaluating banks is a lot more difficult than traditional goods based industries. But a ton of money goes through it, so is certainly worth taking a closer look. Uncle Stock has recently added the some extra ratios that target the banking industry, also a custom bank view has been created. The purpose of this article is to give an explanation for the most important bank ratios available on Uncle Stock. You can find these ratios under the bank view, as shown on the screenshot below. I have divided the ratios into two categories: efficiency and risk.

Evaluating banks

Efficiency


A first category of ratios measures bank efficiency. Efficiency measures how good a bank is in turning received assets into profit. For efficiency the following ratios are discussed: ROA, ROE, Cost/income and net interest margin over earning assets.

Return On Assets And Return On Equity

The first ratios that are very important when evaluating banks are ROA (return on assets) and ROE (return on equity). These ratios are used widely over different industries to determine the profitability or effective use of a company’s resources. But especially for banks they are useful, as cash flow models are difficult to apply on banks. The higher ROA and ROE, the better.

Cost To Income

A second widely used ratio for bank efficiency is the Cost to Income ratio. Cost to Income measures how much costs a bank makes relatively to its income. It should be as low as possible. If this ratio is declining, a bank is becoming more efficient. A recent trend to improve this Cost to Income is reducing costs by closing regional offices and allocating clients towards a central office. If a bank manages to keep the same clients afterwards, this ratio drops as efficiency has improved. Because of the increasing popularity of web applications, that is possible to achieve.

Net Income Over Earning Assets

The last ratio that measures efficiency is net interest income over interest earning assets. Interest earning assets are all the assets that can increase interest earnings. This ratio is so important, as it shows how profitable a bank is in its core activity: earning interests. This ratio is historically usually around 3- 4 percent, but it is very interest rate sensitive. When interest rates are very low and especially when they stay low for a decent amount of time, interest margins get squeezed and this makes it very hard for banks to reach that historical averages nowadays. For example on the screenshot below, you can see the NII/TA for ING declining over the past couple of years.

Risk

A company can improve itself by improving efficiency, but one can only speak of true improvement if efficiency improves without taking more risk. Banks can improve their profits by increased risk, but this is not sustainable. There are many ways to measure bank risk, I will discuss two that are included in the Uncle Stock bank view: Equity Ratio and LTD (Loans to Deposits ) ratio.

Equity Over Total Assets

The Equity ratio helps evaluating banks through its leverage, being a more general way of measuring capital risk. If a bank has a high proportion of equity over total assets, it will be more robust to temporary recessions as there is no fixed term on paying back equity. So a low value implies less risk. As banks make a lot of their profits through leverage, it is normal that this ratio is lower than for other industries.

Loans To Deposits

The LTD ratio is very bank specific as the core activity of a retail bank is transferring deposits into loans. This ratio is important because if loans are covered by underlying deposits, they are more save. Outside borrowing is at a higher cost and could reduce the trust of the deposit holders which will become more likely to remove their deposits in a crisis. This causes a liquidity risk.
It is also possible on Uncle Stock to get more advanced dimensions on these ratios such as growth and standard deviation:

 

Screening

I hope this post gives some insights in evaluating banks using Uncle Stock. In 1-2 months the data from the new ratios is expected to be populated in the Uncle Stock database and it will be possible to use the new ratios for screening and back testing. Hereafter, I am planning to do another post about banks focusing on screening and back testing.

Partnership with StocksCafe – Subscribers receive a discount

Dear Users,

Uncle Stock is now affiliated with StocksCafe, an intelligent portfolio management tool. Concretely for our users, this means they will get a 23% discount on subscribing for this tool.

Uncle Stock focuses on finding the best selection methods for individual stocks, this allows us to go deep in this area in creating a screener using over 270 financial metrics, a 10 year backtest coverage, availability over many markets and many more. But to add maximum value in our own field, it is necessary to save time in areas that we are not an expert. This is why we have never really focussed on building a portfolio management tool.

However, we still want to help our users in managing their portfolios. That is why we offer a discount on Stocks Cafe. A web application that allows you to track and optimize your portfolio focussing on parameters such as Beta, Value at Risk, expected shortfall, dividend timing and sector diversification. An extra possibility that we like, is the possibility of sharing portfolios with other users.

We wish our new partner all the best, and hope this collaboration might lead to stronger collaboration in the future.

All the best,

Alexander