Defensive value stock screen
Each issue of the UK Value Investor newsletter contains the results of a unique stock screen. The screen covers more than 200 FTSE All-Share companies that have paid a dividend for every one of the last 10 years.
The shares are ranked and ordered using a combination of metrics which measure the long-term growth rate and growth quality of revenues, earnings and dividends, as well as the share price relative long-term average earnings and dividends.
There is also an interactive version of the screen available on the website, where you can sort and select shares using your own criteria. You can also download the results to your computer as a spreadsheet. If you want to see how the online version works there is a sample online stock screen that you can try out.
How the screen works
The stock screen focuses on FTSE All-Share companies with long histories of profitability, reliable dividend payments and consistent growth. When it comes to investing in the stock market, these are the three things that really matter:
The most important return for many investors is their dividend income. Generally, income investors will prefer shares with high dividend yields, where the dividend can be increased over the years faster than inflation. Shares will rank higher on the stock screen when their price is low (and yields therefore high) relative to the company’s long-term dividend payments.
- Every single stock in the screen has an unbroken, decade-long history of dividend payments
Consistent, inflation-beating growth
Another important source of returns for investors is growth of the company whose shares they own. This is impossible to calculate exactly, because the first question is, growth of what? The stock screen takes a common sense and long-term view of growth.
It does this by measuring growth of revenues, earnings and dividends over the long-term, in order to look for strong underlying growth, rather than being overly influenced by any one year’s results. It also looks at the quality of the company’s growth, favouring those companies with defensive characteristics, i.e. those that have grown revenues, profits and dividends consistently for many years.
Growth is measured in two ways:
- Growth Rate – The combined 10-year growth rate of revenues, earnings and dividends
- Growth Quality – The consistency with which the company has been able to increase revenues, earnings and dividends
Very few companies pay out all of their earnings as dividends. Some earnings, typically more than half, are retained within the business in order to invest for the future. From an investor’s point of view, it is important to know what sort of return the company might get on those retained earnings.
A company that cannot generate decent returns on reinvested earnings – typically measured as return on capital employed (ROCE) or return on equity (ROE) – then that may indicate that the company has a weak competitive position, which means it could be a riskier investment. It also means that a company that appears to be cheap, on a price to earnings basis, may actually not be that cheap because much of those earnings are being reinvested for unattractive returns.
To avoid low profitability companies the stock screen includes a ROCE column, which calculates each company’s 10-year median net ROCE, where net ROCE is calculated using post-tax profits rather than the more common operating profits, in order to include debt interest payments in the results. With this approach, companies that have high debts will have lower ROCE scores, which will make them look less attractive and also reduce their stock screen rank.
If a company has a ROCE of less than 7% it is considered to have too weak a competitive position to be considered for inclusion in the UKVI portfolios.
In summary, profitability is measured with:
- ROCE – The median 10-year return on capital employed using post-tax profits, or
- ROE – The median 10-year return on equity, used for banks and insurance companies
Debt is often a major problem for companies. A little bit can be helpful for boosting returns, but too much can quickly cripple a company, causing dividend cuts, rights issues or worse.
In order to avoid excessively indebted companies, the stock screen calculates a Debt Ratio, which is the ratio between a company’s current borrowings and its 5-year average adjusted profits after tax. Companies that operate in defensive sectors are allowed a maximum Debt Ratio of 5, while companies that operate in cyclical sectors are only allowed a Debt Ratio of 4.
- Debt Ratio – The ratio between total borrowings and 5-year average post-tax profit
The idea of buying low and selling high is often talked about, but rarely practised. That’s because saying high or low begs the question, “high or low relative to what?”. For most investors the answer is this year’s earnings, or the most recent dividend. But current earnings and dividends are volatile and unpredictable, and what looks low this year can easily look high the next year.
This stock screen provides a better idea of what’s high and what’s low because it focuses on long-term earnings and dividends, which by their nature change far more slowly and predictably than short-term earnings and dividends. It uses the PE10 ratio (share price to 10-year average earnings) instead of the standard PE, and the PD10 ratio (share price to 10-year dividend ratio) instead of the standard dividend yield, although dividend yield is also included on the screen.
It is this focus on the long-term which really separates investors from speculators or traders, and it is a lack of a long-term focus which often hurts private investors.
- PE10 – The ratio between the current share price to 10-year average earnings
- PD10 – The ratio between the current share price to 10-year average dividend
- Dividend yield – The current dividend as a percentage of the current share price
A Screen is just the first step
Finding a successful company where the shares appear to be good value for money is a start, but for most people it isn’t enough. There are usually many other things to consider, such as the overall diversification of the portfolio, the number of different companies to own, the sectors they should operate in, decisions on when shares should be sold to lock in capital gains, and so on.
These decisions are just as important as the screen you use to find investment ideas.
To help investors with the work that goes on after a screen has been run, my investment newsletter details every decision I make as I manage a model portfolio of 30 defensive value stocks which mirrors my own real-world investments.