I focus on a few basic selection criteria to quickly eliminate the majority of securities from this list.
Here they are:
1. An understandable sector and business model
I stick to companies whose business I understand. For example, this implies that I eliminate companies active in the semiconductor sector. I also eliminate stocks of companies that operate in notoriously cyclical industries such as automakers, mining, and metals producers, among others.
2. A high return on capital
I then look at the average return on capital of a company (ROIC or Return on Invested Capital). I know that the average company earns a return on its capital roughly equivalent to its cost of capital, which I estimate at around 8%. This is why I eliminate any company whose ROIC for the last 12 months has not exceeded 10%; ideally, I favour an ROIC of more than 15%.
3. A low net debt-EBITDA ratio
If a company has a net debt-to-operating profit (EBITDA) ratio above 3.0, I eliminate it.
4. A reasonable expected price-earnings ratio
Stocks of quality companies deserve higher valuation ratios than those of average companies, but I am not comfortable paying high ratios. In my mind, a ratio above 30.0, even if justified by quality and growth prospects, does not provide the investor with an adequate margin of safety.
5. A long history of value creation
If a company’s stock hasn’t created shareholder value over the past five to 10 years, there’s a problem and I’d rather pass on it.
6. Shareholder managers
I want the executives of a company to own a lot of stock, either a high percentage of outstanding shares or a significant dollar investment. Otherwise, I let it go.
These six criteria allow me to eliminate the vast majority of securities from my list of candidates. In this case, there were four left, or only 0.7%!
Once these candidates have been identified, my real analysis work begins.
