Ranking the watchlist

In my last post I mentioned that I intended to more clearly record my shorthand assessments of the quality of the various shares on my watchlist. Doing this could help to clarify both how I am adding certain shares to the watchlist and how I am deciding which of these shares to add to my portfolio when funds become available.

I want to do this because I am concerned my decision-making on these points has been somewhat arbitrary (e.g. I can be unduly influenced by what I have looked at in most detail last) and so I can communicate my thinking more clearly on this blog.

To do this I have created a spreadsheet. The spreadsheet scores shares against a small number of qualitative criteria, which can be sorted against.  This provides me with a shorthand visual memory aid to help me decide between shares on my watchlist and communicate my thinking more clearly. I have also created an aggregated score which I can use to sort against (and focus my thinking more clearly on preferred candidates) – though the aggregated score is quite arbitrary and I do not attach great meaning to it.

It is quite different to something like the Stockranks developed on Stockopedia. My spreadsheet is simply a record of my own assessments against some qualitative (hard to measure but important) criteria for a small number of stocks, while Stockranks create a complete index based on a whole range of measurable metrics for all listed stocks.

The spreadsheet is not intended to mechanise my decision-making (much!) It just gives me a clearer point of reference. My decision-making will continue to be steadfastly qualitative but using the spreadsheet as an visual aid. Exactly how I use the spreadsheet to make decisions may change on an ongoing basis.

Criteria and measurement

I measure criteria relating to quality, news momentum, price momentum and valuation. For deciding whether a share makes it onto the watchlist I only consider the quality factors. I will add it provided each individual criterion > 0 and the overall score is high enough (currently > 7) to keep the number of shares on the watchlist to a reasonable number.

For deciding what share watchlist to buy at a given point in time I also consider news momentum, price momentum and valuation and create an aggregate score. To make the aggregated score more meaningful I’ve tried to weight each individual score according to what I think is appropriate. This is a bit arbitrary but has resulted in quality being scored out of 12, and news momentum, price momentum and valuation being scored out of 6 each.

Quality

For my purposes I regard quality as the likely extent, certainty and consistency of future growth in profits of a business – how ‘good’ a business is it? This definition allows me to also define quality criteria according to a simple logical structure of four questions (discussed in greater detail here):

  1. Does the business have ‘good economics’ that means it creates a high level of cash profits?
  2. Does the business have a good track record?
  3. Does it have a competitive advantage or ‘moat’ that allows it to persistently earn high margins?
  4. What scope is there for more growth?

The idea behind this structure is that it is both holistic and all criteria are required. In other words, failing to meet any one of the criteria individually should mean that a share is definitely not high quality for my purposes while meeting all of the criteria collectively should imply that a share definitely is high quality.  This makes the assessment clearer than if the criteria were an arbitrary set of ‘factors’ or metrics without analytical structure (though the downside is that my questions cannot be simply measure directly).

The criteria are all qualitative and none are binary. To keep things simple I have decided to measure all of them on a 0-3 scale. Broadly 0 means that I don’t think the share meets the threshold for that criteria to be regarded as sufficiently high quality to make it onto my watchlist, 1 means that it just meets the threshold but I may have some doubts, 2 means I am confident it comfortably meets the threshold and 3 means I am confident that it substantially exceeds the threshold. I go through what this means more specifically for each criterion below.

Good economics

0 = ROCE generally less than 10%, little cash generated, high debt

1 = ROCE > 10% but low margins, high debt or concerns about cash flow

2 = ROCE consistently > 10% (or higher but inconsistent), reasonable margins, profits consistently turned into cash

3 = ROCE consistently very high > 20%, consistent high margins, profits consistently turned into cash

Good track record

0 = Little shareholder value created over time e.g. stagnant or oscillating share price, no long term growth in profit

1 = Very recently listed or recent major dip in profits (but one-off)

2 = Reasonably consistent growth in profit, FCF and share price, but some minor dips

3 = Long track record of consistent and substantial growth in profit, FCF and share price

Competitive advantage

0 = Clearly competitive market, unlikely to be any long term advantage

1 = Some competitive advantage but apparent concerns over how sustainable it is

2 = Clear competitive advantage but without clear support of long term durablity

3 = Strong competitive advantage (e.g. market leader) with clear reasons supporting its long term durability

Growth potential

0 = Serious concerns about growth potential

1 = Growth likely to continue but at slower rate e.g. due to limited possibility of expanding market share or into new markets, major risks to growth (e.g. technological or regulatory)

2 = Plentiful opportunities for further expansion at current rate but some risk

3 = Likely accelerated growth or rapid current trajectory and opportunities for continued rapid expansion (especially geographic)

News momentum

A more short term metric to help decide which watchlist candidate to buy is news momentum. I think a particularly good time to buy a share is when it has recently issued good news – prices typically take some time to react. News momentum qualitatively assesses the outlook of the most recent trading update issued. I have measured this on a scale of 0-6 as follows:

0 = Profit warning i.e. below expectations

1 = Broadly in line with expectations

2 = In line with expectations (+1 if statement within one month)

3 = Marginally, slightly ahead (+1 if statement within one month; +2 within one week)

4 = Substantially, comfortably ahead (+1 if statement within one month; +2 within one week)

Sometimes current trading or the outlook is not directly compared against previous expectations, in which case I have to draw an analogous assessment from the tone of the statement e.g. to what extent is it focused on risks vs opportunities? How does it compare to previous statements?

Price momentum

I look at price momentum qualitatively just by looking at the share price graph. I measure this on a scale of 0-6:

0 = Long term up trend broken

1 = Near breaking long term up trend

2 = Long term up trend but short term trend broken / consolidation

3 =Long term up trend, but near breaking short term up trend (volatility)

4 = Long term up trend, short term up trend and positive e.g. minor consolidation, bouncing off support, ‘bowl’

5 = Long term up trend, short term new highs

6 = Long term uptrend, short term breakout

Valuation

When investing in growing businesses it is essential for valuation to account for the likely growth of the business. Comparing the PE ratios (or other similar static metrics) of businesses with varying growth profiles is a foolish exercise. The implication of a certain compound growth on valuation is not an intuitive calculation to approximate in your head. Consequently even if you try to mentally account for the differences in likely growth when comparing the PE ratios of two different growing businesses you are likely to get it wrong.

I think a better approach is to use a discounted cash flow (DCF) model with some conservative assumptions for future growth. A criticism made by many of this approach is that these assumptions are necessarily very speculative and the future uncertain. However, this criticism is ill-founded – it is the valuation itself that is inherently uncertain as it is determined by the uncertain future profits of the business – a DCF methodology forces you to explicitly confront this uncertainty while PE ratios give you an entirely false sense of certainty about valuation.

However, by the same token I don’t think it is worth doing anything too complicated as it is not really possible to predict the future with much degree of accuracy. I use the Ben Graham rule of thumb approximation:

Where g is the growth rate for the next 7-10 years and Y is the current yield on 20 year AAA corporate bonds.

My assumptions for growth are just educated guesses so I don’t think it is worth giving my direct valuation estimate a great deal of weight. I score valuation on a 0-6 scale, based on the difference between the valuation implied by the model and the current market price.

0 = ‘looks overvalued’ – more than 10% overvalued

1 = ‘looks about fairly valued’ – between 10% overvalued and 10% undervalued

2 = ‘looks marginally undervalued’ – between 10% and 25% undervalued

3 = ”could be quite cheap’ – between 25% and 50% undervalued

4 = ‘could be very cheap’ – between 50% and 100% undervalued

5= ‘could be a bargain’ – between 100% and 150% undervalued

6= ‘could be an absolute steal’ – more than 150% undervalued

The spreadsheet

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