Not that long ago I used to get my ideas from various articles and tips and then try my best to do further research to make the ideas ‘my own’. Unfortunately this is a bit like trying to learn how to play darts by watching a monkey play. One of the things I haven’t explained here yet is how I screen for the investment ideas that go on my watchlist.

Looking back now many of my early investmenting decisions seem pretty shocking. Many apparently cheap but unprofitable, capital intensive debt-laden businesses hoping to turn around or with good stories about future growth. Several had profit warnings and one quite unexpectedly went bust (Silverdell). I wouldn’t have made any of these investments had I followed the screening process I do know.

If you don’t have a systematic screening process for identifying candidate investments, then I think you’re missing a trick. This is not difficult these days – there are lots of online providers of screening tools, such as the one I use, Stockopedia.

My investing approach is multi-stage. First I identify a watchlist of shares using qualitative and quantitative factors and then I pick the best looking options from this watchlist when opportunities arise. Here I’m just looking at the very first step i.e. how do I identify candidates for the watchlist in the first place.

Basically the idea at this step is to identify candidates that meet my quantitative factors for identifying quality: good business economics and a consistent track record of growth. I do this by using various permutations of mechanical screens (on Stockopedia) based on a handful of criteria as filters:

1. ROCE. A high and consistent return on capital employed is one of the key factors I am looking for. It indicates a high level of historic profitability which provided it can be maintained in the future should lead to compound growth as new investments are made. I screen for the 5yr average ROCE setting a threshold of 15% or 20%.
2. Operating margin. A high and stable operating margin indicates a competitive advantage and/or a relatively low fixed cost base. While gross margins may be a better measure of competitive advantage in some cases, I think operating margins (which also include fixed costs) are closer to what I want to measure. The level of operating margin that suggests a competitive advantage varies from industry to industry depending on the competitiveness, asset turnover and level of fixed costs required. However, I’ve found that most of the sort of businesses I like to invest in tend to be in markets where they can earn high operating margins, so I keep the filter simple and screen with a threshold of 10% or 15%.
3. Growth in free cash flow. I want to invest in businesses that are growing profits and cash flow. I screen for free cash flow as I prefer companies that are consistently turning a significant proportion of profits into cash. However, note screening for free cash flow has the potential to miss out businesses that are reinvesting a very large proportion of profit. If they are doing so at high rates of return then this suggests a lot of growth is coming so don’t want to miss these. Partly because of this I set the bar quite low and screen for the 5yr compound annual growth rate in free cash flow of 5-10%.
4. 5yr Relative Strength. I also use the relative strength i.e. share price appreciation versus the wider market as a screening factor. High quality businesses should in my view generally outperform the wider market and I believe historic outperformance over the longer term is a reasonable indication outperformance is likely to continue. Erratic historic share price performance raises questions – sometimes it can be due to temporary factors but in general I prefer to use as an indication to stay away. I screen for RS 5yr greater than 50%.

So that’s it – I just screen for these factors in combination and there you go. There are a few other factors I think are relevant, such as the market cap (I prefer smaller), financial position and net debt, but I prefer to look at them in detail rather than screen for them.

That said, screening for these factors in combination is not quite so straightforward. Applying the criteria too strictly can lead you to overlook some high quality businesses. To deal with this I run a number of permutations of the screen, relaxing the thresholds for some factors, while increasing others. I have also calibrated the thresholds in the screens to give me a sensible number of results. The purpose of the screening is to maintain a watchlist of about 60 of the highest quality businesses available so I want each screen combination to produce a manageable number of candidates (about 20 or so).

The next step is to go through the list of new candidates in more detail, doing a bit of research to see which ones look to have a sustainable competitive advantage and decent growth prospects. These days I compare the candidates directly against the worst on the watchlist and, as I want to get to know the businesses on my watchlist well, only if they are convincingly better do I swap.