The 9-point checklist to screen for opportunities

In a wire I published with Livewire on the 6th March 2018, ‘Don't buy value just for value's sake’, we outlined as our top pick a company called IDP Education (ASX: IEL). Since then, fortunately for clients, the share price has had a meteoric 122% price gain from $7.55 to $16.82. Livewire reached out to us to revisit this call, to review our process for screening for opportunities, and also discuss some live examples from running the screen today.

Despite the recent run-up in share price, we remain attracted to the business attributes long-term, and our 9-point checklist, which we expand on below, would indicate likewise.

IDP Education, a former spin-off from SEEK, is a world leader in international student placement services while also being a provider of English language teaching services, as well as being a co-owner of the preeminent IELTS (International English Language Testing System).

After listing in 2015 the business has emerged as a quality company delivering strong numbers across the board. As ASX: IEL had been only listed for one year in 2016 the 9-point checklist wasn’t appropriate at that time.

In 2017 however, things were starting to take shape for the business. A 9-point screen would’ve delivered a pass across all metrics with the exception of the PEG Ratio, which at 7.03 caused a hard fail for the screener.

In the case of ASX: IEL in 2018 the strong earnings growth came through the following year and the PEG ratio fell, with the 9-point screener delivering a hard pass

As I outlined in my article last year, just because a company passes or fails the screening process it doesn’t automatically complete the screening process. At times the screen will fail, but will ultimately identify businesses with potential that may warrant further investigation and research.

For instance, although a PEG ratio of 7.03 in 2017 is undoubtedly high, strong future earnings growth can quickly see that number fall. Therefore, if you as an investor determine through your research and due diligence that future earnings are likely to rise quickly, you might decide to slightly relax the screen and overrule the fail.

In the event that many of the key indicators fail the checklist, it’s more than likely in our view that the business is worth leaving alone…

The Medallion 9-point checklist for screening for opportunities

Below we look to breakdown the reasoning behind the inclusion of each of our criteria:

1: Market Capitalisation - > $100m

• Perhaps the most subjective of all the criteria. Larger businesses tend to have greater liquidity allowing investors to easily enter and exit positions.
• Liquidity is also an important consideration. Individual investors tend to have an advantage over large institutional funds given their ability to be nimbler being able to enter exit positions in smaller businesses without affecting prices.

2: Revenue Growth - > 2yrs + successive revenue growth

• Revenue growth is important as it can shed light on the quality of earnings and profit growth. Revenue helps investors determine if profits are improving because of cost-cutting measures or more sustainable market share gains?
• For a business growing at a rapid rate, revenue can be a superior measure than earnings.

3: Earnings Growth - > 2yrs + successive earnings growth

• Whether the business is making money and becoming more profitable is important. Our belief is that over the long-term share price growth is highly correlated to earnings growth.
• We acknowledge that certain businesses will sacrifice profitability for growth particularly in earlier years as we’ve seen with the likes of Xero and Amazon. Investors need to be conscious of this and adjust their screening process if they wish to capture such names.

4: Return on Equity (ROE) - > 10% & preferably growing over time

o ROE a key measure of profitability revealing how much profit the company is making on each dollar invested by shareholders. Ostensibly if a company is generating a greater return on each dollar invested by shareholders then that’s a good thing.

o Beware however that higher leverage and debt has the effect of inflating the ROE. For that reason perhaps Return on Assets is a superior measure for highly indebted companies.

5: Free Cash Flow (FCF) - Positive

• As defined by Investopedia, Free cash flow represents the cash that a company is able to generate after required investment to maintain or expand its asset base.
• FCF is a measure used to determine the amount of cash that can be distributed to stakeholders. It, therefore, is an important measure when considering dividend sustainability.
• A positive, high and growing FCF yield is preferable as it indicates the business is generating greater cash levels.
• Negative FCF can indicate a requirement for debt to maintain operations. This may hinder profitability in outer years.

6: Operating Margin – Relatively Flat or Growing

• Operating margin is a measure of business efficiency. It essentially highlights what percentage of revenue earned remains in the business after expenses are accounted for.
• A growing Operating margin signals improving economies of scale and greater profitability.

7: Net Gearing - below 20%

• Net gearing is a similar measure to the debt to equity ratio, however net gearing takes into consideration the cash on a company’s balance sheet.
• Ideally a company will have a negative net gearing, as this indicates that the company holds more cash than debt on the balance sheet.

8: PEG Ratio - below 2

• In our opinion, the PEG ratio is a far superior measure than the simplistic P/E ratio as it takes into account a company’s earnings growth.
• The lower the PEG ratio the ‘better’ as it eludes to the company being undervalued relative to its earnings growth.
• A company with a P/E ratio of 20x and earnings growth of 20% will have a PEG ratio of 1.

9: Dividend Per Share

• Whether a company is paying a dividend or not isn’t of the greatest concern to us if they are successfully reinvesting the cash for growth. Notably, this preference may differ from investor to investor.
• However, if the business is paying a dividend, we’d prefer to see that dividend per share grow over time to at least offset inflation and maintain the purchasing power of that capital.

Resmed revisited

Medical device manufacturer and distributor ResMed Inc delivered their 3^rd quarterly result in recent weeks, and as has become custom over the years the numbers make for good reading. The result highlighted an increase in sale by double-digit figures after strength in the company’s connected-care offering. The March Quarter sale 12 per cent to $US662.2 million ($946.3 million), or up 15 per cent on a constant currency basis.

Gross margin is a key metric analyst look for when analysing ResMed’s results and gross margin expanded 100 basis points to 59.2 per cent from 58.2 per cent a year ago. Non-GAAP net income was down 3 per cent to $US128.1 million. while consensus was sitting at $US121 million.

ResMed gained market share in Masks in the March Quarter due to strong demand for new products. Momentum in this area is expected to continue with the release in early April, ResMed launched AirFit N30i, its first top-of-head continuous positive airway pressure (CPAP) mask, expanding the mask portfolio with an option of reducing tubing to improve comfort and allow for more movement and sleep positions.

Pleasing for shareholders was the continued improvement in operating leverage a trend which has been evident in recent reports. Selling, general and administrative expenses (SG&A) as a percentage of Revenue fell to 24.8% down from 25% in the prior corresponding period.

Long term Tailwinds

The long term structural thematic remains for the industry and we believe RMD will maintain its position as the dominant player in what is undoubtedly a growth market. The key statistic often referred to when looking at ResMed is the US National Heart Blood and Lung Institutes estimate that 12 million people suffer from sleep apnoea, yet only 4 million have been diagnosed. That statistic gives you a sense of the potential untapped market even before you take into consideration the increasing propensity for emerging middle classes to afford ResMed devices.

Technology Evolution

The underappreciated shift towards remote monitoring technology in which RMD is a clear leader helping the business to lower costs and improve patient adherence rates. ResMed has now significantly boosted cloud-connected patient devices helping to develop a Software as a Service (SaaS) business with an accretive recurring revenue stream. SaaS revenue surged 101 per cent in the quarter ended March 31, due to continued growth in its Brightree services and the incorporation of recently acquired MatrixCare and HealthcareFirst.

Does RMD pass the Checklist?

With one quarter remaining in the financial year for RMD its probably best to reserve judgement until the conclusion of the financial year on whether it passes the filter. Last year in 2018 the company delivered an improvement in every key metric outlined in the 9-point checklist and thus far in 2019 the company remains well on-track to deliver a similar outcome.

One stock that fails the checklist

When scouring through the market another business that fails most, if not all, the filter criteria is the company formerly known as Cabcharge, now A2B Australia. The emergence of Uber has had a well-publicised effected on the established taxi industry, including the likes of Cabcharge. It's interesting to take a moment to examine how the seismic industry shift impacted Cabcharge’s key financial variables.

As a starting point, it’s important to note that Uber entered the Australian market in late 2012. Referring to the table below you can see that it was essentially from that moment forward that Earnings, Dividends, Free Cash Flow, Margins and Return on Equity all began their steady decline for Cabcharge. 

Over that time the share price hasn’t fared too well either, falling from a high of $6.52 in 2012 to $1.80 today.

As an investor, you mightn’t always ‘cotton-on’ anecdotally to an emerging trend or the impending demise of a business, however, the balance sheet can alert you to emerging red flags. 

Even had investors missed the initial entry of Uber into the marketplace, they still had 3 whole years until 2015 to avoid significant declines in the share price. Had investors examined the balance sheet they could have been subtly warned about the deteriorating position of the business, allowing them to shield themselves from material capital loss.