The only 4 stocks to pass our filters

Around this time of year, for the past two years, we have published on Livewire the results of our quant screening of Australian stocks, in search of companies that meet our particular metrics around valuation, expected EPS growth and balance sheet safety. One thing they all have in common is net cash on their balance sheets, which is usually a sign they are doing something right (provided the cash hasn’t just been raised from investors) and gives companies flexibility when business conditions become tougher.  

Last year’s list appeared under the heading ‘The only 6 stocks to pass our filters’. Since it was published a year ago, those six stocks have produced an average capital gain of 43% (equally weighted). Most of the gain came from just three stocks (one in particular) – Jumbo Interactive (JIN, +244%), Noni B (NBL, +16%) and A2 Milk Co. (A2M, +12%).

Another of the six stocks, Corporate Travel Management (CTD, +5%), became the subject of a very public short-seller attack but has since steadied after a robust defence and another good profit result. Two stocks fell in price over the year, Lovisa (LOV, -6%) and Sandfire Resources (SFR, -11%).   

The previous year’s screen produced 7 stocks with an average gain of 90%, with Altium (ALU) and A2 Milk Co. being the standout performers that year. Inevitably, the returns are never evenly distributed.

We have been invited back to run the screen again this year. Luck has no doubt played a role in the outcomes, but the key principles of balance sheet safety, free cash flow generation, high return on equity, healthy EPS growth, and attractive valuation are always worth looking for in a potential stock investment. There are other intangible factors to look for too, such as capable, shareholder-friendly management running companies with resilient business models.

Tempting fate, we run the screen again, searching for Australian stocks that currently meet the following criteria:

1. Market capitalization above A$200 million
2. Net cash on balance sheet
3. Return on equity above 15%
4. Positive free cash flow yield and dividend yield
5. A forecast 3-year EPS CAGR greater than 10%
6. No EPS downgrade compared to 3 months ago
7. A PEG ratio below 1.10

We calculate the PEG ratio as the next twelve months (NTM) PE ratio divided by the forecast 3-year EPS compound annual growth rate (CAGR), using consensus EPS estimates. The lower the PEG ratio the better.

Only four stocks currently meet all of those criteria. They can be seen in the table below, ranked from lowest to highest PEG ratio.

Three of the stocks were on the list last year. The new entrant this year is Service Stream (SSM), a provider of essential network services to the telecommunications, energy and water industries. Service Stream is benefitting from NBN activations and the provision of network maintenance and meter reading services. Wisely, the company is diversified across a broad range of utilities.

Jumbo and A2 Milk have the highest PE ratios in the group but, if the analysts are right, there is more than enough EPS growth expected over the next 3 years to justify them.

For all of the companies, the consensus earnings forecasts embedded in the 3-year forward EPS CAGR and the forward PE ratio are always going to be subject to revision risk. Some companies will have a higher degree of “predictability” about their future earnings than others. A mining company, for example, will tend to have more volatile earnings (and bigger revisions to forecasts) due to variability in commodity prices and exchange rates, as well as operational issues.

Companies that have had an earnings downgrade over the past 3 months have been deliberately screened out in this exercise (which knocked out CTD and LOV).

The list is shorter this year and there is always risk in equity investing, including the risk of overpaying for a good company. Few companies are immune from the business cycle and competitive forces, but having a net cash balance sheet gives a company more flexibility and provides at least some degree of safety for investors.

Marcus Tuck – Head of Equities, Mason Stevens

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