The only 6 stocks to pass our filters

This time last year we published an article on Livewire called ‘Screening for low-risk equity investments’. Of the seven stocks we discussed, most did well, with an average gain of 90% across them. Livewire got in touch and asked us to reflect on the original research, and reapply the strategy we used then on today's market.  

It is interesting to see what worked and what did not. Two did very well (A2 Milk and Altium) and one did very badly (Vita Group), a reminder that risk is always present in equity investing. In Vita’s case, the risk was that it didn’t have a wide enough “economic moat” around its business model, being vulnerable to Telstra renegotiating its key contracts.

No doubt good luck played a role in the overall outcome, but it is always worth looking for the following key principles in any potential stock investment:

• balance sheet safety,
• free cash flow generation,
• high return on equity,
• healthy EPS growth, and
• attractive valuation  

There are other intangible factors to look for too, such as capable shareholder-friendly management running companies with bullet-proof (or at least bullet-resistant) business models.

Running the screen again today

Tempting fate, we ran the screen again, searching for Australian stocks that currently have the following characteristics:

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 15%
6. No EPS downgrade compared to 3 months ago
7. A PEG ratio below 1.70

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

The six stocks to pass our filters

Six stocks met those criteria. They can be seen in the table below, ranked from lowest to highest PEG ratio.

Two of those stocks were in the list last year, A2 Milk Co. and Corporate Travel Management. The new entrants are Sandfire Resources (copper mining), Noni B (retailing), Jumbo Interactive (lotteries), and Lovisa (low-cost jewellery).

We relaxed two of the criteria a little from last year – we dropped the market cap minimum from A$300M to A$200M and raised the PEG ratio limit from 1.10 to 1.70. (Under the original criteria, LOV and JIN would drop out under the lower PEG ratio rule, and NBL and JIN would miss the higher market cap cut-off.) Conversely, we lifted the EPS growth hurdle from 5% to a 15% CAGR.

Pull out the weeds... not the flowering shrubs

There is always the temptation to ditch one of last year’s winners such as A2M because it has run so hard, but it is usually better to remove the weeds rather than the flowering shrubs (unless something has gone seriously wrong operationally, or the valuations no longer make sense).

Short-term pullbacks are inevitable (the latest sparked by news that Nestle has launched its own A2-protein-based infant milk formula product) but our investment timeframe is longer.

Retail stocks are generally out of favour at the moment but there are exceptions, with companies such as Lovisa and Noni B punching above their weight.

The consensus earnings forecasts embedded in the 3-year forward EPS CAGR and the 12-month forward PE ratio are always going to be subject to earnings revision risk.

Some companies will have a higher degree of “predictability” about their future earnings streams than others. A mining company, for example, will tend to have more volatile earnings (and bigger revisions to earnings forecasts) due to variability in commodity prices and exchange rates as well as operational issues.

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 competition but, as we wrote last year, having net cash on the balance sheet gives a company more leeway and hopefully adds some degree of safety for investors.

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