Below the YouTube video is a full transcript of the webinar with links to all the mentioned resources.
Welcome to this webinar on Screening 2.0 – How to take your investing to the next level.
Agenda
I’m going to tell you something that I found about the Free-Cash-Flow Yield indicator and why you should be careful of that ratio at the moment;
You can also see how to find quality, undervalued companies now. In spite of the US market so overvalued, I am still finding lots of companies that are really good quality, very undervalued and have good stock price momentum.
I’m going to show you broadly how my portfolio is structured and how I’m thinking about my investing at the moment.
And then I’m going to give you a few thoughts about how to prepare yourselves for a crash should there be one. Everybody says the markets are very high. Maybe they’re due for a correction. Who knows? They’ve been unbelievably high for a long time though.
Be careful of the Free-Cash-Flow Yield Indicator
Let’s just quickly go through how it is calculated. Free-Cash-Flow Yield is Free-Cash-Flow divided by Enterprise Value.
Free-Cash-Flow is obviously cash from operations minus capital expenditure, but cash from operations also includes working capital changes. So in other words is the company investing in inventory and accounts receivable or what changes have occurred?
During the Corona lockdown, inventory and accounts receivable ran down substantially. Just think about it. These companies were getting paid, maybe they didn’t produce anymore. They sold less but they still sold and they weren’t producing so their inventory went down. And also because everybody didn’t know what their future was going to look like, they completely stopped capital expenditure. All these three factors, or probably more, led to Free-Cash-Flow increasing substantially in most of these companies.
Stock price up 40.5% since April 2021
Here's an example of a company we recommended in April in the Quant Value Newsletter.
It’s a German crockery and cutlery manufacturer called Villeroy & Boch. Just look at the bottom right arrow. You’ll see the changes in working capital.
There was a little bit of cash generation, investment, a lot of investment and a little bit of cash generation. But look at the cash generated in 2020 from working capital changes as inventory and accounts receivable went down.
I don’t show it here, but capital expenditure also went down substantially. And you can clearly see it here. Here’s the Free-Cash-Flow Yield or Free-Cash-Flow per share divided by share price – 3.6 times, which is obviously extremely slow.
If you take the five-year average, it was 14.4. So remember, this number is included in the five-year average so this number was probably even higher, say 15 or 17.
And then if you look at Free-Cash-Flow Yield or rather the inverse of it, Enterprise Value to Free-Cash-Flow, you’ll see the latest here 2.4 whereas on average it was 9.5 times. If you exclude that number from the average probably 12 times.
This is one of the factors we look for when looking for undervalued companies in the Quant Value Newsletter. Obviously there’s three other factors in the QI Value and we’ll get to that later. But the stock nevertheless performed extremely well since April 2021 when we recommended it, it is up 40.5%.
Just be careful, if you just use Free-Cash-Flow Yield as a valuation measure because obviously that’s going to turn around in the next year. As these companies start producing, working capital’s going to absorb cash, maybe they’ll spend more on capital expenditure and the Free-Cash-Flow Yield will go down substantially.
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How to find quality, undervalued companies now
Because a lot of companies were under-performing substantially during the Corona crisis with the lockdowns and whatever, I thought it would be better to start the screening from the point of view of looking for a quality company first, which means removing the worst 50% of companies according to Gross Margin Marks.
Gross Margin Mark is gross profit divided by assets
It’s one of the only quality ratios we tested that really worked well.
Debt to equity, obviously the old classic one – not to buy too leveraged companies.
Free-Cash-Flow to Debt, obviously this one’s going to be a little bit affected by the factors on the Free-Cash-Flow generation that I mentioned earlier, but a lot of these companies use a lot of this Free-Cash-Flow they generated to pay down debt, which obviously is a good factor and makes the company a bit more quality, worthy you can say.
External Finance is another good ratio
The ratio just shows you is this company able to finance its asset growth from cash generated by the business or does it have to go and get external financing like bank debt to finance its asset growth.
The studies or the tests we’ve done, in spite of the academics that developed this ratio, found that this is a very, very strong ratio even just on its own to find good companies to invest in.
Screen out value trap companies by looking at companies with strong momentum
To do that we’re going to look at companies with an adjusted slope value of greater than 30. Or if you prefer price index greater than a value of 1.5, which means the share price increased about 50% over the past six months as price index six months is calculated by the current share price divided by the share price six months ago.
To get quality companies first, look for momentum companies to screen out value traps. And of these companies that are remaining, we want to find cheap companies as defined with QI value.
The QI Value Indicator
Just to refresh your memory, it consists of EBIDA Yield (Earnings Before Interest, Depreciation and Amortisation) divided by Enterprise Value.
Earnings Yield (Earnings Before Interest and Tax) is divided by Enterprise Value, and Free-Cash-Flow Yield as well.
It’s only one of the four factors, as we discussed previously.
Low liquidity
Companies that are not as highly traded per year compared to their total market value and we found that that was also a really valuable ratio to find good quality companies.
Quick snapshot of what the screen looks like
We’re taking the top 50% companies, getting rid of the bottom 50%. Debt to Equity of the top 50% companies we want in the database or the screen. You want to get rid of the bottom 50.
Free-Cash-Flow to Debt, same story. Get rid of the worst 50% of companies.
External Finance, get rid of the worst 50% of companies, keep only the best.
I’ve got a small Daily Volume Indicator, 80,000, that’s enough for me to invest my own money.
And here you can see the adjusted slope. I entered the number of 30, click on this little magnifying glass and select greater than. You’ll see it’s selected there.
And then you’ll only get companies that’s worth an adjusted slope value greater than 30. And then sort by QI value.
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You can see the companies that the screen came up with yesterday
As you can see, there’s a few forest products companies that obviously benefited by that huge spike in lumber prices in North America. They’ve come back greatly, but these are obviously companies with record profits that you want to avoid.
Newsletter subscribers will remember companies like Oriental Watch Company. That one we recommended I think it was about a year ago.
Anyway the stock price is up 95%, but the company is still very undervalued. AND they paid two substantial dividends after the start of the Corona crisis.
This company was already undervalued before that Corona crisis dip in the markets came. And then the company bought back 20% of its stock. So biggest Rolex dealer in Hong Kong, I think probably all of Asia. Really it seems like a super company that is still undervalued even though its stock price has gone up 95%.
Strabag, that’s the Austrian construction company, that one’s also in the newsletter.
Manitou was recommended by the newsletter last month.
Here’s another lumber company, obviously record profits. Here’s another newsletter company. As you can see, some companies with large amounts of profits, the old story with the screener - you always get the companies with record results and you have to just ignore them.
Value Composite 2
Let’s look using another composite value indicator, Value Composite 2. This one’s got even more valuation indicators and only one has is related to cashflow, which is Price to Free-Cash-Flow.
The other ratios that are all included in Value Composite 2 are:
- Price to Earnings
- EBIDA Yield
- Price to Sales
- Price to Book
- Shareholder Yield
So there’s a lot of classic value investment criteria in there.
And as you can see, the results don’t differ too much from the QI Value that we used previously. Forest products, there’s Oriental Watch again, there’s Strabag again, another forest product company. Here’s the one from the Newsletter again, Manitou last month.
But these are basically good quality companies, upward moving share price and they’re still undervalued, which means they’re still a good investment at the moment because not as expensive as those expensive US companies.
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How is my portfolio structured at the moment?
Stocks 43%
Mainly stocks recommended in the newsletter.
Bonds 12%
I bought some inflation-protected ETF’s. Very straightforward stuff, no funny things.
This bond investment was forced on me a little bit because if I keep too much cash with my two banks that I use as brokers at the moment, they start charging me 0.5% just because of the negative interest rates of the European Central Bank.
Tobaco stocks 8%
I started looking for a bond alternative, something with a good yield that should be stable.
Although tobacco stocks also move with the market, I started buying four or five tobacco stocks because I didn’t know which one of those would be the winners in the tobacco product category and they have a dividend yield of about 8%. So that’s sort of a bond alternative, something stable that I was looking at.
I’ve got 33% in cash
And I have no hedging in my portfolio so no out of the money puts or anything like that. If I get a little bit more uncomfortable or as I am at the moment a little bit about the US market, it just keeps on going higher with the possibility of interest rate increases, then I just increase the cash percentage of my portfolio.
No funny hedging or anything in my portfolio. As you can see, it’s very, very straightforward and simple.
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How to prepare yourself for a crash
Here are my few ideas on how to prepare yourself for a crash, should there be one, but it’s beginning to look more and more likely because things can’t go on.
What was that saying? Things that you think can go on forever just cannot. I’m paraphrasing really badly.
Anyway, this a great quote from a great book that I can’t recommend more enough. It’s called The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness by Morgan Housel.
It’s a short read. It’s basically a summary of a lot of his blog posts that he wrote.
“Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term traders playing another.”
Basically he says that, for example, you’re a value investor buying undervalued companies and value has under-performed so long that you get completely fed up and you start buying companies like Tesla and other high-flying tech stocks.
Obviously traders know what they’re doing. They’re buying this company on a momentum play and trade in and out daily.
But the long-term investor first of all doesn’t watch the stock that closely so he’s moving into a completely different game. He doesn’t know exactly what to do and he’s got no experience which probably means he’s going to lose a lot of money.
Just think about all the value investor guys that started buying internet stocks at the top of the tech bubble just because value was under-performing so badly.
And I wonder how much of that is happening at the moment with value fund managers throwing in the towel saying, “We’ve lost so many assets on the management, we’ve got to start buying some tech stocks.”
And here’s another piece of something out of his book.
“… few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviours of people playing different games than you are.”
Think about the trader and the value investor again.
“The main thing I can recommend is going out of your way to identify what game you’re playing.”
What kind of investor are you?
I know I’m a value-type investor. I like momentum to avoid value traps.
But my basic investment strategy is buying undervalued companies, holding them until they become fairly valued or even overvalued and then moving on to the next undervalued company.
And that’s why I’m not trading Tesla, I’m not getting interested at Microsoft at a PE of 35.
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Avoid a permanent loss of capital
I mentioned Microsoft just before with a PE of 35.
If you buy Microsoft with a PE of 35 and there is a market crash and after the market crash the market comes back to normal and the people start thinking that a normal company growing at a nice tract of rate should have a PE of about 18, if Microsoft goes from a 35 PE to an 18 PE, that’s permanent loss of capital.
But think about some of the companies recommended in the newsletter, they have a PE of between 8 and 12.
If there’s a crash, of course they’ll be pulled down from a 12 PE maybe to an 8 or an 8 will go to a 6, but once the market comes to its senses over time, they’ll see that this 12 or an 8 PE was really a good or maybe even undervalued or a fair price for this company and the company will trade at 8 or 12 times earnings again, which means there’s no permanent loss of capital.
There was a quote if you bought Microsoft at the top of the internet bubble, it took something like 20 years for the stock price to get back to that level, obviously at a much lower PE, but the company grew substantially over that period.
Avoid overvalued junk
Obviously you want to avoid over-leveraged junk and like Spac's, you can think of I don’t want to say Tesla, but these VERY overvalued companies.
And think about all these internet-type companies with absolutely no profits with monster valuations like Uber and things like that. Those are the kind of companies you want to avoid.
If you want to trade them, fair enough, but don’t bet the house on those companies and don’t get sucked into what’s working now.
Do not become a trader if you’re a long-term investor. We talked about that in the previous quote from Morgan Housel.
Have a plan to implement as the markets fall
And this is something where I lost out in the Corona crash as well as the financial crisis.
When the markets lost 20% or 30% I thought they were... They are going to lose another 20% or another 30%.
This largely kept me out of the market until a lot later.
And now I’ve got a bit more of a plan that says; if markets are down 20% then I’ll start investing 10% of that cash percentage that I have. And then if they go down to 30% then I’ll buy another 10%.
And I know that it’s going to be difficult because I always have this tendency to think that the markets will fall further even after they’ve fallen 20% or 30%.
But I’ve got a plan now and I’m going to see if that maybe helps me.
Think about something in terms of what you want to do with your portfolio, how you want to start investing if markets fall because remember when there’s a big crash, markets always overreact and it’s usually the best time to invest because you get companies that are really so cheap, good quality companies as well.
Have a plan on how you will manage the pain
I have a friend, we came through two crashes already and there’s that great finding by Daniel Kahneman, wrote about in his book Thinking Fast and Slow, where the pleasure you get from a gain in the stock market is only one fifth as much as the pain you feel from a loss.
And that is really true. I mean, think about how many friends sold out of the market at the bottom of the crash, just because they were so tired and exhausted from looking at that negative number on their brokerage statement all the time. Have somebody that you can talk to that understands these things, that can help you, stay in the game, because that’s the main thing that you want to try and do.
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Q&A
Q: “How to avoid buying at the peak with the six-month momentum indicator being at a high level? Can you apply a strategy that might catch momentum at an earlier stage?”
A: That was something that I always thought of as well, but catching momentum at a lower point never helped us at all. If you think about that back case that we did with all the European strategies, we looked at the highest momentum companies and then the valuation. And they did extremely well.
Also there's an article What to do with 52-week and all time high stock prices. There was a study done by 52-week high and all-time high stocks, what happened afterwards. Generally as soon as that number was reached, either a 52-week high or an all-time high, there were some investors that sold them.
There was a little bit more selling pressure coming into the market. But generally stocks moved on from there. I mean, they moved on even higher. So even a 52-week high or an all-time high was definitely not a negative indicator. Something that’s very, very positive actually.
Q: “Why is momentum a good indicator for avoiding a value trap?”
A: Basically a value trap is a company that is cheap, but cheap for a reason because the business is falling apart or it’s just not growing at all.
It’s very unlikely that these companies will start moving up in their stock price.
So if you look for a company with positive momentum, say over six months or twelve months, on the screener you can go up to five years, then it’s very unlikely that a business that is dying is going to go up in stock price.
Obviously you have to watch out for things like game stock where there’s some sort of other things going on where those small traders tried to shake out those short sellers in game stock. But generally if a stock price is moving up it’s moving up for a reason.
Think about a small company, even one that is not that widely traded, if there’s good news in the company, maybe the employees are talking and saying, “Man we’re working like donkeys there. We can’t produce everything that is coming in orders.” And maybe the stock price moves up slowly because there’s some insider buying. Not illegal, but they can buy shares when it’s not closed periods and then the stock price goes up.
Generally that is reflected in momentum. So momentum is a very, very good indicator. It took me a long time as a value investor to really realise that it is valuable.
Q: “What about currency hedging?”
A: That’s a good question because even in my portfolio, the same as the Quant Value newsletter, there’s a lot of companies in Japan. I bought quite a few companies recommended in Hong Kong and they’re doing extremely well, recovered from the problems with Corona.
I don’t hedge currency in my portfolio.
Generally I’ve found that currencies, the one moves up and the other one moves down, but they wash out against each other and I’ve had some losses on stocks obviously.
There was one time when I bought a Japanese company and even though the company was up 20%, I lost a 16% on the currency so it was only a small gain.
But in general I don’t go to the trouble. My portfolio is also not that large that I can really effectively and at a low cost hedge the currency.
There’s an article that I wrote on currency hedging and there were two research papers that I found that basically showed if you want to hedge, you must always hedge because generally people start hedging after a very strong negative currency movement and that’s obviously the worst time to do it because the currency starts moving in the other way.
So if you want to hedge, always hedge. And if you don’t want to hedge, stay with that strategy as well because it’s probably going to come out as a wash.
Q: “Do you rebalance your portfolio, increase the positions that fell and those that went up?”
A: No, I generally don’t do that. I have in the past sold undervalued companies too early so what I generally do now is I move them to a different part of my portfolio where I follow a strict or a bit stricter trading stoploss.
This allows me to let companies that have picked up momentum, let them run a lot, lot higher because generally what I found is I sold out when a cheap company went to fair value and generally once they start moving up like that, they even go to overvalued in terms of my valuation numbers. And I always missed that last part of the momentum.
So I generally just keep them. I don’t rebalance inside of my portfolio if companies have gone up or down. I do use a trading stoploss though. The trading stoploss is also explained in this article: Truths about stop-losses that nobody wants to believe
Q: “What about moving averages to get back into the market after a crash? I recall buying in the dip is not a good strategy.”
A: I think even this month there’s an article coming in, there’s like a little reading section in the Quant Value newsletter and it talks about buying in the dip is not a good strategy.
But I think he tested buying the dip if you only buy when the market dips.
For the newsletter we use a 200-day moving average so we look at once a month on the main markets, on the S&P 500, on the Stoxx 600 for Europe, on the Japanese market. And if the market is below the 200-day moving average then we stop buying in those countries.
There was a study by Mebane Faber where he talked about tactical asset allocation and he found that that was a very, very effective indicator.
He did however mention that he doesn’t look at it every day just like we do for the newsletter. We look at it once a month because otherwise there’s just too much noise and you will generally trade too much.
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So for the newsletter we don’t buy, we don’t recommend new companies if the market is below the 200-day moving average because the most volatility is there as well. That’s what Mebane Faber found as well, the most volatility on the downside, in other words, negative movements.
We start recommending companies again when the market is above the 200-day moving average.
Q: “How do you, in your opinion, best identify sector rotation, i.e. out of tech into materials, etc.”
A: I don’t look at that at all. I just look at what companies are cheapest on the screener, and I start buying them.
Obviously I generally keep in mind that I don’t want to put all of my money into lumber stocks, for example, just say that they’re all coming in cheap on the screener.
I don’t buy too many companies in one sector, but that’s also the other reason why I generally buy a few companies every month just like we recommend in the Newsletter.
Because each month if there was something that maybe a lot of oil service companies were cheap this month, then we’ll pick up one or two maybe in the Newsletter, but we won’t pick up six oil service companies.
Then next month, because of momentum or maybe there were quarterly reports, a whole group of other companies will be cheap. Generally it won’t be the same ones that came up the previous time or the previous quarter in this screener.
That generally keeps me out of any specific sector.
I don’t have a sector rotation idea or strategy at all. I know there was that one, I think it was Meryl Lynch, there’s a wheel or something that they put together saying if the economy is just recovering, if it’s at the top, then you generally move from this sector to the other one, but it’s not something that I look at.
Q: “Do you back-test results for the quality screener you showed before?”
A: No, we haven’t back-tested that specifically, but you can easily do that if you want to.
You can just use the historical screener in the Screener if you wanted to test them and you can completely customize it as to exactly how you want to do it.
I know that we used this exact screen to start buying companies after the Corona crash and that portfolio, I think we recommended 26 companies and after a year the average return was 61% of all those companies.
Q: “Why did you not mention the Piotroski F-Score?”
A: That’s a very good question. As you know I love the Piotroski F-Score, it’s a great one.
I generally avoid companies with a Piotroski F-Score under five. I don’t necessarily buy the best as Piotroski specified, the nine and the eight companies.
Piotroski F-Score goes from zero to nine. Nine is the best quality companies and zero is the worst. I just generally look that I screen out the bottom 50% of companies. I don’t buy companies with a Piotroski F-Score of less than five.
Q: "You have measured the performance of your portfolio relatively to the benchmarks?"
A: I do that every now and then, but because I’ve held so much cash, generally the performance is worse.
That doesn’t mean that I’m happy or unhappy with the performance.
I’m very happy with the performance because of the level of risk that I’m taking.
For example, this year even though I’m 33% in cash, I think my portfolio is up about between 18% and 20%. So that I’m very happy with.
Last year I was probably up only 6%. But compare that to the S&P, it doesn’t sound that good, but I’m very happy with that performance because I sleep very nicely with the 30% of cash that I’ve got in the portfolio and it was even higher in the middle of last year. I think it went up to 40% or 47%.
Q: “What about companies that are cheap but are now way above the 200 daily moving average?”
A: If I understand your question, you’re asking what about companies that are cheap but above the 200-day moving average.
I wouldn’t avoid those companies at all.
I just say I stop buying generally in the US market if the US market is below the 200-day moving average. I won’t look for companies in North America.
But say, for example, in Europe, if the Stoxx 600 is still above its 200-day moving average then I’ll still look for companies in Europe or in Japan, if the Japanese market is above its 200-day moving average.
Q: "What if I outlive you, who will look after the screener and the newsletter when your time on earth has come to an end."
A: I’m only 54 at the moment and quite fit and healthy. I’ve also been vaccinated. So I think it’s very unlikely that anything will happen to me.
I’ll keep on writing the Newsletter as long as I possibly can and I’m fit and I’m mentally healthy to do it because I just love doing it.
It’s basically the reflection of the best strategy I use in my own portfolio and if I do the work for myself or I do it for the Newsletter it’s basically the same thing so I plan on doing it for a very long time still. Thanks for the question though.
Q: “Minimum number of stocks in portfolio for optimal diversification benefit?”
A: That’s a tough one to answer. A lot of value investors say you must put a lot of money in your best ideas.
I’ve just learned that even though I think something is my best idea, it never turned out to be my best idea.
My best idea was sometimes the companies that I thought would definitely not do well but I bought them anyway, made the position far too small and didn’t profit on that too much.
Now I just do the same as I do in the newsletter. 2% of every idea I stick into each company and I just let them run as I mentioned with that momentum strategy that I have.
If something goes from cheap to fairly-valued I don’t sell it anymore. I keep the momentum on it and then sell it with a trading stoploss.
So I generally have a rule – 2% or 3%, but I stick to that for companies and 50 stocks.
If you don’t do a lot of research, that sounds fine. 2%, that’s fine because if something is on the Screener and you bought it and it shouldn’t have been there then it’s not going to do too much damage to your portfolio.
If generally you’re following a strategy that’s sound, you’ll choose more good companies than what you’ll choose bad ones. Maybe have something like a stop-loss strategy where you can throw out companies that are really falling.
That's all for today
I hope I’ve given you a few good ideas.
As always, if you have any other questions just use the “Get Help” little box on the website. I’ll be more than happy to answer any questions and help you with the Screener or with the Newsletter if you’ve got any questions.
Also, there’s a lot of frequently asked questions that I’ve answered there with my really best answer.
