Podcast Transcript

In today’s episode, we will be talking about stock filters and their time saving benefits. 

A stock filter is a way to screen out any undesirable businesses by using a predetermined set of metrics like low debt and high returns on capital. This will help save you time when it comes to analysing in which business to invest. As you could imagine, trying to analyse each of the roughly 2,000 businesses listed on the ASX, one by one, could take you years, but by applying a simple filtering process you can eliminate many businesses which would almost certainly not meet your criteria. 

I like to keep my filters pretty broad and not too restrictive. I have provided a link in the show notes to the stock filter available on the gurufocus website for you to play around with. This link has some filters already in place, these are; debt-to-equity of less than 2, Return on Equity of greater than 8%, Return on Capital greater than 8% and the removal of 47 different sectors and industries which do not meet my ethical criteria or fall outside of my circle of competence. With just these three filters, which are not at all restrictive, has already reduced the number of businesses from around 2,000 to less than 200. You can also view my watchlist which is available on my website at https://growthwithvalue.com/watchlist/. This is a list of businesses which I follow and believe are better than the average business listed on the ASX.

Now I will go into a little more detail about the three different filters I’ve applied:

• • First, I filter by the type of industry and on which exchange the businesses are listed. I will filter out all exchanges other than the ASX, as this is the only exchange which I am currently interested in investing. This is mainly due to the fact I have a better understanding of how the Australian market works and the rules and regulations Australian businesses have to operate under. I would suggest that other well established markets such as the USA and UK would also be safe markets and not offer much difference. I will also filter out any industry I do not understand or does not fit my ethical criteria. For example, I will filter out all gambling, alcohol and mining businesses.
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  • The second important filter is to look for low levels of debt. I generally start with a debt-to-equity ratio of about 2. This is rather high, but I do this to give me a chance to see where the debt used in calculating the ratio actually comes from within the business. For example, the debt may be derived primarily from operating leases, which is considered as debt. Operating leases are basically the money that is still owed on a lease contract. If we are to look at Nick Scali, which operates about 60 furniture stores across Australia and New Zealand, many of their premises are not actually owned by the business but are leased or rented out. This expense is recorded as a liability on the Balance Sheet and is treated as debt. Nick Scali has historically held very little amounts of traditional debt derived from banks and bond holders, with long term debt averaging about 13% of total assets over the last 5 years, resulting in an average debt-to-equity ratio over the same period of about 0.35. If we include operating leases in the calculation of long term debt, this will increase the average debt-to-equity ratio of the last 5 years to about 1.8. If we used a more conservative debt to equity ratio of say less than 1, during the filtering process, it would result in us not capturing a great business like Nick Scali.

Another example of why I like to use a high debt to equity is to not filter out businesses that may have recently increased debt levels to complete an acquisition. One company that comes to mind is Reece, this company has previously carried little to no debt on its balance sheet but recently took on a large amount of debt to acquire another business. This resulted in increasing the debt to equity from about 0.1 to 1.8. Given the business has historically carried very little debt, I would expect the debt to equity to reduce to more conservative historical levels.

• • The last criteria I look for is reasonable returns on equity and invested capital. I have these also set pretty low at about 8%, I also opt to use a 5 year average rather than current years ratio. This will avoid unnecessarily eliminating any good businesses that may be experiencing some short term cyclical problems which have reduced profits, resulting in these ratios to trend below their long term average. For example, with the current Covid-19 pandemic, many businesses will see a large reduction in their earnings, but in most cases this is just a temporary shortfall and I don’t want to screen out any good businesses that are currently experiencing some short term pain.

After applying these few simple filters, I have reduced the number of businesses from about 2,000 to less than 200. This was all achieved within a matter of minutes. From here you can easily look through each business’s website to gather information on what they do and decide whether or not you understand the business model. This process will take a few hours and will reduce a few more businesses from your Watchlist. You can always adjust the filter inputs to reduce the number of businesses even further. 

From this list I will begin a more in depth analysis, looking for those great companies which have strong balance sheets with little or no debt, have long term future growth prospects, are able to produce free cash flow and have high returns on invested capital.

So summing up, I use a few key metrics to filter out any poor or undesirable businesses to save me time when I begin the analysis process. I will compile these businesses into a Watchlist which I will continue to monitor over time. I will also continue to add new businesses that meet my criteria, as well as remove those which I believe do not show the signs of being a wonderful business.