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Quality Screens: Part 2

In Part 1 of this post, I looked at some quality screens I look at occasionally to generate ideas. In this second part of the post, I thought I’d briefly review an industry specific screen that I put together more recently that I will make a point to review every month or so.

I’m doing a lot of work on bank stocks lately, looking at a lot of cheap stocks selling for significantly less than their tangible book value. I’ll comment more on this and put up some basic notes on these soon. When it comes to banks, most of my time is spent looking at deep value cheap bank stocks and trying to find the highest quality ones from that list.

Very Simple Quality Bank Stock Screen

But I also thought it would be interesting to put together a list of quality banks that have achieved 10% or greater ROE in each of the past 5 years (2008-2012, plus the trailing twelve months). A bank that made 10% or more on their book value in 2008 and 2009 is one that might be interesting to look at. Very few banks make this list.

There are 1,025 US Regional Banks in Morningstar’s database. Only 32 make the cut of having 10% ROE in each of the last 5 years. This is roughly 3 out of every 100 banks. So we’re talking the cream of the crop. On the list you’ll find a lot of quiet, small banks that you’ve never heard of.

Many of these banks are in rural areas (think farms, mountains, countryside, etc…) with financially conservative customers with prudent spending and borrowing habits. These customers make for a strong, local, and loyal deposit base—which is a small bank’s key funding source and most important foundation.

Many of these banks are very well capitalized, pay steady and increasing dividends, have predictable earning power, and have a history of creating shareholder value despite a very challenging environment.

To paraphrase what Buffett once said, banking is a business with numerous commodity like aspects (they all sell the same basic service), but yet it also is a business where certain banks can develop a moat (a durable advantage over their competition).

This type of industry specific list can be checked occasionally, but doesn’t need to be checked often. It’s just another way to generate ideas. I’ve already gone through a few of these banks and found a few interesting ideas, but most are not priced attractively, which is understandable given their higher level of quality.

But one thing to keep in mind when using simple valuation metrics like P/B is another Buffett comment on banks:

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

I think what Buffett implies here is to not get too caught up with discounts to tangible book values if you plan to be a long term owner of the business. This quote alone can be the subject of a separate post. I have a few thoughts on this, because I think Buffett is right, even though I happen to love looking at lists of small banks selling at discounts to tangible book.

So to sum it up, here are the quality screens I check that might be of interest to you in your search for ideas:

  • Use Value Line to identify the Top 100 or so businesses
  • Buybacks (Stocks that have reduced their share count by 30%+ over the last 10 years)
  • 10 Years FCF (Non-financials with 10 consecutive years of positive free cash flow)
  • Stock Price (Stocks that have compounded at 10%+ annually for the last 10 years)
  • Book Value (My favorite quality screen: Stocks that have compounded their book value at 10%+ for last 10 years)
  • Quality Banks (Banks that have achieved 10%+ ROE in each of the last 5 years)

Remember, many of these stocks are not cheap—many of them are actually overpriced. Many of them never get cheap. These should be starting points to identify good businesses that can be tracked over time and purchased only at cheap valuations. There are lots of ideas here, but only a small handful would really qualify for further evaluation at any given time.

Idea Infrastructure

You could use these lists to build your own database of businesses you understand well. Read the 10-K’s, get the annual reports from the company websites, study the industries, and get familiar with them over time. One at a time. We’re after base hits… think of this as methodically building infrastructure. These lists are the raw materials that we can build our toll bridge with. As the database of businesses grows, you’ll have a list of ideas ready for you when Mr. Market decides to serve up some great opportunities.

Since we’re discussing quality lists here, I have a few follow up thoughts on value, quality and growth that I’ll post next week some time. I’ve had a lot of email questions on the theoretical aspects of these terms… to me, they are all intertwined and can’t really be separated. They are like the colors of a Monet painting.

I’ll discuss some brief thoughts on them, and sum up this post by saying this: Lest we forget, value is the most important factor. And by value, I don’t necessarily mean some multiple of earnings or assets. I simply mean the intrinsic worth of the business. But having said that, I tend to prefer stocks at low multiples—it helps me accomplish “Rule #1”. I tend to miss a lot of opportunities of great businesses with perpetual high prices, but I also tend to avoid a lot of losers. But in the end, as I’ve mentioned many times, I like Greenblatt’s definition of value: “Value investing is simply figuring out what something is worth, and paying a lot less for it”.

That’s what we’re after here at BHI. And we’re focused on building methodical processes to replicate this exercise over and over.

12 thoughts on “Quality Screens: Part 2

  1. I like your description of screens to use. Where do you find the screening tools that have “book value growth of 10%” or screens that sort out “buybacks resulting share count reduction”? Any preferred sites?

    1. Achit, I like to use Morningstar for these screens. I use the paid service, which is not very costly. It allows you to go back and screen for 10-year data in a variety of categories, and you can screen for all of those things. For buybacks, I use Gurufocus to screen, but also Morningstar and ValueLine to manually notice stocks that have been reducing their shares outstanding and keep a database of them…

      1. Hi John, if you could recommend only one site, which one would it be? Reviewing your articles, I have seen that you are using ValueLine, Gurufocus and Morningstar (not sure if I am missing others). As suscription fees for these sites are 300$, 600$ and 195$ respectively for a one year suscription, I was wondering if it is possible to choose only one site that covers all/majority of information needs. Thank you for your feedback and for the excellent articles!

        1. Hi Joris,
          Good question. My answer to that is easy: I could do without Morningstar and GuruFocus, but it would be painful to give up Value Line. It’s not that you need it to be successful, but I have found it very productive to go through the pages each week. I think if you pay for an online service, you’ll be able to get the same basic data, but you’ll learn a lot less because you won’t be getting something in the mail each week to read.

          Plus, Morningstar and GuruFocus have free versions that get you most of the way to where you want to be regarding the data.

          I’d pay for Value Line as a way to force yourself to flip through 150 companies each week. From there, you can always find a few ideas that are worth putting on your watchlist or list of 10-K’s to read.

  2. John, a quick question re your review of the Valueline pages. As you’re screening, what metrics of value do you specifically look for further due diligence?

    1. Hi Henry… I look for different things depending on the industry and business I’m looking at. With Value Line, the first thing I do is read the company summary so I know what business I’m looking at. I want to figure out what they do… some industries I just skip altogether if I’m not comfortable understanding the basic business model. VL sorts the universe by industry, so I find it very helpful for building up knowledge as you go (you look at all banks, then all retailers, etc… )

      I’ll look at different metrics for banks than I would for retailers or consumer products businesses, etc… Basically, I’m interested in looking at the return on equity for just about all businesses. For banks, I like to see double digit ROE, but more importantly, I want a stable history of ROE and a growing book value per share. For most other non-financials, I like to see steady returns on capital of 20-25%+ over the last decade (Value Line measures this by debt plus equity, or total capital including intangibles). I have my own way of calculating ROIC but I use Value Line’s measure as a way to quickly glance at the history. For most firms, I like to see growing sales and growing earnings, preferably high operating margins, and also a conservatively financed capital structure (low debt to equity).

      I don’t really have an exact science… each page is different. But the thing I look for in each business is a very stable operating history. I’m very interested in firms that have maintained stable margins, stable returns on equity, and stable/growing sales over the last 10 years.

      Obviously, I’m also glancing at the valuations (P/E mostly, for banks and insurance companies I’ll look at the P/B). But mostly when I’m looking at Value Line, I’m looking at the operating business and less concerned about valuation. This process allows me to build up knowledge over time, and keep track of good businesses so that when their valuations do come into my strike zone, I’m ready to swing. But this process has the added benefit of occasionally finding a business that happens to be undervalued currently also.

      I sometimes look at screens as well… and there also, it just depends on what I’m screening for. But over time, you’ll get better at understanding metrics that are important to each business, which will then frame your search process and help you simplify what you’re looking for.

      1. Hi John,

        The time that you take to help us improve our investment results through your blog is something that I will be forever grateful for. Many, many thanks!

        Now onto my question.

        How do you prfer to calculate ROIC?

        Thank you,


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