When initially looking to invest in the stock market, finding high quality companies to invest in can not only been daunting, but difficult, not least because your knowledge of investment knowledge is unlikely to be particularly strong. As a result, many investors initially look for companies either written in a publication or those they have previously heard of. However, think of it this way; if you look at 5 companies with the intention of investing in 1, when there are over 2000 companies on the London Stock Exchange, chances are that you are not considering a handful of other companies that are potentially better value. This is a scenario where stock filters can be useful and this article will look at how to use them to streamline a list of companies to research.
For this tutorial I will use ADVFN's 'Advanced Search' filter, that can be found here. The reason is that it's free and although there are some very good stock filters on paid websites, spending large amounts of money on research tools is not really required to become a good investor. In fact, it can make you less inclined to read financial statements; that is not necessarily good as being able to understand financial statements is a core skill when analysing a company.
It's important to understand one more thing before we start. Screening using stock filters to find a list of companies is only the start of a research process; it is not the end. The reason why it is not the end is that it's only useful for basic data searching and even so, you should not rely on the information derived; it is often inaccurate as it is based on software grabbing.
Again though, that's not to say its not useful. Rather, be careful and where possible stick to common filters such as market cap and PE ratio.
Methods to Use
Now that we have established the ideas above, we can start to look at how you might wish to start a search. Generally speaking, there are two main types of investing technique:
- Bottom Up Investing: Looking for company-specific factors and identifying companies that fit those criteria. For example, you may wish to scan for companies that have cash representing at least 30% of the valuation (market cap).
- Top Down Investing: Looking for a macroeconomic or microeconomic theme and then looking at a list of companies that fit that theme. For example, you may want some precious metals exposure for your portfolio and proceed to decide that exposure to a gold producer would suit. You would then scan the mining sector for gold explorers.
Both of these methods should be used over time dependent on the type of company you are looking to invest in.
Starting a Search
For the purpose of this tutorial, I will look at a top down investing method. Perhaps, with strong UK consumer confidence, I wanted exposure to car retailers. In particular I want to research those that are only at least £50m in size. I am also only interested in companies that are profitable and pay a dividend of at least 1.5%. As a final constraint, I don't want to be paying more than 20x a company's trailing earnings (i.e. the PE ratio must be less than 20).
This is a reasonable set of constraints as it does not require the use of more obscure filters. To exaggerate what I said earlier, the more obscure the screening factors, the more likely the data you get is incorrect.
How would I go about researching the sector using a stock filter? Using the advanced search webpage linked to earlier, or here, we can start that process.
The image above shows the two things that need to be done. Firstly, you need to choose the sectors to look at. We can achieve that by unclicking the tick in the 'All Segments' section. We then need to scroll through the box on the top and choose the sectors to include. Since we are interested in car retailers, there are two sectors we need to click on, whilst holding the CTRL key. We need to click on both the General Retailers and Automobiles & Parts sectors.
Secondly, since the criteria I mentioned earlier was for companies with a market cap over £50m, we need to click 'Market cap' on the list. and in the typing box on the right hand side, enter '50'. The box to the left of that is pre-set to 'Greater than' so we don't need to change this. Then click 'Search'.
Having clicked search, we are left with the results above. We have essentially cut down the 2000+ companies on the LSE to just 48. What are these 48? These 48 companies are all companies in either the Automobiles & Parts or the General Retailers sectors that have market caps over £50m.
The only problem so far is that the General Retailers sector and the Automobiles & Parts sectors include companies that are not car dealerships or even companies that own car dealerships.
Therefore, what we need to do is pick out those companies that fit our criteria and discard the rest. In reality, we would probably need to visit the company website for each company to determine whether they derive any sales through car dealerships. This gets easier in time, but for example, it's obvious that some companies on the list are not car dealers because you have probably visited their stores; Marks & Spencer, and JD Sports, for example. Some of those are clearly not car dealers because of their names too; Signet Jewelers and Shoe Zone. Equally, some are likely to be car dealers because they either have Auto or Motor in their company name.
For simplicity, I have highlighted all those companies with the sort of business operation that we are looking for. We have cut down the 48 companies to just 7 in a very short amount of time. We need to track these 7 names throughout the rest of the process so you may wish to note these down.
Refining the Search?
We will now proceed to add the two final criteria; a trailing dividend yield of at least 1.5% and a PE ratio of less than 20. The ADVFN filter is generally good for these two criteria given they are fairly simple and widely tracked. However, there is another problem. Stock screeners are often based off historic data from the company's results last year. Marshall Motor and Auto Trader are both new companies to list on the London Stock Exchange so there is no PE or dividend yield data on them!
As a result, we have two options.
Option 1: Refine the search. Proceed with the filter by adding the extra criteria as per the image below. Note that you have to re-click the sectors you are looking at
Option 2: Don't filter further and conduct a manual search. We can do this by click on each of the 7 company names and directly examining the PE ratio and dividend yield data.
In this instance, Option 2 is easier given that there are only 7 companies. So let's go ahead and open each of the 7 links in new tabs. We don't want to invest in a company that is too illiquid. We can conduct a very quick visual chart check to make sure there is decent looking liquidity. All of the 7 appear to have decent-enough liquidity so we can look at our final two criteria.
For the PE ratio are any trading at above 20? For the dividend yield are any trading below 1.5%? These two figures are located on the respective company page as below. Generally speaking, you want these PE ratio and dividend yield criteria to be quite lenient as you can always tighten them later.
|Click to enlarge|
In reality, looking in the rear-view mirror is one thing, but ideally we need to look to the future. Therefore, although our 5 companies adhere to our historic PE ratio and dividend yield constraints, they don't necessarily adhere to them in the future. That's especially important since we've basically failed to check the PE ratios and dividend yields of Auto Trader and Marshall Motor Holdings. So let's do that now. One of the easier ways is to open up each company's web page in Digitallook; here is an example link for Vertu Motors. To change between company, click the magnifying glass at the top of the page (see image A below). Then simply scroll down the page to the Key Financials section and look for the Forecast section (see image B below).
Again we can see that Vertu Motors comfortably fits our PE ratio of 20 and dividend yield of 1.5% criteria. In fact, it has a PE ratio for 2016 of 11.6 and a dividend yield of 1.7%. Perform this check for each of the companies. Cambria Automobiles fails the dividend yield check and Auto Trader fails on both a PE ratio check and a dividend yield check. Marshall Motor Holdings fails on the dividend yield check.
The Screening Results
Pendragon, Vertu Motors and Lookers all pass the two very basic fundamental analysis checks that we set out. These are essentially the 3 companies we can now conduct in-depth fundamental and technical analysis on to determine whether they are worth investing in. After all, all we can really deduce at the moment is that these three companies pay a decent dividend with a yield of at least 1.5%, and are not overly expensive (trailing and forward PE ratios are less than 20).
That does not mean to say that they are cheap and are worth buying. In fact, each of them may be on their rating for a particular reason that you might pick up during more in-depth fundamental analysis. That analysis would include assessing other valuation metrics such as free cash flow and comparing them against the sector average and how they have changed over time.
For example, before the financial crash when credit was easily accessible and in a car boom period, were these companies trading on 5 times earnings or 30 times earnings, or almost certainly somewhere in between. However, if they had been on just 5 times earnings then was the market worried about a bubble in the market given the sector is very cyclical? Or perhaps you think the entire car dealership market is cheap now; in which case you may want to diversify amongst these 3 companies or select the one that you think has the best business model/outlook.
In addition, we haven't even started to look at the company's balance sheet, quality of earnings and cash flow, amongst other ideas, so we have only narrowed down the search via these filters and cut down some of the legwork.
What can we conclude?
The bottom line is that you now have 3 companies to research fully and you have 3 competing ideas for the same story that you started with; a company to play car dealerships in the UK. Using a stock filter can provide more structure when you are looking for a theme/particular company. It doesn't have to just be profitable companies either; as an example, you may prefer to screen for every single company in every single sector that has a market cap between £20m and £60m.
As long as you appreciate that, the more complex the filtering criteria, the more likely it is to be wrong, and that this is only the starting point of your research, then stock screeners can be a very powerful and time-saving tool.