Today’s post is our first visit to a new book – The Equity Edge by Mark Jeavons.
I don’t know anything at all about Mark.
- I was drawn to this book because unlike most of the titles on the Harrison House list, it appears to describe a quantitative approach that is not a day trading system.
From reading the reviews, it seems that Mark makes extensive use of stock screens and the Stockopedia service, all of which sounds very promising.
According to the author blurb, Mark has an economics degree and is a professional investor, managing family office-style multi-asset portfolios.
Mark has been using this system for the bottom-up analysis of stocks for decades.
- He’s had considerable success and has reached financial freedom (but still works for an asset manager).
The Equity Edge
Right at the start, Mark makes the claim that you can beat the stock market in terms of returns and drawdowns.
- This is a slightly more aggressive target than my own (which is to match the market returns, but with lower volatility).
He’s averaged 15% pa (he doesn’t state the period) compared to 5.2% pa for the UK market and 6.9% pa for the world index.
- His max drawdown was 12.5% (compared to 47.7% and 52.8% respectively – so it sounds like we’re going back at least as far as 2008).
His system is aimed at individual DIY investors – you don’t need professional help or specialised training.
- He points out that professional investors are under pressure to perform over short periods (one year or less), whereas DIY investors can choose their own timescales.
The system has several elements:
- Quantitative analysis (of a company)
- Qualitative analysis
- Charting (of the company and the market)
- Risk management to avoid significant loss from one company or a market crash
The risk rules naturally de-risk the portfolio in severe bear markets, such as the 2008 great financial crisis, by reducing equity allocations as the downturn begins.
Although it seems to be a system rather than a “gut feel” approach, Mark still pays lip service to the stock-picker’s creed (perhaps in hope of higher book sales):
Selecting quality companies that can reliably grow earnings and create market value over long time horizons helps to provide consistent returns. More importantly, avoiding the poorest companies which are steadily destroying market value helps to avoid losses and achieve market outperformance.
Mark also notes that the rules of the system will help investors to avoid mistakes arising from behavioural biases.
Mark’s investment process has five stages:
- Select quality companies using stock screens
- Value these companies to see if they are cheap
- Time entries (purchases) based on valuation and the market tone (from charts)
- Test holdings against selling rules to decide when to sell
- Use risk rules to ensure diversification and limited downside
The screening process has three stages:
- initial screens to remove companies with poor fundamentals
- specific checks on earnings, sales, cash-flow, dividends, debt, competitive advantage and valuation
- qualitative checks based around leadership, prospects, strengths, weaknesses and risks and opportunities
The valuation process makes use of broker forecasts and a long-term fair value calculation.
- The entry process involves three key strategies designed to take advantage of Screening and data
Mark uses Stockopedia (as do I).
- The main UK rival is SharePad/ShareScope, though I know people who use ADVFN.
- I also use simple Google Sheets with live prices for technical analysis of portfolios and watchlists.
US rivals include Zacks and UncleStock
Free screeners are not as good as Stockopedia, but Mark mentions FinViz and Yahoo.
- He also likes MorningStar for historical financial account data.
For charting, Mark suggests TradingViews and StockCharts.
- These are both good, but I find that I increasingly use broker charts or the charts within Stockopedia.
For news, Mark likes the FT and Economist (both of which have deteriorated significantly over recent years, as their politics have slid leftwards) and Bloomberg.
- He also likes the Investors Chronicle (which I find repetitive) and Shares magazine (too lightweight for me).
I find Twitter to be very useful for financial news, but there are two rules:
- Use TweetDeck on a desktop, so that you can follow four or five curated lists of useful people (rather than the firehose of your raw Twitter feed).
- Do not get drawn into time-consuming and fruitless debates with those who disagree with you (there will be many, no matter how uncontroversial your position).
The daily Small Cap Value Report (which often covers larger caps and growth stocks) within Stockopedia is also fun, though like every internet forum (and indeed, real-world meetings, when they were a thing) the comment section suffers from being a groupthink bubble.
And of course, a lot of the best information appears on blogs (mostly in the US, but there are a few good ones in the UK, including mine).
- Mark has his own monthly newsletter and subscription website (theequityedge.com), which I have not used.
Stock screens are useful because there are too many companies for an individual to research by hand.
We make extensive use of stock screens here on 7 Circles.
Each month I publish the output from 23 screens arranged into six groups:
- S1 – Quality Income
Here are the rules:
Dividend yield > min( market yield+1%, 4% )
The FTSE All-Share yield (which Mark sources from the Investor’s Chronicle) is well over 4% as I write, so I will use 5% as our target.
- The minor complication (under Covid-19 lockdown) is that many dividends are currently suspended, so choosing stocks on the basis of last year’s dividend is pretty dumb.
Dividend yield < 15%
Stocks with high yields are usually those where the market expects a dividend cut, or sometimes because the share price has fallen a lot (and therefore might be expected to fall further).
- Either way, you don’t want to be buying them.
I think 15% is way too high – I would be wary of any stock with a yield over 8% (or say twice the index average, so maybe 9% at the time of writing).
Dividend cover > 1.5
This compares earnings per share to the dividend payout.
- Beware companies that are paying out everything they earn (or more).
Market cap > £800M
Mark prefers companies of a decent size.
- I am interested in company size, but I deal with this parameter through top-down allocations to stocks of various sizes.
So I do have an allocation to companies smaller than £800M – my usual lower limit is £50M.
Piotroski F-score > 6
The F-score looks at balance sheet strength.
- I usually look for a score of 6, but Mark wants seven.
Mark explains the way the score is calculated in some detail:
- Bottom line.
- Score 1 if net income is positive in the current year.
- Operating cash flow is a better earnings gauge.
- Score 1 if cash flow from operations in the current year is positive.
- Return on assets (ROA) is a measure of profitability, defined as net income divided by total assets.
- Score 1 if the ROA is higher in the current period compared to the previous year.
- Quality of earnings warns of accounting tricks.
- Score 1 if the cash flow from operations exceeds net income before extraordinary items.
- Leverage is the amount of debt used to finance a company’s assets – a company with improving financial health should gradually reduce its leverage.
- Score 1 if there is a lower ratio of long-term debt to assets in the current period compared to the previous year.
- The current ratio is a liquidity measure that is used to monitor a company’s ability to pay back its short-term liabilities (short-term debt and payables) with its short-term assets (such as cash, inventory and receivables).
- It is defined as short-term assets divided by short-term liabilities. e higher the current ratio, the more capable the company is of paying its obligations. e liquidity of a company is improving when the current ratio is rising.
- Score 1 if there is a higher current ratio in the current year compared to the previous year.
- Shares outstanding is a measure of potential dilution.
- If the total number of shares outstanding increases, the current ownership of the company is being diluted.
- This generally won’t happen for companies in good financial health (unless they are intent on making an acquisition).
- Score 1 if the company did not issue new shares in the preceding year.
- Gross margin is a measure of competitive position.
- Score 1 if there is a higher gross margin compared to the previous year.
- Asset turnover is a measure of a company’s ability to use its assets to generate sales.
Altman Z-Score > 1.8
This one measures bankruptcy risk.
Here are the five ratios it uses:
- X1 = Working capital ÷ total assets.
- This measures the liquid assets of a company.
- A company experiencing financial distress will usually experience shrinking liquidity.
- X2 = Retained earnings ÷ total assets.
- This ratio represents the cumulative profitability of the company.
- Shrinking corporate profitability is a warning sign that the company may be in trouble.
- X3 = Earnings before interest and taxes (EBIT) ÷ total assets.
- This ratio shows how productive a company is at generating earnings relative to its total asset size.
- Weaker companies will be less efficient at earnings creation.
- X4 = Market value of equity ÷ book value of total liabilities.
- This ratio offers a quick test of how far the company’s assets can decline before the rm becomes technically insolvent (i.e., its liabilities exceed its current value).
- A company with weakening fundamentals will become less solvent over time and the ratio will fall.
- This ratio is used for manufacturing companies.
- X4A = Book value of equity ÷ total liabilities.
- This ratio also offers a quick test of how far the company’s assets can decline before the rm becomes technically insolvent (i.e., its liabilities exceed its accounting value).
- This ratio is used for non-manufacturing companies, as it provides greater predictive power than X4 when considering the probability of financial distress.
- X5 = Sales ÷ total assets.
For publicly listed manufacturing companies, the Altman Z-score is calculated as follows: (1.2 × X1) + (1.4 × X2) + (3.3 × X3) + (0.6 × X4) + (1.0 × X5)
The Altman Z-score for non-manufacturing companies is calculated as: (6.56 × X1) + (3.26 × X2) + (6.72 × X3) + (1.05 × X4A)
Mark notes that, strictly, 3 is a good score.
- But 1.8 keeps us away from the companies that are likely to go bust within the next two years.
Sector <> Finance
Finance companies have opaque accounts, and their ability to continue paying dividends is hard to estimate.
- As I write, many financial companies have been ordered by the government to not pay dividends.
Quality Rank > 80
This is a Stockopedia number.
S2 – Growth and Income
Broker forecast (2 yrs ahead) upgraded in the last 3 months.
I see what Mark is after here, but this could be tricky to incorporate into a stock screener.
ROE > market average (median)
This is net profit/shareholders equity (= assets – liabilities)
- It’s a quality measure as it indicates the company’s efficiency at generating profits from its equity.
Rolling PE < 20
Rolling PE uses the earnings from last year and the forecast for this year, weighted by where we are in the company’s tax year.
- This makes it easier to compare companies, but I prefer trailing PE since historic numbers have been found to have more predictive power than forecasts.
Forward PE < market median Gross gearing < 1 Gross gearing = total debt / shareholder's equity
A highly geared company is more vulnerable to adverse shocks, such as operational problems or a downturn in the economy.
Dividend yield > market median
There’s no premium needed on this screen because the earnings are growing more quickly.
Beta < 1
Beta measures the company’s sensitivity to the market’s volatility.
- This is a Low Vol (defensive) selection criterion.
F-score > 5
A somewhat lower target this time.
Dividend cover > 1.5 Forecast dividend yield > market median Market cap > £20M
This is a much lower bound than for the previous screen, and a bit lower than I am comfortable with.
- I’ve never used a limit below £40M.
S3 – Low PE
This is the first of Mark’s value screens, based on David Dreman’s book Contrarian Investment Strategies: The Next Generation.
- The book looks for low valuations and higher than average dividends.
Mark is one of those investors who likes to “get paid to wait” (until the value in the stock has been realised).
Value has had a terrible time since the 2008 crisis, and I must caution readers against using value strategies alone.
- The move to virtual rather than physical assets means that many of the old value tests don’t work today, and a very large share of value creation over the last decade has gone to expensive internet growth stocks.
PE in the bottom 40% of the market Sales > £100M
I’m not sure why Mark has switched from market cap to Sales as an indicator of size.
- It’s actually a better indicator, especially for value screens, since market cap incorporates the share price, and so favours expensive stocks.
Debt to assets < market average Current ratio > 1
The current ratio is current assets / current liabilities.
- In accounts, current usually means during the next accounting period (year).
Net profit margin > market average Return on equity (ROE) > market average Earnings growth > market average
I’m slightly surprised to see all these quality measures in a value screen.
- If these companies are so good, why are they so cheap?
Dividend yield > market average Sector <> Collective Investments F-score > 5
S4 – Low PCF
PCF stands for Price to Cash Flow – this is the share price / operating cash flow per share.
PCF in bottom 40% of market Sales > £100M Debt to assets < market average Current ratio > 1 Net Profit Margin > market average Earnings growth > market average Dividend yield > market average Sector <> Collective Investments F-score > 5
S5 – Zulu Growth
The idea behind growth screens is to buy fast-growing companies at a reasonable valuation – most growth screens are GARP (growth at a reasonable price) screens.
Mark’s first growth screen is based on Jim Slater’s Zulu books.
- We have our own Zulu screen, so it will be interesting to compare notes in a future article.
PEG < 0.75
The PEG is a ratio invented by Slater which compares growth rates to PE ratios, on the basis that faster-growing companies are worth paying more for.
- The Slater PEG is the forecast rolling PE/forecast earnings growth.
A PEG of less than 1 is seen as good value, and less than 0.75 is cheap.
- You also need four consecutive years of earnings growth for the PEG to be valid.
PE < 20
Earnings growth rates of more than 20% are hard to sustain.
Forecast earnings growth > 15% Relative Strength (1-year) > 0
Relative strength compares the share price change of the stock with the change in the market index.
ROCE > 12%
Return on Capital (ROCE) is earnings before interest and tax (EBIT) / net capital employed (NCE? – I’m not familiar with this abbreviation).
NCE = total assets - current liabilities. Market value > £20M Market value < £1 bn
Slater subscribed to the view that “elephants don’t gallop”, so large companies are excluded.
- Smaller firms need to grow earnings by less in absolute terms, and will, in general, have more remaining market share to target.
S6 – Naked trader
This screen is based on the Robbie Burns book the Naked Trader, which we have reviewed on this site.
- We also had a go at putting a screen together, though from memory the end result wasn’t much use.
Market cap > £20M Market cap < £1 bn Sales up over 1 year Earnings up over 1 year Dividends up over 1 year Relative Strength (1-year) > 0 Price more than 5% above the 1-year low Spread =< 4% PE < 20 PE > 12
This avoids blue sky and high growth stocks, and also value traps.
Net debt / Operating profits < 3
In this screen, debt is judged to be too high total debt minus cash equivalents could not be completely paid off from profits within three years.
Sector <> Collective Investments Price / Pre-tax EPS < 15
Mark calls price to pre-tax earnings per share PPTE, another abbreviation I haven’t come across.
Market <> AIM
This one is a surprise to me – many of Robbie’s followers are big fans of AIM, and often of the dodgiest stocks on that market.
F-score > 5
S7 – Economic Moat
Economic moats were made famous by Warren Buffett.
- They describe the sources of the competitive advantage enjoyed by companies – which deter attacks from competitors.
This, in turn, supports pricing power, and hence high returns on capital and high free cash flows (FCFs).
- So this is really a Quality screen.
FCF / Sales in top 20% of market
FCF is cash generated by the business after all capital expenditures (factory improvements, machinery repairs and replacement, etc).
- It can be reinvested in the business or paid out as dividends.
Operating profit margin > 20% Operating profit margin in the top 20% of the market ROCE > 15% ROE > 15% ROCE ave 5-years > 15% ROE ave 5-years > 15% Index = FTSE 350
That’s it for today.
- It’s been denser than I expected, and we’re only around an eighth of the way through the book.
But I hope things will be easier from here, and I hope to get through the rest of the book in another four articles.
- Then I’ll try to build the stock screens in Stockopedia, and finally, there will be a summary post.
So that’s a target of seven articles in total.
- Until next time.
Article credit to: https://the7circles.uk/the-equity-edge-1-stock-screens/