Wednesday, November 24, 2010

Share selection criteria

My current favoured share selection criteria are:
  • MFI (Magic Formula Investing)
  • GR (Graham Ratio)
  • GG (Graham Gearing)
  • PIO (Piostroski score)
 I think that most of the formula above are "doable", esp. MFI , with the expection of GR, which needs to be significantly relaxed in order to work. I think that very much weakens its approach. PIO I think is also a little tricky, as you have to start stepping outside the ideal range of PTBV.

I think that an MFI-based selection criteria is quite good, as it yields a sensible universe of stocks to choose from. I'm still not 100% sure MFI is a sound investment idea.

My MFI approach is better what I would call a "take" on Greenblatt's approach. I don't really like the way he does the ranking, and I think that his Return On Capital and Earnings Yield seem unnecessarily complicated. I'm also a little worried about the theoretical underpinnings of his ROC. With that out of the way, here's my selection criteria:
MKT > £75m (market cap)
ROE > 15% (Return on Equity)
PER > 0 (P/E ratio)
PER < 15
EGP1 > 0 (Earnings Growth Projected yr 1 out)
EGP2 > 0 (Earnings Growh Projected yr 2 out)
Z >= 3 (z-score)
ROA > 7.5% (Return on Assets)

Sharelock Holmes doesn't publish ROA figures, but you can find them on Google. The ROA figure was taken from "The Little Book That Builds Wealth"., by Pat Dorsey. It is an indicator that a company has a franchise business. Together with demanding a z-core of at least 3, it acts as an additional security that the ROE hasn't been obtained by taking on massive debt. I added EGP1>0 and EGP2>0 to ensure we aren't buying dogs that we think are going to collapse.

You do get a sensible selection of shares out of the process. To help whittle them down, I suggest going down in order of descending dividend yield because hey, everyone loves a dividend. As a final check, ROA can be examined on Google to ensure it passes the requisite hurdle.

What you end up with should be quite a sensible list. You aren't buying shares that are too highly priced. You demand to see rising expected growth figures, which adds safety that you aren't buying on some current earnings anomoly, and that the market expects it to be a growing company. Also, by demaning that both EPS1 and EPS2 are positive, you tend to eliminate any timing anomolies that might be going on at year-end. I think the dividend yield helps you in two ways, too: dividends are great to receive in their own right, and they also help prevent wacky EPS anomolies.

So, I think my criteria mutually boost each other. You get a great company at a reasonable price, with positive prospects and financial health. This should help weed out a lot of the crud.

Also, take a look at a previous post I made in July 2009 of the various selectio criteria I have used in the past.

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