Bill Miller is another excellent, but not someone as widely known as Benjamin Graham outside of financial circles. Miller spent 35 years at Legg Mason Capital - his last role at the asset management firm was as Chairman and Chief Investment Office (CIO).
During his time there, Miller was able to beat the S&P 500 (in after-fee returns) for 15 consecutive years (from 1991 to 2005). This spectacularly consistent and exceptional performance is considered highly improbable per well-known financially theory that says the market is efficient and that above-market returns will most likely arise to do chance.
If there is a 50-50 chance of beating the market (the S&P 500) on any given year (as the Efficient Market Hypothesis would lead us to believe), the chance of beating the market for 15 consecutive (eg. flipping heads 15 times in a row) is 0.0031%. Miller's approach, therefore, seems to be more than just pure luck and many investors believe that his deep value-oriented approach to picking stocks can consistently produce market-beating returns if applied in a disciplined and knowledgeable way.
Market Cap Less than 3X Free Cash Flow (FCF) for Next 5 Years
The first screen wants us to only allow those firms whose market capitalization is less than three times the total estimated free cash flow (FCF) over the next 5 years. Here we are clearly looking for undervalued firms in terms of earnings, but we're not looking at the typical price to earnings (P/E) ratio that most investors look at - Bill Miller is concerned not with profits but with free cash flow (FCF), an important measure that is much harder to manipulate than is profit by the firm's bookkeeper.
A firm can make a profit but lose cash. A firm can lose money but be raking in cash (this is the case with Amazon). The reason for this has to do with accounting principles and how they have to be applied for publicly-traded firms reporting their quarterly earnings. Without getting into the weeds here, the nature of financial reporting leads to quite unintuitive representations of things - profit on the books might not translate into real cash every quarter and losses might not really be as bad as they might sound if cash if rolling into the firm's bank accounts.
By eschewing profit nad focusing gon cash, Miller moves toward a more realistic and intuitive measure. By looking at those firms that have a market cap less than three times the esteemed free cash flow (FCF) over the next 5 years, we are effectively putting a maximum multiple over free cash flow (FCF) on the firm. This means that we expect the full market cap to be repaid within the next 5 years in free cash (not in profit). This is a powerful criterion that will leave relatively solid value plays in terms of free cash flow (FCF).
Price Earnings to Growth (PEG) Ratio Under 1.5
As with Peter Lynch and Phillip Fisher, Miller also focused on the P/E to Growth (PEG) ratio. However, unlike Lynch whose screen includes a filter to eliminate PEG ratios greater than 1 and Fisher whose screen only seeks to include PEG ratios between 0.1 and 0.5, Miller is more aggressive in terms of accepting a higher PEG ratio of 1.5.
In this screen, although a PEG of 1.5 still is reasonable, the PEG filter can best be understood as eliminating overly expensive items rather than being a hard screen for deep value plays. If that was the case, the PEG ratio would likely be lower - around 1 or less.
Long-Term Debt Ratio Below Industry Average
Finally, if we're looking at value plays in terms of market cap to free cash flow, we want to make sure that the deep value present isn't because the firm is over-levered - we want to make sure the firm isn't burdened by excessive debt as debt can be a killer both to the ability to effectively use the cash the firm generates and because it creates a lot of risks.
By looking at firms with debt ratios below the industry average, we can be sure that we are being conservative in our stock pick. Combined with a reasonable PEG ratio and a low market cap relative to estimate future free cash flow (FCF) over the next 5 years, we can paint a full picture of the firm as a reasonably conservative value play.
Philip Arthur Fisher is going to be on the fringe of investors' knowledge - only those that are truly serious and deep in investing and stock analysis will likely know this man's name in our era. Everyone should know his name, however, as Philip Fisher is one of the greatest investors of all time.
Starting his career after dropping out of Stanford in 1928 to work in a San Francisco bank. Think about how astonishing this is - the likes of Bill Gates, Steve Jobs, and other Silicon Valley wunderkinds would follow suit (likely without even knowing who Fisher was) half a century or more later.
Fisher's seminal work Common Stocks and Uncommon Profits is a foundational piece of investing theory and writing that was published in 1958 but has remained in publication ever since, demonstrating how relevant Fisher still is to this day.
Fisher's investing approach was focused on purchasing growth at incredible discounts. Let's take a look at what to screen for if you want to perform stock screening in a manner aligned with Philip Arthur Fisher's investing principles.
Increase in Year-over-Year (YoY) Sales Over Last 5 Years
Here we can already see that we are not going to be playing games with the typical price to earnings (P/E) ratios and similar metrics most investors focus on too much - Fisher isn't going to play in that field but will instead be looking at metrics that evince a strong and growing business.
Year over year sales growth simply means that the current year's sales are greater than last year's sales - we want to see such growth for the last 5 years. Seeing a dip (or even a plateauing) of sales indicates that the business model is either (1) quite mature, (2) is experiencing cyclical difficulties, or (3) the firm's management isn't doing a good job.
Clearly, 1 and 3 above are not good, but many investors would accept 2 and say that the sales decline is simply due to the business cycle or the general cyclicality that the firm's business is exposed to. By required year-over-year sales growth for 5 years, Fisher implicitly answers the investors by saying that if the business is capable of being affected by this type of cyclicity, it isn't the type of business we want to invest in - we want businesses that thrive in good time and do well in bad times (we want robust businesses that can thrive in almost any economic environment).
Price Earnings to Growth (PEG) Ratio Between 0.1 and 0.5
The P/E to Growth (PEG) ratio is simply the P/E divided by the earnings growth rate - it shows you how much you're paying relative to a firm's earnings growth.
In the piece on The Peter Lynch Stock Screen we looked at a PEG ratio of less than 1 - here we take that even further and require an almost astoundingly low PEG ratio between 0.1 and 0.5. We can see that Fisher's approach is to find not just deeply undervalued companies, but deeply undervalued companies in terms of the growth they are exhibiting. In effect, the key in Fisher's approach is to pay as little as possible for as much steady and reliable growth you can get.
Research and Development (R&D) as a Percent of Sales Greater than Industry
Again we are focusing on things that will demonstrate intense growth or growth potential. Research and development is a good indication of a firm's belief of its ability to innovate - generally speaking, if a firm invests in R&D it believes that the benefits derived from the initial capital outlays (eg. the returns) will be higher than other potential capital uses (eg. the opportunity cost) - if a firm invests in R&D, it generally means that they think they have an ability to innovate.
Additionally, successful R&D generally results in growth. Therefore, a firm that is heavily investing in research and development is more likely to be a firm that is either already growing at a strong pace or will do so down the line. By choosing those firms that have a higher research and development expense compared to sales than others in the industry, you have a greater chance to look at firms that are Horwitz and creating new and innovative products/services.
However, it is important to be aware that only looking at research and development expenses as a percentage of sales is far from sufficient - looking only at R&D can deeply mislead you if that's all you look at. For example, imagine a firm that has sales of $1 and R&D expenses of $10 - this firm would have a tremendous R&D budget compared to sales, but we can clearly see that this firm is doomed because it's sales are too low in absolute terms and its R&D is excessively high in relative terms.
Growth in Sales Greater than Growth in Research and Development (R&D) Expenses
Here we see Fisher again focusing on research and development - this time, however, we're focusing on R&D growth. We want R&D growth to be less than sales growth - this will help prevent the plant scenario ($1 sales vs. $10 R&D) discussed above because a growing R&D budget doesn't by itself mean that much. A growing R&D budget that is accompanied by growing sales, however, does mean a lot - sales growth even greater than R&D growth means even more because it implies that the R&D expenses are producing great returns and that the firm is ultimately becoming more efficient in terms of the percentage of sales required for R&D.
Peter Lynch is one of the greatest investors of all time - any investor (or anyone involved in the financial markets for that matter) likely has heard of Peter Lynch.
Lynch managed the Magellan Fund at Fidelity from 1977 to 1990 during which the funds assets under management grew from about $18 million to about $14 billion dollars - this is an increase of about 777x, meaning that $1000 invested in the Magellan Fund under Lynch's helm in 1977 would yield about $777,000 in 1990 - an absolutely astounding return that skyrocketed Lynch into the top echelon of investors not only in his generation but in the history of investing.
In case the above numbers aren't enough to convince you of Peter Lynch's investing genius, let's compare the Magellan Fund's performance from 1977 to 1990 with the performance of the Dow Jones Industrial Average over the same time period. The Dow Jones Industrial Average managed an increase of about 3x over the same period - $1000 invested in the Dow would yield a comparably paltry $3000 in 1990.
Clearly, any investor should at least be interested in the general methods employed by Peter Lynch. Although Lynch articulates some general principles regarding his investing philosophy in the now classic One Up on Wall Street, we will look at what can be called a Peter Lynch Stock Screen - a stock screen that generally uses his principals to screen the universe of potential stocks for a small number of potentially lucrative stock picks.
Price Earnings (P/E) Ratio Lower than Industry
The common price to earning (P/E) ratio is often used in stock screening and Peter Lynch was no stranger of this classic and often used metric. By screening for firms that have a lower P/E ratio than the industry, an investor can find potentially undervalued equities.
In order to perform this screen, one would first need to accurately identify the industry. It's key that the industry classification is not too broad - this will create a more accurate comparison. For example, a luxury car company such as BMW might be better grouped with other similar luxury firms (eg. Mercedes Benz, VW Group, etc.) instead of as part of the car industry as a whole (eg. Ford, GM, etc.).
Once an industry P/E ratio is identified all stocks that have a P/E ratio at or above it can be screen out. More conservative investors might even choose a slightly lower P/E in order to more aggressively target deep value plays.
Price Earnings to Growth (PEG) Ratio Less than 1
The Price Earnings to Growth (PEG) ratio is an excellent metric and is especially useful for high-growth firms. The ratio compares the P/E ratio to the growth of earnings per share (EPS) - clearly, firms that have earnings per share (EPS) growth might allow for greater accommodation of higher P/E ratios because you are paying for future growth.
A PEG ratio allows investors to take the P/E into full account by also looking at EPS - it's possible that a relatively high P/E will be viewed in a much better light when the PEG ratio is looked at.
A PEG ratio below one is a low PEG ratio - it can be said that "growth is being purchased cheaply" with a low PEG ratio.
Insider Buying to Selling Ratio Greater than 1.5
This is an interesting thing to look at and it gives us a glimpse into Peter Lynch's thinking. Who has more knowledge of the firm, random investors or insiders? Clearly, insider buying implies optimism about the future prospects of the firm - relying on this easy to see metric requires no real analysis or calculation and is simply based on an understanding of the nature of knowledge and human society.
Sequential stock screening involves reducing the universe of stocks to a manageable size. For example, sequential stock screening might involve reducing all US publicly-traded stock to 10 stocks for use in a portfolio by eliminating stocks, one by one, based on filtration criteria (usually with the most important criteria first.
Although there's no absolutely best way to perform sequential stock screening, using criteria articulated by the famous Benjamin Graham is both a good way to approach stock screening and an excellent way to better understand some fundamentals that this man (and his successful investing successors) feel are important.
Benjamin Graham -- Warren Buffet's professor and mentor at Columbia University and author of such foundational books in investing as Security Analysis and The Intelligent Investor -- had a stock-picking approach that fundamentally could be described as looking for deep value. He effectively advocated looking for those stocks that were pretty much sure bets but whose current prices were deeply undervalued. The main components of a Graham-style stock screen would consist of the following criteria when performing a stock screen.
Adequate Size - Avoid Overly Small Firms
Adequate size can mean different things for different investors and there's not a hard and fast rule that Graham articulated that we can apply in today's market, but an investor can do one of two things in order to screen for size:
Sufficiently Strong Financial Conditions
This is another slightly ambiguous criterion and can be interpreted in different ways - it can mean having enough cash or not having too much debt (eg. various leverage-related metrics). Things to look at can be:
Non-stop Dividend Payments for Last 20 Years
This is the heart of Graham-style investing - you're focusing on a company that has done well over a very long period of time in the investing world. This would remove:
No Losses for Last 7 Years
This is similar to the dividend requirement - it shows that the firm has been doing well for a significant period of time. Not having losses for the past 7 years (or however many years you might choose - 5 years, 10 years, etc.) will provide some sort of assurance over the quality, resiliency, and robustness of the businesses the firm is in.
As above, this filter will rule out companies where you can't actually observe profits or losses for the last 7 years or companies that haven't existed for at least 7 years.
Increase in Per-Share Earnings of at Least 33% in Last 10 Years
As with the above, this shows long-term stability of the firm's business model - you want to see that the business is at least keeping up with (or beating) inflation in terms of its profits.
Current Price Less than 1.5x Book Value
This is a deep-value filter - we're looking for first that that are trading at only 1.5x book value. Book value can be thought of as liquidation value - book value is different from the market value in that it literally show the value on the "books" of the firm. This filter tells us that we want to buy firms whose market value is only 1.5x the firm's book value - this usually means the firm is reasonably valued.
To compare the 1.5x market to book value we're looking at here and to better understand it in the context of the overall market, let's look at the market to book value of the S&P 500. As of late 2016, the price to book of the S&P 500 was right around 3x, meaning the overall S&P 500 was trading at a price three times higher than the combined book value of all firms that comprise the S&P 500. Near the Dot Com Bubble the price to book of the S&P was about 5x.
Current Assets Worth at Least 1.5x Current Liabilities
This is a classic leverage filter where you look at whether your current assets are sufficient to provide current liability coverage if necessary. The world "current" in finance (for both assets and liabilities) generally means that one year or less - so current liabilities are liabilities (eg. debts) that can reasonably be expected to need to be repaid within one year.
This filter prevents a very unpleasant situation where an otherwise profitable firm might possibly be forced to liquidate productive assets or be forced into bankruptcy due to an inability to cover short-term debts due to adverse economic conditions or a change in the business cycle.
It's important to note, however, that not all of the above criteria have to be used - Benjamin Graham didn't articulate a particular sequential screening strategy but instead articulated principles that are represented in the above filters.
When people think of stock screening, they usually think of sequential stock screening - that is they think of taking the stock universe and narrowing it down by applying filters one after the other until a final list of stocks that each meet the criteria is obtained.
Sequential Stock Screening is Binary
One key point is that sequential stock screening is binary - this means that at each point on the screen, the stocks in the stock universe (or the remaining stock universe) either continue or don't continue. Unlike simultaneous stock screening -- which screens stocks simultaneously based on a z-score -- sequential stock screening either keeps a stock in or tosses is out at each junction.
This binary nature of sequential stock screening is considered a weakness by some because a stock may be disqualified early on that would otherwise prove to be excellent given the overall screen (given the upcoming filters that will occur on the screen).
The Initial Investment Universe is the Starting Point for Sequential Stock Screening
The starting point of a stock screen is the initial investment universe - this is simply the totality of stocks that will enter the filtering system. Usually, an investment universe is comprised of publicly traded equities on the NYSE and the NASDAQ.
It is possible to include stocks that aren't traded on exchanges, but this isn't recommended for new investors or those new to stock screening as this can add complexity and can hinder liquidity.
Screen Criteria - What to Look at in Sequential Stock Screening
You can literally look at almost anything in a stock screen - there really is not set requirement. Things such as
can all be looked at in stock screens. There are many sequential stock screening strategies out there but they are beyond the scope of the current discussion.
Many Free Sequential Stock Screening Resources Exist Online
Here are a few popular free online stock screeners (that don't require a brokerage account to use):
Other sequential stock screeners exist -- some of which are more powerful than the ones above -- but they are tied to specific brokerage and require you to have an account with them.
Check out the video below for a basic example of how to use a stock screener
This is one of the better YouTube videos available on how to use a basic stock screener. The creator is a reputable individual in the investing community and is known to produce high-quality material.
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledge technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).