QUALIPORT
Screening For Quality Shares

By Maynard Paton (TMFMayn)
May 3, 2005

Stock-screening websites are one of the seven wonders of online investing. Simply key in a few parameters -- say, a price to earnings ratio of less than ten and earnings growth above 20% and -- hey presto! -- a list of suitable shares is produced. No longer do you have to plough through reams of Extel cards or back issues of the Investors Chronicle to find your next investment. Hurrah!

Though they're easy to use and convenient, share filters are sadly no magic cure for the difficulties of beating the market. Collectors of quality shares must still use a bit of common sense and perform some good old-fashioned research.

Fooled by figures

Before any screening takes place, users must be aware of their limitations. The main ones to bear in mind are:

1. Accounting nuances:  Accounting has never been a straightforward practice and opinions vary on how to interpret, for example, reported earnings per share and balance sheet figures. This creates problems with related investment statistics, such as the P/E ratio, return on capital and so on.

2. Latest year: Many of the bookkeeping ratios used for filtering are based on one year's accounts and may not be representative of the company's longer-term performance.

3. Old data: Some sources use annual results only and ignore interim figures.

4. Errors: No data supplier is perfect and innocent mistakes in the compilation of the figures can sometimes occur.

Those caveats aside, stock screeners can often be useful tools to help form a 'buy and hold' watch list. So, how should a long-term investor start screening?

Margin

By far the best filter to use to unearth a long-term 'franchise' is the operating margin. With more profit produced from every £1 of sales, a company with a high margin could well have some sort of pricing power over its customers. Such power may stem from limited competition or a strong operational advantage, either of which are attractive features of any buy and hold share. Generally speaking, businesses producing an operating margin of over 15% are worth noting for further research.

However, despite what could be a long list of high-margin candidates (a quick check on one popular stock-screening site provided 119 different firms with margins of 15% or over in the FTSE 350 alone), return on equity, gearing, cash flow, or any other financial ratio, should not be used to shrink the list.

As well as increasing the scope for the aforementioned accounting issues to influence the search, further screens using other financial criteria are likely to exclude some worthy selections. Levels of debt, for instance, can vary among quality companies. On the Qualiport's own watch list, companies such as Imperial Tobacco (LSE: IMT) and Gallaher (LSE: GLH) are able to trade with relatively high borrowings, while others, for example, Renishaw (LSE: RSW) and Rotork (LSE: ROR), favour carrying large piles of net cash. Read more.

Avoid any filters based on valuation as well. If the aim is to build up a watch list, then ensuring the company fundamentals stack up is the first priority. Setting an attractive buy price can only be done after the company has passed the 'quality of business' criterion, assuming the company actually measures up in the first place. And it's this criterion that forms the best share filter.

Basic questions

Long-term investors should first and foremost ask some basic questions about their potential holdings. In particular: Do I understand this business?, which then leads onto: What is the sustainable competitive advantage of this business?

Common sense would suggest the best long-term portfolio performances are achieved from actually knowing something about the activities of the companies held. Needless to say, the competitive advantage of obvious, everyday firms should be easier to determine, and should therefore restrict stock-picking mistakes.

So, a 'circle of competence' needs to be drawn. For the Qualiport, at least, past experience has helped deem nine FTSE industries as no-go zones. There may be a few generalisations within the exclusions, but funny accounts, political interference and covert products are among the unknowns stopping many shares getting a portfolio look-in (for better or worse).

Once a group of understandable businesses with good competitive advantages are located, only then should the accounts proper (ordered via the Fool) be evaluated. Of course, annual reports provide the source data for every stock screener, and all financial ratios should be calculated independently with their figures. Naturally, if the company enjoys a truly sustainable competitive advantage, what's in its accounts should not prove much of a problem.

Where next? Operating Margin | Key Questions For Long-Term Investors | The Ideal Qualiport Company

This article was first published in May 2004.

Portfolio value

Holding	Number of shares	Closing price 29/04/05 (p)	Value (£)
Associated British Ports	681	460.25	3,134.30
Emap	372	794.5	2,955.54
Halma	1,920	145.75	2,798.40
Johnston Press	1,608	495	7,959.60
London Stock Exchange	2,018	461.5	9,313.07
Cash			268.36
Total			26,429.27