In an article published by Fairfax media today, a division director at Macquarie Securities, Jason Todd, shared the results of a screening test he used to identify stocks with sustainable, reliable and growing earnings over the next few years.
He screened for:
- Positive revenue and profit growth out to 2018
- Profit growth of at least 5% per annum for the next two years
- Return On Equity (ROE) above 10%
- Excluded stocks that have a high ROE due to debt or rising revenues
- Excluded stocks with net debt of more than two times Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA)
- Stocks must generate free cash flow over the next two years
It's a fairly exhaustive list, but it generated a surprising amount of good businesses including gold miners Northern Star Resources Ltd (ASX: NST), EVOLUTION FPO (ASX: EVN), Myob Group Ltd (ASX: MYO), Fisher & Paykel Healthcare Corp Ltd (ASX: FPH), Cochlear Limited (ASX: COH), James Hardie Industries plc (ASX: JHX), Link Administration Holdings Ltd (ASX: LNK), and Domino's Pizza Enterprises Ltd. (ASX: DMP).
Among the smaller cap stocks identified were Retail Food Group Limited (ASX: RFG), G8 Education Ltd (ASX: GEM), Virtus Health Ltd (ASX: VRT), and Mortgage Choice Limited (ASX: MOC).
It looks like a great list, but would-be buyers need to remember that it was generated through screening tools (with the criteria listed above) and not all stocks that fit the criteria are necessarily a buy right now.
Some stocks like Domino's, Fisher & Paykel, and Cochlear need a closer look before buying, given that they are all trading north of 30 times earnings – double the ASX average. There might not be a margin of safety available at these prices.
Other stocks like Myob, Northern Star, and Evolution face either competitive threats, or the value of the commodities they produce (gold) is outside their control, which might make them unsuitable for investors.
