Not all investors would be looking at capital appreciation as the only way to judge a stock's quality. As the 2008-09 economic downturn has proved that stock values could decline much below fair values despite companies having strong fundamentals, stocks which offer good short-term returns (through regular dividends) and long-term appreciation (not necessarily the best-in-class but above industry peers) will always be attractive investments.
I used the following parameters in the Gridstone Screener to screen the entire Technology stock universe and arrive at the top stocks that can be considered for investor portfolios with the above investment objective in mind:
1. Dividend Payouts and Operating Asset Acquisition Ratio [DPOAAR]: This was defined as =(TTM Dividends payouts+ Acquisition of businesses,net)/TTM EBITDA). Since technology companies typically have a higher free cash flow, they either tend to use them to pay dividends or 'acquire' companies/business operations that are typically complementary to their existing business model. If DPOOAR is consistently higher, it means that the company either (1) pays substantial dividends or (2) deploys its free cash flow by acquiring businesses to increase returns for its shareholders or (3) does both. For this stock selection, I only considered companies which had spent at least 10% of their TTM EBITDA in both 2007 & 2008 for dividends or asset acquisitions (i.e. DPOAAR of at least 0.1 for both 2007 & 2008).
2. The best way to judge whether deploying cash as described above has yielded results is to check both operating income growth and Return On Equity (ROE). If operating income has grown in the periods post acquisition and ROE is also pretty high, it indicates that the acquisition of assets or organic growth has been good and therefore resulted in better returns for shareholders. This also reflects the company management's ability to spot good investment opportunities and look away from bad acquisitions which can destroy shareholder value. If the management feels that their company generates a lot of excess cash which have no 'planned use' in the medium term, it should ideally return the monies to shareholders (through dividends or share-buybacks) so that the individual investors can decide how to allocate this capital. Therefore the lower cut-off for ROE was kept at a stiff 15% for the TTM (trailing twelve months) period while the lower cut-off for growth (3-yr CAGR) was kept at 10%.
3. The list of stocks was restricted to mid-caps and large caps i.e. Market capitalization of >$2B as I was looking at companies in the 'mature growth' phase rather than 'nascent growth' phase.
4. As has been the case in my earlier articles on stock selection based on specific themes (you can read them here and here), I excluded stocks which are expensive. In this case, the P/E upper cut-off has been kept at 50. Another screening criterion used was the Net Debt/EBITDA ratio as companies which assumed higher levels of debt to fund acquisitions are also a strict no-no. Only companies which have a debt/EBITDA ratio of <2 have been considered for selection.
A summary of the screening criterion used in the Gridstone Screener is given below:
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Source: Gridstone Research
Based on the criteria used above, the top stocks which satisfied the criteria are given below (ranked in descending order of TTM ROE):
1. IBM - IBM corp.
2. INFY - Infosys
3. SAP - SAP AG
4. BR (incidentally a spin-off of ADP) - Broadridge
5. ADP - Automated Data Processing Inc.
6. GRMN - Garmin
7. WIT - Wipro
8. ORCL - Oracle
9.HPQ - Hewlett-Packard
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Source: Gridstone Research
Barring BR (Broadridge), the other stocks in the list are well-known names and therefore I will not get into a discussion on each of these stocks. However it would be sufficient to say that looking at this list, the one common theme around them seems to be 'Management Quality', i.e. the ability of the management team to execute on its strategies.
Great companies need not necessarily have a visionary CEO (there can be only one Apple (NASDAQ:AAPL)) who can envision and create wildly successful product/service franchises. They can be like IBM or HPQ (or others in the list above) which can build and grow successful businesses through superior execution skills.
Disclosure: Long INFY