This article by Adam Ritt, BetterInvesting's director of communications and editor in chief of BetterInvesting Magazine, includes discussion of companies that are mentioned only for educational purposes. No investment recommendations are intended. Note that Ritt owns shares of one of the companies mentioned: Skyworks Solutions.
BetterInvesting's approach to investing in stocks comprises several common-sense ideas. Those of us employing the BetterInvesting methodology seek the following types of companies:
1) They've proven they can grow sales and earnings. We want to be able to study at least five years of fundamentals, mainly sales, earnings per share, pretax profitability and return on equity. This criterion means excluding IPOs and companies that haven't generated profits. Ideally, we'd have 10 years of fundamentals to study to see how a company behaves through an economic cycle.
2) They're growing at rates suitable for their size. For small companies with less than $1 billion in annual revenues, that means 12% or more. For midsize companies with annual revenues of $1 billion to $10 billion, the minimum we seek is 7% a year. For large companies, the minimum is 5%.
3) They've shown consistent growth in sales and earnings, which indicates quality management. Underpinning BetterInvesting's approach is the idea that the most important driver of a company's success is its management.
4) They have stable or growing pre-tax profitability and return on equity. These are further tests of management ability.
As a starting point for studies, screening can provide help. BetterInvesting-style investors ask a lot of their companies, and few online services provide the fundamental data required. One of the services that does is MyStockProspector.com, which is operated by ICLUBcentral, a subsidiary of BetterInvesting.
For this screen, we'll seek companies in the midsize category with annual revenues between $1 billion and $10 billion. Companies in this range occupy a sweet spot in investing: Quality companies exhibit growth that's still significantly stronger than the general economy's growth while being more financially secure than small companies.
As mentioned above, we also want long-term annual sales and EPS growth of at least 7%. Consistent growth is preferred, because it's an indicator of quality management and, when we conduct our stock study, provides more assurance when we forecast future growth rates. That's where the R2 calculation comes in. R2 is a measure of consistency with a maximum of 1.0; the closer the number is to 1.0, the straighter the line on a graph. For this screen we've asked for an R2 for earnings and sales growth of at least 0.80.
To evaluate management further, we look for companies for which the pre-tax profitability and return on equity trends are at least stable. The screening program compares recent PTP and ROE results with the five-year average. To winnow the candidates a little more, we've added a criterion for a five-year average ROE of 15% — that's a high standard. Finally, we asked for a debt-to-equity ratio of 33% to help ensure financial strength (we admit that this is a somewhat arbitrary measure and that there are plenty of financially secure companies with higher ratios).
Assessing a stock's valuation requires a lot of judgment by the investor and isn't easily assessed via a screen. But we've found that high-P/E stocks often provide disappointing returns over the long term, and many BetterInvesting-style investors are wary of stocks selling at a P/E above 30.
Six companies made the final cut: Fastenal (FAST), F5 Networks (FFIV), Gentex (GNTX), Skyworks Solutions (SWKS), T. Rowe Price (TROW) and Tractor Supply (TSCO). Again, a screen is just the starting point for studies; companies sometimes look great in stock screens but their story falls apart under scrutiny.
Once we see that a company has these characteristics, we'll study the stock's investment potential. We'll do this by making four estimates: the company's five-year annual sales growth rate, its five-year annual EPS growth rate, the stock's average annual high P/E, and the potential low stock price. Using our Stock Selection Guide, we'll be able to understand a company's quality and investment potential.
Disclosure: I am/we are long SWKS.