A Stockopedia subscriber recently asked if we could help to create a stock screen that reflects the ‘Way II’ strategy outlined by Richard Koch and Leo Gough in their excellent book, The Financial Times Guide to Selecting Shares that Perform. Accordingly we purchased a copy of the title to investigate further and come up with a set of appropriate screening rules.

The chapter entitled ‘Way II’ has two main tenets. First, “identify a few good businesses, and invest in them for the long term.” Then “follow a system that, over time, limits the losses from mistaken and maximises the return from good investments.” Taken together, these tenets constitute a strategy that blends quality and momentum, with a ‘Darwinian’ approach to running profits and cutting losses.  

Identify a few good businesses:

In the first instance, Koch and Gough advise investors to choose “good companies with strong competitive positions”, coupled with a good record of earnings growth. They insist that past winners have a good chance of being future winners, on the basis that “good businesses stay good and bad businesses stay bad.” This is because of the competitive structure that firms operate in. The authors are not prescriptive in terms of quantitative criteria, but note that a competitive company usually has a “real edge in terms of market share and size, brand, technology, service levels or some other structural advantage.”

Our screening rules therefore placed heavy emphasis on Return on Capital Employed and growth in Earnings Per Share. We also selected the Dividend Streak because Koch and Gough recommend companies with 'cultures' and 'ways of doing business' that are conducive to long-term success. The Dividend Streak could be used to identify these companies because regular dividend payments can help to curtail 'inefficient empire building' which inhibit growth. Furthermore, companies that regularly pay dividends should have a good financial position and generate a steady cash flow.

Relative strength is also important because the ‘Way II’ strategy advises investors to pick shares with the highest annualised rate of share price return.  Koch and Gough insist that "we can take an educated guess that some of them will continue to" be "top performers", especially in light of their competitive advantage.

To come up with an appropriate list, we suggested the following screening rules:

  • ROCE% Rank in Market > 80%
  • ROCE% 5y Avg Rank in Market…

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