How to find good quality shares at reasonable prices

It’s often said that beauty is in the eye of the beholder. For some, it’s about aesthetics and the appeal of shape and form. But for others, real beauty is found in qualities that aren’t always obvious.

In the stock market, the same subjectivity applies to company quality.

Unlike other broad investing themes, such as valuation and momentum, quality doesn’t really have a precise definition. That said, many would agree that quality is a broad measure of business strength, financial health and accounting stability.

In other words, a high quality company is one that’s very efficient at generating sustainable, exceptional profitability. Its finances are improving over time and there aren’t any accounting red flags to worry about.

At the other end of the spectrum, a low quality company is one where profitability is non-existent or intermittent. Its financial health is shaky, with debts and cash flow a concern, and the red flags of weak finances show it to be a risky investment.

With this in mind, owning shares in high quality, “beautiful” companies makes lots of sense to many investors. Indeed, it’s the signature strategy of some of the world’s most respected stock pickers.

Yet because quality can mean so many different things (and be measured in many different ways), knowing what to look for isn’t always obvious.

There are numerous financial ratios that can help. Indeed, there are entire frameworks for finding economic ‘moats’ or understanding a company’s competitive environment - and these can be very useful ways of finding out just how good a company is.

But day-to-day, any investor with even half an eye on financial strength (and whether it’s good or bad), needs a go-to checklist to see where the strengths and weaknesses are.

A quality checklist can be a useful part of any investment strategy. It can be particularly useful in trying to understand potential mispricings and where the market is unfairly marking down the prices of quality stocks that have, for some reason, fallen out of favour.

Why quality checks can improve any strategy

Buying high quality stocks is a tried and trusted approach to the stock market. Warren Buffett, the billionaire legend of company investing, forged a long and formidable reputation for profiting handsomely from owning what he describes as “wonderful” businesses.

From an academic standpoint, research in this area has accelerated in recent years. So much so that quality is now a well understood factor and influence on investment returns from shares.

But for regular investors, the challenge with high quality is that the market often prices it accordingly. High quality often results in equally high popularity and, as such, high prices. Companies that enjoy strong profitability and solid finances often end up being some of the best loved stocks in the market - and they rarely look cheap.

For this reason, it can make more sense to focus on finding companies where financial quality is on an improving trend. Rather than focusing on current high quality, it may be preferable to find stocks that are in the process of improving their finances.

It was with this in mind that a finance professor called Joseph Piotroski, introduced a checklist called the F-Score back in the year 2000.

A checklist to assess financial health

Professor Piotroski’s research showed that it was possible to make predictions about stock returns by studying the trends in company accounts. He came up with a nine-point checklist that could be applied to any company. The higher the score (out of nine) the more promising its health trend was.

Crucially, it was designed to look back over a company’s previous accounts and detect the most important signs of improvement or deterioration.

Here’s a breakdown of what Piotroski’s health trend checklist looks for (together with the accounting measures he looks for):

Profitability

The first four tests look for a positive earnings trend and the company’s ability to generate cash:

• Is the company making a profit?

(positive net income in the current year)

• Is it generating cash?

(positive cashflow from operations in the current year)

• Is it making more cash than it's reporting as profit?

(Return on Assets is higher than the same period last year)

• Is it more profitable than it was last year?

(cash flow from operations exceeds net income before extraordinary items)

Leverage, liquidity, and source of funds

The next three tests look at how the company is financing itself and whether this poses a financial risk:

• Is the company's long term debt reducing or stable?

(long term leverage is lower than the same period last year)

• Is it increasing its ability to pay short term debts?

(current ratio is higher than it was last year)

• Is the company trading without having to raise funds from shareholders?

(the company has not issued new shares)

Operational efficiency

The final two checks look at the efficiency of the company, with a focus on margins and how good it is at generating sales:

• Is pricing power improving and/or are costs reducing?

(gross margin is higher than last year)

• Is it more productive than last year?

(asset turnover ratio has improved)

Hunting for quality in the market’s cheapest stocks

A crucial point about Piotroski’s work is that he actually designed the F-Score as a way of analysing the very cheapest stocks in the market and detecting which of them were most likely to re-rate in price. He supposed that those with the strongest financial health trends would do the best - and his research proved him right.

In the years that followed, Piotroski’s F-Score checklist became a general rule-of-thumb for finding high quality shares anywhere in the market. Part of the appeal is that it’s essentially an entire assessment of quality and fundamental momentum in a single number.

Screening for cheap, high quality stocks

In the hunt for high quality, underpriced stocks, Piotroski used ‘price-to-book’ value as his preferred valuation measure. But his quality checklist can be used with any version of value - plus, of course, any other set of rules - that you prefer.

In this screen, I’ve combined a search for companies with a valuation in excess of £1 billion, with a Piotroski F-Score of 7 or greater and an Earning Yield of more than 5%.

Earnings Yield tells you how much profit a company is making in relation to its underlying value. It compares profit with market valuation (worked out by dividing the company’s operating profit by its enterprise value). It gives you a total value of the stock (including its cash and debt), which makes it easier to compare different stocks. As a percentage, the higher the Earnings Yield, the better value the share.

To use the F-Score in a screen, click Add Rule and either search for Piotroski F-Score or select Quality and then find it under Earnings Quality.

The resulting rule in the screener gives you the option to choose what F-Score you’d like to see in the companies it finds. In this case, I’ve chosen a minimum of 7.

In the final set of rules, I’ve included an Earnings Yield of at least 5%. This screen looks for stocks with a minimum of £1bn and excludes financial securities.

Here is what the results look like. You can Copy, Edit and Save this screen here.

In search of quality at a reasonable price

In summary, quality is an instinctively appealing characteristic in stocks, yet knowing how and where to find it isn’t necessarily easy. In broad terms, quality is an assessment of business strength, financial health and accounting stability - and those stocks that score well against these tests are often some of the most in-demand securities.

While quality isn’t always a factor that’s rewarded by the market (like other factors, it has phases of being out of favour), it’s a formidable force and can also act as a catalyst when combined with other factors, such as value. Joseph Piotroski’s combination of his own accounts-based quality checklist with some of the cheapest shares in the market proved to be an effective strategy. But a broader lesson from this approach is that a keen eye on quality characteristics can be a useful extra check in nearly any strategy.