SIF Portfolio: What would happen if I changed the rules for 2017?

The criteria I’ve used for my Stock in Focus screen fall into two categories. A small number are essential characteristics which characterise the majority of stocks in the portfolio. The remainder are safeguards to avoid ‘outliers’ carrying specific risks.

This week I’m going to highlight some of these key criteria and explain how they work against each other to restrict my choice of stock. Would it make sense to target a broader range of stocks?

Am I too focused on one type of stock?

The SIF portfolio was designed to target affordable growth stocks. The screening criteria include a number of rules whose purpose is specifically to reduce downside risk. This approach reflects my belief in the Warren Buffett rule that avoiding losses is as important as identifying winners.

This conservative approach has often resulted in a restricted choice of stocks. At the time of writing, just four stocks qualify for the screen. I’ve still had some big winners, such as IG Design (+49.5%), Avesco (+132%) and Beximco Pharmaceuticals (currently +60%). But serious growth picks such as Paul Scott success story Boohoo.com (up 255% in one year) have never qualified.

Nor have highly-ranked big cap income stocks such as housebuilders and insurance stocks, even though they’ve performed well since the referendum.

The portfolio will be one year old in April. This will give me a chance to tweak the rules if I want to. Would it make sense to relax certain criteria to capture a broader range of stocks? Or will any gains be offset by an increase in the number of losers?

The key screening criteria

There are four rules which have a huge impact on the number of stocks which qualify for the screen:

• Earnings yield >8%
• Piotroski F-Score >6
• PEG rolling <1.2
• RS 1y >0

That’s only four out of 14 rules. You may wonder what the purpose the other 10 rules serve. I’ll come back to this in a moment, but first I want to explain how the four rules above combine to set a fairly high bar for potential buys.

Value, Quality, Growth & Momentum

You may already have spotted that the four rules I’ve listed above are each classic characteristics of a style of investing:

• Earnings yield (EBIT/EV) = Value
• Piotroski F-Score = Quality
• Low PEG ratio = Affordable growth
• 1-year relative strength = Momentum

Finding a stock that combines all of these attractions is naturally going to be difficult. Value stocks often have poor momentum. Growth stocks often look expensive. And so on.

Removing any one of these four criteria from the screen typically results in a massive increase in the number of qualifying stocks. At the time of writing, reducing the minimum earnings yield from 8% to 4% causes the number of qualifying stocks to rise from four to 15. Attractive growth stocks such as Revolution Bars (Paul Scott comments) now appear in the screen results.

In fact, the revised selection contains a number of stocks which seem suitable for the portfolio at first glance:

Perhaps my 8% earnings yield requirement is weighted too much in favour of value and mature businesses? I may give this some thought when I review the portfolio rules in April, after one year of operation.

Changing the relative strength rule so that RS 1y >-20 has a similar effect, increasing the number of stocks from four to 14:

There’s more of a bias towards value here, I think. A number of stocks are included which were hit hard by the referendum result but have since performed well. Examples include Morgan Sindall and Aviva.

Abandoning this key momentum indicator is a big step. I’m not sure I will. But I might consider adding a small amount of leeway to improve stock choice.

Refining the selection

My core rules are quite tough, as we’ve seen. But my ‘safeguard’ rules then make stock selection even more difficult. The screen contains a number of rules designed to filter out outliers which may meet the core criteria, but still carry specific risks. For example:

• The rolling P/E ratio must be between 5 and 30
• The dividend yield must be greater than 1.5%
• Net debt must be less than 5x net profit
• EPS growth must be greater than 5%
• Forecast dividend growth must be positive
• Sales growth must be positive

Some of these criteria may seem irrelevant at first glance. But most of them are recognised indicators of risk.

For example, a company with a flat dividend and falling sales may be able to deliver rising earnings per share through cost cutting or share buybacks. But the outlook is likely to be uncertain.

These rules don’t usually have a dramatic effect on the screen results. But they do definitely have an impact on the overall appearance of the portfolio. Here are a couple of examples.

Numis

Stockbroker Numis has a StockRank of 92 and passes 13/14 of the SIF screening rules. The only rule on which it fails is that sales growth is expected to be negative over the next twelve months, even though earnings per share are expected to rise:

This is an excellent example of a company which meets all of my core criteria but does not qualify as a result of its unusual valuation and poor earnings visibility.

In his small cap value report on 7 December, Graham Neary commented that while Numis is heavily cyclical, its recent track record suggests a higher rating might be justified.

Pan African Resources

I sold Pan African Resources from the portfolio in January. But a quick check today shows that the only reason why Pan African no longer qualifies is that the dividend is expected to fall this year.

A dividend cut is always a concern. Worryingly, this appears to be a symptom of a spectacular collapse in momentum. Pan African’s StockRank has fallen from 93 to 68 since the start of December. This is solely because the stock’s MomentumRank has fallen from 75 to 14 in less than two months.

Consensus net profit forecasts have fallen from £52m in December to £38.2m today. A 17.7% reduction in share count means that earnings per share are still expected to rise, but this is a major downgrade:

Pan African fits the profile of a contrarian play, with high Quality and Value ranks. But there appears to be a new risk here. The stock no longer fits the well-rounded profile I’m seeking for the portfolio.

Should I change?

There’s much food for thought for me here as the portfolio’s first anniversary approaches. I won’t be making huge changes to the rules, but I may consider some small tweaks to improve stock choice and the diversification of the portfolio.

As always, I’d love to know what you think. Am I simply too impatient, or does it make sense to target a broader range of stocks?