Spotting 'Way IV' Winners

20th Oct '14 by Alex Naamani

4 comments 21800 reads

A Stockopedia subscriber recently asked us for help in creating a stock screen that reflects the ‘Way IV’ investing strategy outlined by Richard Koch and Leo Gough in their excellent book, The Financial Times Guide to Selecting Shares that Perform. It’s an approach that endeavours to find dynamic growth companies. Using guidelines from the chapter titled ‘Way IV: Detecting earnings acceleration’, we came up with a set of screening rules and had a look at some of the companies that currently make the list.

Backing the horse after the winning post

Koch and Gough believe that companies with higher growth prospects deserve a higher PE ratio. For example, firms with what they describe as ‘accelerated earnings’ deserve PE ratios of 30 or over, while companies in ‘slow lane industries’ should trade on a PE of around 8. Accordingly, investors could pay a higher price for companies that enjoy a favourable industry tailwind. Such a tailwind may occur when a firm starts to make a 'product where demand is expanding rapidly, like semi-conductor chips in the 1960s, Filofaxes in the 1980s, telecoms in the 1990s or oil in the 2000s.'

According to Koch and Gough, investors could make a profit from investing in companies that have already enjoyed an earnings growth tailwind for a number of years. As such, investors could 'back the horse after the winning post'. This is because 'the market is often unduly sceptical about the sustainability of profit surges'. Companies therefore require 'a long track record before' the market is 'willing to believe that earnings will continue growing.' Koch and Gough thus explain that a company 'often reaches its peak’ price ‘after its period of maximum earnings growth.'

Building a Way IV Screen

While Koch and Gough do not offer a definitive set of rules, they do provide a questionnaire which is designed to measure the prospective growth rates of a company. These are the questions they pose.

How much has operating profit in the last two sixth-month periods gone up?

What does the pattern of operating profit growth look like in the past six to ten half-year periods?

Has earnings per share history broadly been similar to the operating profit history above?

Based on your best guess at extrapolating the past numbers, would you expect annual earnings growth in the next two to three years to average?

Repeat question…

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ajsmck

22nd Oct '14

Please correct me if I am wrong but with regard to the 5th and 6th criteria, I believe these should be >= rather than just >. Specifically, if the company qualifies at the border line, where the parameter is described as being inclusive of said border, then your screen, as shown above, would discount it in error.

So your screen should be:
...
5. EPS Streak >= 5
6. Mkt Cap >= £20

Alex Naamani

Hi ajsmck,

Thanks for this feedback. I can see where you're coming from, but I don't think it would make too much of a difference. The number of qualifying shares is the same (8) if you use '>' or '>='.

Re 5. - Perhaps a 6 year streak may be a bit harsh given the recent recession, but you can of course edit the rules.
Re 6. - It is quite unlikely that a company will qualify exactly at the borderline (ie. £20,000,000=00).

What do you think?

Alex

sunnylands

9th Nov '14

I THINK IT IS FASCINATING TO READ BUT DO FEEL THAT ONE OF THE MOST IMPORTANT FEATURES IN ASSESSING HOW SAFE IT IS TO INVEST IN A COMPANY IS HOW MUCH DEBT IT BURDENED WITH AS NEAR DEBT FREE A COMPANY IS MAKES IT FAR MORE SAFE TO INVEST IN.

Miserly Investor

"Several of the companies that qualify for the screen have enjoyed a strong industry tailwind in recent years. Barratt Developments (BDEV) and Galliford Try (GRFD) are both in the cyclical housing industry and have therefore benefited from Government’s Help to Buy Scheme and the wider economic recovery.
...
It is also interesting to note that some of the companies which qualify for the screen have a relatively low P/E ratio. Galliford Try for example has a PE of just 12.3, while Barratt Developments trades on a multiple of 13. This supports Koch and Gough’s argument that the inefficient stock market can sometimes be slow to factor growth prospects into the stock price."

It is however worth thinking through the reliability of such methods with cyclical industries such as housebuilders. For example takes Barratt's "relatively low" P/E of 13. Does this make it better or worse value?

To illustrate the point, take BDEV's share price at its peak, on 6 February 2007 before the credit squeeze set in when it was 1,289p (note: this was the contemporaneous price rather than the rights issue adjusted price as you would see on the Stockopedia chart for example). At this point in time, at its most expensive, the P/E ratio was just 11.

Conversely, take BDEV at a point in time when quite a few value investors (including myself) were taking positions, say at 70p in November 2010. This was after some years of losses and even on a forward P/E the measure was very high indeed. But the company was an absolute steal at this price.

So in cyclical industries I think P/E ratios can be very misleading indeed. (And as an aside, in this case, price to book value was singularly a far more useful indicator).

@miserlyinvestor

Spotting 'Way IV' Winners

Backing the horse after the winning post

Building a Way IV Screen

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Alex Naamani

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