Investing

A Reliable Screening Strategy For Good Quality Growth Companies

For 2021 through the end of May, the S&P 500 Growth index posted a total return—including dividends—of 8.2% while the S&P MidCap 400 Growth index and S&P SmallCap 600 Growth index had year-to-date total returns of 11.2% and 14.7%, respectively. The strength of growth investing is also reflected in the return of the Nasdaq 100 index, which includes the 100 largest nonfinancial companies listed on the tech-heavy Nasdaq Stock Market. For 2021, the Nasdaq 100 had a price gain of 13.0% through the end of May.

Our Inve$tWare Quality Growth screening model has shown solid long-term performance, with an average annual gain since 1998 of 10.8%, versus 6.5% for the S&P 500 index over the same period. For 2021 (through June 30), AAII’s Inve$tWare Quality Growth screen posted a gain of 31.2%.

A Screen for Quality Growth

The Inve$tWare Quality Growth methodology is based on the National Association of Investors Corporation’s (NAIC) philosophy of selecting reasonably priced stocks of “good quality” companies that merit further investigation. The NAIC adopts a simple buy-and-hold, fundamental approach to growth investing.

The “good quality growth companies” come from those companies whose historical track records indicate the capability of doubling an investment in five years—a compounded annual growth of around 15%.

The NAIC is a nonprofit association whose membership consists of investment clubs and individual investors. NAIC was founded in 1951 with a mission to provide a program of sound investment information, education and support that helps create successful, lifetime investors.

The evaluation and selection of companies is generally accomplished using the NAIC’s Stock Selection Guide (SSG)—a form that is used to guide the investor through some simple steps to determine if the company is a good candidate for investment and if the price of the stock is reasonable.

Inve$tWare is the producer of the NAIC’s primary software product, the Investor’s Toolkit, which supports and implements the NAIC Stock Selection Guide. Inve$tWare has helped to develop a growth screen for AAII’s Stock Investor Pro software using the NAIC approach.

Investors Seeking Good Quality Growth Companies

The Inve$tWare Quality Growth screen’s criteria revolve around management’s performance as evidenced by the company’s track record, influenced to some degree by its stage in the life cycle of a typical corporation.

The Inve$tWare Quality Growth screening strategy seeks to identify growth companies with:

  • Sales over the trailing 12 months greater than or equal to $100 million,
  • At least five years of public trading,
  • Growth in sales of at least 7% a year over the last one-, three- and five-year periods as well as fully diluted earnings per share from continuing operations of at least 14.9% over the same periods,
  • Coefficient of determination (R2) over the last seven years for sales growth and fully diluted earnings from continuing operations growth greater than or equal to 95%,
  • Operating margin for the last 12 months greater than or equal to 95% of the company’s five-year average operating margin,
  • Operating margin for the last 12 months greater than or equal to the industry’s median operating margin for the same period,
  • Return on equity (ROE) for the last 12 months greater than or equal to the industry’s median return on equity for the same period and
  • Estimated growth rate in earnings per share of at least 14.9%.

Minimum History

The first two filters in the screen seek to find companies with a minimum of $100 million in sales and whose stock has been publicly traded for at least five years. These criteria attempt to eliminate the speculative companies with insufficient history or experience.

The remaining filters address the issue of a company’s “quality”—i.e., its suitability for inclusion in a long-term portfolio. Alluding to this issue of quality, Thomas E. O’Hara, one of the founders of the NAIC, cites a few critical management tests that the company must pass to be considered a suitable candidate.

Minimum Sales Growth

The first major question to be answered deals with sales growth. If management can market and sell enough of the company’s products or services every year to surpass the previous year’s by an average of 7% to 15% or more (depending upon the size of the company), it passes the first test. The screen requires that the compound growth of sales for the past one, three and five years be greater than or equal to a benchmark that factors in the size of the company (determined by annual sales). This benchmark requires a minimum of 7% sales growth for a company with approximately $4 billion or more in sales; the minimum required growth is increased to approximately 12% for companies with sales of $400 million or less. The smaller the company, the greater the risk and the greater the reward.

Earnings Growth

The second major quality test deals with earnings growth. If management is able to demonstrate that, historically, it has been able to increase shareholder value by growing its earnings per share by an average of approximately 15% each year, it passes the second test. The filter retains only those companies whose earnings from continuing operations equal or exceed a compounded growth of 14.9% for one, three and five years.

Testing for Sales and Earnings Stability

Stability of earnings is an important factor to consider along with the absolute level of earnings growth. The R-squared, or the coefficient of determination (R2) over the last seven years was calculated for both earnings and sales. The R-squared is a measure of the degree to which plotted data falls on or close to the trendline for the data used to calculate the least-squares growth rate. If all of the plotted points fall precisely on the line, the coefficient of determination would be 100%. If none of the points bears any relationship to the trendline (which can still be mathematically calculated), the value would be zero. Thus, a higher value for R-squared indicates a higher degree of stability or predictability for the plotted points.

The AAII Inve$tWare Quality Growth screen requires an R-squared of 95% or higher for both sales and earnings over the last seven years. This high R-squared helps to identify if the company’s long-term growth is stable enough to be reasonably predictable.

Profit Margins

The next test looks at the historical operating profit margins. If those margins are above average when compared with other companies in its industry, and there is no downtrend to indicate that management’s control of its costs is slipping, then management passes the test. Acceptable levels of profit margins vary widely by industry, so it is important to compare a company’s performance against industry norms. The filter requires the company’s operating margin to exceed the industry median, and it looks to see that the operating margin for the most recent 12 months exceeds the average of the past five years.

Return on Equity

Next, the AAII Inve$tWare Quality Growth screen looks at the same criteria with respect to management’s ability to achieve the best return on equity. A favorable comparison of the most recent 12 months’ ROE with the industry’s median passes this test.

Expected Earnings Growth

The filter looks at future earnings growth and enlists the consensus of the analysts that follow the stock to determine if, in their collective opinion, the company could be expected to grow its earnings per share from continuing operations at a rate that would double in five years—a 14.9% annual growth rate.

Closer Scrutiny

The goal of the AAII Inve$tWare Quality Growth screen is to accomplish the broad task of finding quality growth companies worthy of further analysis using principles put forth by the NAIC. Some of these companies may not pass your more rigid qualifying characteristics or may fail to pass your valuation testing. However, within this group you may be able to find companies that satisfy your need to select from a variety of industries or various size companies.

Stocks Passing the Inve$tWare Quality Growth Screen (Listed Alphabetically)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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