A Stock Screen with a Forward-Looking Twist

The following screen applies some of the principles outlined in my book, Quantitative Strategies for Achieving Alpha (McGraw-Hill, November 2008), to the current market. The current bear market has taken down valuations on even the best U.S. corporations to levels not seen, in many cases, since the late 1970s and early 1980s. So, my belief is that both the intermediate and long-term investor may find significant value among the rubble of the current market.

The screen below utilizes four of the seven basics presented in my book: profitability, valuation, cash flow, and red flags. However, it turns another building block from the red flags category on its head—more on this later.

First, the screen looks for companies with return on invested capital greater than 15%. ROIC measures a company's after-tax operating profit as a percentage of total invested capital—it tells us what kind of a return a company is able to generate for shareholders, including the effects of leverage. Return on equity could easily be substituted for ROIC.

Second, the screen looks at companies whose enterprise value to EBITDA multiple is less than six. EV to EBITDA (earnings before interest, taxes, depreciation, and amortization) is a very widely used valuation metric, and works well quantitatively. Enterprise value is the theoretical total value of the company, including debt, equity, and cash. EBITDA can be thought of as operating income before depreciation and amortization charges. Price-earnings ratio could be substituted for EV to EBITDA. In this case, I'd use a p-e ratio below 10.

The third factor is free cash flow to operating income, which must be greater than 75%. This factor makes sure that a company is generating cash, as well as accounting income. Free cash flow is calculated as cash from operating activities over the past 12 months minus capital expenditures. Operating cash flow to net income could be substituted for this ratio.

The fourth factor requires that total debt to EBITDA be less than 30%. Total debt represents long-term debt plus debt found in current liabilities. We include this factor to ensure that the company does not have significant credit market risk. Other debt coverage ratios (such as debt to equity) would work, as well.

The final factor—capital expenditures to property, plant, and equipment—has been turned on its head for this screen. Capex to PP&E measures capital intensity, the amount of capital necessary to manufacture a company's goods or provide services. Generally, companies with high capex to PP&E ratios underperform. However, our research shows that companies that invest significantly in plants and equipment during an economic downturn subsequently outperform. Thus, the screen requires that capex to PP&E, over the past year, be greater than 30%.

To sum up, here's the list of criteria I used:

* Return on Invested Capital greater than 15%

* Enterprise Value to EBITDA less than 6

* Free Cash Flow to Operating Income greater than 75%

* Total Debt to Invested Capital less than 30%

* Capital Expenditures to Property, Plant, and Equipment greater than 30%

And here are the dozen stocks that resulted from this screen (using data available as of Feb. 27, 2009):

Quantitative Stock Screen
Company Symbol Market Cap ($mil) ROIC EV/EBITDA FCF to Oper. Income TD/EBITDA Capex to PP&E
Autodesk ADSK 2,872 30% 3.2 124% 6.7% 75%
Robert Half International RHI 2,326 24% 4.0 90% 0.7% 49%
T. Rowe Price Group TROW 5,820 20% 5.7 87% 0.0% 36%
Adobe Systems ADBE 8,754 19% 5.3 110% 28.2% 36%
EZCORP EZPW 467 18% 5.2 87% 11.2% 41%
QLogic QLGC 1,118 16% 3.3 98% 0.0% 31%
Sapient SAPE 488 15% 4.9 122% 0.0% 55%
Comfort Systems USA FIX 368 16% 3.4 126% 13.1% 47%
Accenture ACN 17,729 77% 4.8 96% 0.2% 38%
NeuStar NSR 1,221 18% 5.3 87% 9.1% 40%
Net 1 UEPS Technologies UEPS 806 23% 5.7 94% 26.1% 71%
Teradata TDC 2,721 36% 5.9 117% 0.0% 39%
Before it's here, it's on the Bloomberg Terminal.