How to Screen for Quality Stocks in a Market Sell-Off
Author: Charu Chanana, Chief Investment Strategist
Key Points
- A market sell-off can present investment opportunities if investors can differentiate between temporarily lower prices and fundamentally weak businesses.
- To identify quality companies, investors should look for strong growth, healthy margins, solid returns on capital, low leverage, and positive free cash flow.
- Examples of companies that emerged from the screening process include Nvidia, Microsoft, Meta Platforms, and Adobe in the US, and Novo Nordisk, Barrick Mining, and Experian in non-US markets.
Importance of Screening in a Sell-Off
During market downturns, all stocks tend to be marked down, making it difficult to distinguish between strong and weak companies. The focus should be on identifying businesses that can maintain growth, defend margins, generate cash, and remain self-sufficient despite challenging conditions.
Screening Methodology
Base Universe
The screening process began with two primary universes:
- US Screen: Active, primary listed US companies with a market cap above USD 25 billion.
- Non-US Screen: Active, primary listed companies in Western Europe, Asia, and Canada with a market cap above USD 10 billion.
Quality and Resilience Filters
The following criteria were applied to filter for quality:
- 52-week high change percentage: below 20%
- Revenue growth (5-year CAGR): above 10%
- Operating margin: above 20%
- Return on invested capital: above 10%
- Free cash flow yield: above 2% for US, above 4% for non-US
- Net debt to EBITDA: below 2
- Return on common equity: above 15%
Valuation Discipline Filters
To ensure quality stocks were not overvalued, the following filters were added:
- Forward 12-month P/E: below 25
- Forward 12-month PEG ratio: below 1.5
Results of the Screening
US Large-Cap Screen
The screening narrowed the US universe to 8 notable companies:
- Nvidia
- Microsoft
- Meta Platforms
- Micron Technology
- AppLovin
- Newmont
- Adobe
- Autodesk
Western Europe, Asia, and Canada Screen
The non-US screen produced a list of 10 companies:
- Novo Nordisk
- Zijin Mining Group
- Barrick Mining
- Pop Mart International
- Experian
- Kinross Gold
- Pan American Silver
- Evolution Mining
- Genmab
- Endeavour Mining
Insights from the Screening Process
- Quality does not always equate to defensive stocks; some may still be sensitive to market cycles.
- Strong margins and returns indicate businesses with pricing power and market position.
- Valuation filters help avoid overpaying for quality stocks.
- Balance-sheet strength is crucial for identifying companies that can withstand volatility.
- The non-US screen offers a broader perspective, highlighting different sectors and opportunities.
Conclusion
The screening framework is beneficial for identifying companies that are likely to perform well in uncertain market conditions. It emphasizes the importance of proven growth, profitability, capital efficiency, cash generation, and manageable leverage. However, it is essential to conduct further research beyond the screening results to understand the underlying factors affecting stock performance.