Passive Equity Screens & Bargain Purchases

Updated: Feb 20

How to set up Equity Screens

Investors generally use screens to find attractive investing opportunities. The following describes an example of a passive equity screen.

It is important to consider our time horizon, taxes and transaction costs as these costs generally eat away the paper returns. The returns of the strategies driven by passive equity screens are for the long term (five years or longer) and strategies could underperform the market in the short term. Throughout the process, we would have to consider a proper proxy for risk from traditional measures such as beta and volatilities to other measures of risk.

The objective is to look for a mismatch, between the pricing of the company and fundamental drivers of that pricing in order to find cheap companies that do not deserve to be trading at low multiples.

Hence we develop screen and screen the market.

- We screen for price.

- We screen for risk.

- We screen for growth.

- And finally, we screen for the quality of growth as we would have to pay for the growth.

Screening on its own does not lead to success as we have to bring something unique to the table and in this case, we are going to pair screening with intrinsic valuation. We can also add a margin of safety, including only those stocks in our portfolio that trade at an x% (i.e. 40%, 50% or 60%) discount to its intrinsic value.

To screen for price, we look at valuation multiples, either equity or firm value multiples that are consistently defined and uniformly estimated. This means the numerator and denominator are the same claim holder to the firm value or equity value of the company.

Once we pick our multiples, the most suitable way is to look at the distribution of these multiples and take the top or bottom decile or quartile of the data rather than having point estimates, which are used as the upper or lower bound of the multiples for determination of the cheapness of the stock.

To screen for risk, we can look at several categories of risk from operating risk, financial risk to liquidity risk.

For operating risk, we can consider the risks in the revenues and costs and the volatility of operating income as the market or sector evolves.

For financial risk we can consider leverage ratios.

For liquidity risks we can consider the bid-ask spreads or share turnovers (daily trading volume or share float in the market) as well as trading volumes.

Screens for risks can also be categorized into the following:

We can consider price-based measures such as beta or volatility of stock returns.<