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Passive Equity Screens & Bargain Purchases

Updated: Jan 18, 2023

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.

We can consider accounting-based measures such as ICR or Fixed charge coverage ratios.

We can consider risk proxies and broad categories such as technology firms as riskier and utilities as safer, or we could focus on the capitalization of the company with larger cap companies or companies with higher revenues assumed safer.

We can look for sector specific ratios such as regulatory capital ratios in banks and financial services firms.

To screen for growth, it is best to look at forward expected growth rate rather than historical growth as valuation is forward looking. It is important to remain consistent and if we are looking at equity-based multiples to consider growth in net income and if considering enterprise value-based multiples, to consider growth in operating earnings.

To screen for quality of growth, of course, ROE and ROC are suitable accounting-based measures to ensure the firm is not spending too much to deliver that growth. Other measures include sector specific measures (i.e. invested capital per unit of revenue drivers, invested capital per KWH of power generated or invested capital per subscriber)

And we repeat the process until we arrive at a suitable list.

There are two important issues as we go through the results:

- If the sample size we arrived at is small, the screens are too tight and we have to relax the upper or lower bounds.

- If there is sector concentration in the results or bunching up, then we have to modify the screens as it appears that there is a risk factor or a factor, being size or sector related measures that we are not integrating, in order to arrive at a more diversified portfolio of results.

To recap we would look for cheap companies with low leverage and stable growth prospect and liquid assets. We can increase our protection against price movements by introducing a margin of safety as well.

That bring us to Kirkland’s Inc. (“KIRK” or the “Company”) intrinsic valuation.

Kirkland's Inc., A Significantly Undervalued Home Furnishings Stock

The stock of this discretionary, home furnishings retailer crashed during the pandemic trading at pennies and has bounced back ever since. 73% of the public float is owned by institutional investors, 5.57% is owned by the management team, board and insiders and the remaining 22% is public float. As of July 17, 2021, with an intrinsic value of $34.79, the stock is 81% undervalued (return to target of 81%). Hence, given the progression of remote work and increased demand for the products as well as the supply chain hick ups, the beaten up, micro-cap, cyclical stocks such as KIRK are good post pandemic economic recovery trades. Generally, value, low sized and high yield stocks tend to do well during the early stages of the recovery in an economic cycle. For a comprehensive report on this company, "A Significantly Undervalued Home Furnishings Stock in the post pandemic Market”, please visit Basic Modelyze.


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