This screen finds stocks that would make it into Morningstar's Wide-Moat Focus strategy.
You may be familiar with the "magic formula" proposed by legendary manager Joel Greenblatt. It's a simple strategy to find attractive stocks.
The magic formula looks for companies with the best combination of return on equity and earnings yield--in other words, highly profitable companies whose stocks are cheap. The strategy works remarkably well.
Independently of Greenblatt, Morningstar has been following a version of the magic formula for years--and we're happy to say it works, too. Instead of looking at ROEs, we use our own Economic Moat Rating as our quality screen.
We focus on firms with wide economic moats, which means that we think they can sustain high returns on capital for 20-plus years. And by return on capital we mean return on invested capital, defined as net income before interest as a percentage of debt, equity, and net working capital. It's a measure that allows for better comparisons across companies of different capital structures. (Companies can boost their ROEs by taking on more debt leverage; ROIC measures the return on the total capital employed by the business, both equity and debt.)
For our valuation screen, instead of earnings yield we use the fair value estimates assigned to each stock by our analysts. This fair value incorporates our long-term forecasts of free cash flow, so it's less sensitive to year-to-year fluctuations than a single-year metric like ROE. We rank stocks by their price/fair value ratio, or P/FV. The lower this ratio, the cheaper the stock in our opinion.
That's all we need: economic moat and P/FV. To form our portfolio, we simply take the 20 wide-moat companies with the lowest P/FV ratios each quarter, equal-weight them, and let the market take care of the rest.
This simple strategy has returned an annualized 16.2% since its inception in 9/30/02, compared with 7% for the S&P 500. Over the trailing three- and five-year periods, it has returned 5.8% and 10.3%, respectively, compared with negative 5% and 2.6% for the S&P 500.
For this issue's stock screen, we'll showcase the companies that would make it into the Wide Moat Focus portfolio if we rebalanced as of early May.