The Value & Growth strategy screens for investment opportunities by building a ‘Buy List’ of what it considers to be the best candidates. This is done by first filtering the V&G strategy’s trading list and then scoring the remaining shares using a 5-factor score.

The initial share list to construct is the Growth Opportunities list, This selects from the strategy’s trading list those shares that don’t already have an open position but which have price momentum and meet minimum thresholds for return and yield. The relevant definitions, from the V&G Strategy Terms, follow (the Has Open Position term is defined in Shared Terms):

These definitions are self-explanatory. In Adequate Return we look for either a good ROCE or CROCI return as a measure of how effectively a company uses its capital to generate profits and cash, respectively, because a well run company is likely to continue to be successful. We use both ratios, for the same reasons as described in the Value & Growth Strategy’s Trading List Selectors. The reason we select on these factors here, when we’ve already selected for them in the strategy’s trading list, is that new results may become available in the period between the monthly list selections. You should also note that in back-tests, to avoid bias, company results are only made available a number of months after the end of a company’s financial year, as described in Trading Rule Evaluation.

The Minimum Annual Return threshold of 10% is a little below the oft quoted 12% for a good company, but as this is a first stage filter we cast the net more widely. That way we’ll still hopefully have something to invest in even if macro economic conditions depress company profitability. The next stage, which uses the 5-factor score (see below), ensures we get the best of the bunch, so relaxing our requirements at this stage should not be an issue.

As well as efficient companies, we also want companies that are good value, in terms of their share price. This is determined by the Adequate Yield term, as EBIT Yield measures a company’s profits (i.e. the return the company is generating, before interest and tax) divided by their Enterprise Value (EV). EV is dependent on market capital, which is dependent on share price, so a low price relative to profit delivers a higher yield. The Minimum Yield threshold should obviously exceed the risk-free rate. Over the last 10 years, when the system was tested, interest rates were very low, so a 5% yield would have been attractive. Obviously this can be varied going forwards, as interest rates change.

Finally, the Price Is Growing term uses the long term AutoTrend price-channel to ensure price growth is at least equal to the Minimum Annual Return threshold, which was targeted in the Adequate Return term earlier. Price growth provides additional confirmation that our simple filter may have found a worthwhile opportunity. Also, there’s no point investing in a company and then having to wait years for the rest of the market to catch on!

So now we can see how the Growth Opportunities Security List term uses the above definitions to test each security in the V&G strategy’s trading list. Each security that doesn’t have an open position (i.e. the Has Open Position term is false) but does have a reasonable price growth rate (i.e. the Price Is Growing term is true) and also has an Adequate Yield and an Adequate Return are added to the Growth Opportunities list.

The initial list of shares created by the Growth Opportunities term is then sub-selected to create the Value & Growth Buy List security list term, which is described next (the Required Number Of Positions term is defined in the Shared Terms area):

The Buy List is constructed by ranking the shares in the Growth Opportunities list and picking just enough of the top scoring shares as we can afford, as defined by the Required Number Of Positions term. You’ll note that this uses the rounded value of cash divided by trade size. As rounding will round fractions >= 0.5 upwards, this may result in 1 more share than required. This is not a problem because RuleTrader has been designed so it ‘just works’. This means that, where possible, you don’t have to worry about details like this, because:

1. The ‘Actual trade-size must be at least … % of the target size‘ System Setting allows trades for amounts that are < 100% of the target trade value so, depending on this setting, RuleTrader may still allow the trade using the remainder of the cash available.
2. If there isn’t enough cash then RuleTrader will automatically suppress the trade in back-tests and won’t signal it in Live sessions (unless you have the option ‘Show buy trade-signals, even if there is insufficient cash for the trade‘ checked in Live System Settings), so there’s nothing to worry about.

The ranking sorts the Growth Opportunities list in ascending order based on a Rank Score, so the  Required Number Of Positions shares at the top of the list (i.e. at ordinal positions #1, #2, #3, etc.), with the lowest (i.e. best) scores (i.e. with scores of 1, 2, 3, etc., respectively) are the ones that get picked for the Buy List.

As you can see from the definitions above, the Rank Score term is the sum of 5 individual factor scores. Each factor score is derived in exactly the same way, so we’ll just examine the Turnover Growth Score term, as a model for them all. This sorts each security in the Growth Opportunities list based on its turnover growth over the last year (i.e. the growth from turnover reported in the penultimate year to the latest reported year). It then returns the security’s ordinal position in that list, which is just a fancy way of saying its index in the ordered list. So the security with the highest turnover growth will be at the top of the list (index position #1) and so will have a score of 1, which is why the lowest Rank Score is the best score.

You may have noticed that the Rank Score is dependent on the Turnover Growth Score term (amongst others), which is dependent on the evaluated security, but we’ve just said that the Rank Score is calculated for each of the securities in the Growth Opportunities list – what’s going on? The simple answer is, don’t worry about it, it’s another example of how RuleTrader ‘just works’, as you’d expect. For a full answer, see List Ordering Expressions.

Turnover Growth is just one component of the Rank Score. All the components, or factors, are calculated in exactly the same way. The full list, and the reasons we chose them, are:

• Turnover Growth: Turnover is the primary cash input to a company. We want that input to be growing if the value of the company is to increase and the share price is to rise.
• Gross Margin: Measures how much of that Turnover input is converted to gross profit. It’s also an indication of the company’s ‘competitive moat’. A wide moat means it is able command a high price and thus a high gross margin. For a company to be able to do that means it must be inherently differentiated from other companies, which bodes well for the future.
• Operating Cash Conversion: Indicates how much of the profit is converted to cash, which can be invested in the company, helping it to grow further, or returned to us shareholders as dividends. EBITDA was chosen because it removes the effect of each company’s different financing and tax structures, which would otherwise distort comparisons between companies.
• Yield: The focus of the first three factors – how income is turned into cash – provides a simple picture of how well the companies are run but it doesn’t give the whole picture. We also need an indication of how cheap the shares are relative to the returns we can expect. The Yield score gives us that.
• Price Growth: There’s a whole army of analysts and investors studying these companies in great detail, so why not ride on their backs? If they think the company is a good buy, then the price will be trending up. It’s not a fool proof reason to buy, but if the trend is consistent and established over a reasonable period, then it can be a good indicator – along with the other factors – that the company is going places.