by Joe Lan, CFA
One of our key goals here at Computerized Investing is to educate the individual investor on investing while harnessing technology to aid in the investment analysis, research and tracking process. Therefore, the aim of most of our articles is not only to teach and provide rationales for different investment strategies, but also to implement these strategies in the real world. In this feature article, we examine Luke Wiley’s 52-Week Low Formula approach to stock-picking. We discuss the reasoning, strategy and thought behind his approach. In addition, we show how to implement the strategy by creating a step-by-step screen using Portfolio123’s stock screening tool. Portfolio123’s stock screener is a fee-based tool available online that comes with a free 15-day trial.
The first step in researching an investment methodology and creating an investable screen is to understand the key concepts behind it. In his book “The 52-Week Low Formula” (John Wiley & Sons, 2014), Luke Wiley identified five different filters he uses when choosing stocks.
Filter 1: Competitive Advantage
Competitive advantages offer a company significant benefits such as the ability to create a “moat,” as it is widely known. This enables the company to adjust and react to changing market conditions, fend off new entrants and insulate themselves from price wars. Companies that have a competitive advantage typically have the ability to charge more for their products, retain or attract talent and force their competitors to play catch-up. These companies generally have products that are considered unique or top-of-the-line without many substitutes.
Take, for example, the case of Apple Inc. (AAPL), one of the most well-known technology companies in the world. When Apple was in the midst of revolutionizing phones and tablets by releasing the iPhone and iPad, the company was able to price their products at a high price point. Their products were considered unique, with no real substitutions available on the market. Apple forced its competitors to change their products in order to compete. During this time, Apple consistently reported gross profit margins over 40% and net profit margins over 25%.
Competitive advantage is a qualitative measure, and screeners are not usually able to screen for qualitative factors. However, one of the characteristics that companies with competitive advantages exhibit is strong profit margins compared to their peers. Therefore, we use high profit margin compared to the industry median as a proxy for this first filter when building the 52-Week Low Formula screen.
Filter 2: Free Cash Flow Yield
Benjamin Graham famously stated that he always looked for companies with a margin of safety. Wiley expanded on Graham’s thinking in his book when creating the next filter, which calls for companies with free cash flow yield greater than the interest rate on long-term U.S. Treasury bonds.
Free cash flow is generally defined as cash from operations less capital expenditures. This figure represents the cash that is available to shareholders other than cash that is needed to keep the firm running and competitive. Free cash flow can be used to repurchase shares or pay dividends or it can be retained for additional expansion purposes.
The free cash flow yield, as calculated by Wiley, is free cash flow divided by enterprise value. Enterprise value is often used as an alternate measure to market capitalization and is often known as the theoretical takeover value of the company. An acquirer that takes over a company inherits the debt and pockets the cash; therefore, enterprise value is calculated by adding debt to market capitalization and subtracting cash and cash equivalents.
Wiley looks for companies with a free cash flow yield greater than the long-term Treasury rate as an indication of a margin of safety. He believes that free cash flow yield is a better measure than earnings since earnings per share and net income can be manipulated easier than cash flows. According to Wiley, an investor should always look for companies with a greater free cash flow yield than Treasuries to account for the risk that is inherent in any company. Investors should simply choose to invest in Treasury bonds over any company with a free cash flow yield less than the Treasury rate. The greater the free cash flow yield, the greater the margin of safety the company exhibits.
Filter 3: Return on Invested Capital
Return on invested capital represents the return a company is generating on its investments in buildings, property, projects, machinery or even other companies. The figure provides investors with a sense of how well a company is using its money. However, one potential downside of return on invested capital is that it does not differentiate between return earned from a one-time event and return earned from continuing operations.
In his book, Wiley highlights the need to compare return on invested capital to the company’s cost of capital. This criterion is quite intuitive. Cost of capital refers to the cost of funds for financing a business or project. (It is also known as weighted average cost of capital, or WACC.) For most companies, their cost of capital would include the cost of equity, the cost of debt and any other possible sources of capital. A company whose return on invested capital is greater than its cost of capital should be creating value, while a company whose cost of capital is consistently above its return on invested capital is eroding value.
Return on invested capital (ROIC) is calculated using the following formula:
ROIC = Net operating profit after taxes (NOPAT) ÷ invested capital (IC)
NOPAT = (operating profit) × (1 – tax rate)
IC = total assets – excess cash – non-interest bearing current liabilities
Wiley’s third filter looks for companies with ROIC greater than the cost of capital over the past 10 years.
Filter 4: Ratio of Long-Term Debt to Free Cash Flow
At its core, Wiley’s fourth filter is another factor that seeks companies with a margin of safety. In his book, Wiley suggests limiting the long-term-debt-to-free-cash-flow ratio to 3.0 or lower. In other words, he is limiting his search to companies whose long-term debt is no more than three times its free cash flow. This means that if the company were to use all of its free cash flow to pay down its long-term debt, it would be able to do so in three years or less (assuming the company did not take on more long-term debt.
Debt, or leverage, allows a company to generate additional returns to shareholders during strong years, but also magnifies losses during weak years. Wiley states in his book that he is more focused on a company’s ability to survive and remain competitive during uncertain periods than during robust cycles. Companies with low long-term debt to free cash flow have a better ability to pay creditors and stay solvent during long periods of economic weakness.
Wiley normally uses historical figures when using his other metrics but for long-term debt to free cash flow, he likes to use a current snapshot. The fourth criterion in his methodology is formulated as follows:
Long-term debt ÷ free cash flow <= 3.0
Filter 5: 52-Week Low
The final criterion that Wiley uses in his book seeks companies trading near their 52-week lows. Wiley incorporates economics into his stock selection process. From a supply and demand perspective, when a stock is trading near its 52-week high, there are more buyers than there are sellers; when a stock is trading near its 52-week low, there are more sellers than there are buyers. Naturally, for investors who are seeking to buy low and sell high, it would be advantageous to buy near the 52-week low and sell near the 52-week high.
In his book, Wiley manually ranks companies based on their past performance over the last 12 months. He actively seeks out those companies whose stock price has dropped by 25% or more over that time frame, believing that these stocks have greater opportunity for rising in price. Wiley states that stocks on the opposite end of the spectrum—those that have significantly risen in price over the last 12 months—hold greater potential for loss than for additional gains.
Wiley’s final filter does not specifically set a target at which he purchases stocks. However, he does mention that he embraces stocks that have declined by 25% over the past 12 months.
Creating the Screen
To create this screen, we use Portfolio123, which is a fee-based site that includes a good stock screening tool. This screener is one of the better screeners available online for a price that individual investors can digest. The Investor level ($29 per month) subscription allows you to create custom screens while the Screener level ($83 per month) subscription enables you to backtest screens back to 1999. However, one of the main issues we ran up against is the inability to create custom fields (although the screener does allow users to perform mathematical functions to different data point)s. Therefore, the screen we built is not exactly the same as the one described in the book, but it remains true to the spirit of the methodology. We also tested the Morningstar.com Premium fund screener, but found it to be grossly inadequate to create this screen. Morningstar.com does not allow users to create custom fields, nor does it allow users to perform mathematical functions on data points. In other words, the data points in Morningstar.com’s screener are not customizable at all, and there was no way to closely match filters two, three or four of the investment methodology. This highlights the trade-offs you sometimes need to make when trying to implement a stock screening methodology. Rarely will you find a screener that can exactly capture a given strategy, so you may have to adjust your screen to fit the screening parameters at your disposal.
The first filter, which seeks companies with a competitive advantage, is really a qualitative factor that cannot be fully quantified. However, as mentioned, one characteristic that companies with a competitive advantage tend to exhibit is higher profit margins than that of their competitors. Gross profit margin is the factor that is typically used because gross margin compares the selling price to the cost of goods sold. Using margins such as operating margin and net margin make less sense since these figures take into account company efficiency and execution, instead of simply pricing power (companies with competitive advantages tend to exhibit strong pricing power).
Gross profit margin should normally be screened against an industry median because each industry has its own typical margin. For example, a grocer will likely have a much lower gross margin than a technology company. Therefore, the first filter used looks for companies with a gross margin higher than its industry median. Using Portfolio123's screener, there are 3,019 companies passing this single criterion (Figure 1).
The second filter looks for companies with a free cash flow yield greater than that of the long-term Treasury bond rate. The service does not have a single data point for total free cash flow, so we calculate it by subtracting trailing-12 month capital expenditures from trailing 12-month operating cash flow. This figure is then divided by enterprise value to calculate the free cash flow yield. In this screen, we are searching for companies with a free cash flow yield greater than 5% (0.05 which is higher than the current long-term Treasury rate and closer to the historical long-term Treasury rate. The screen is now passing 869 companies (Figure 2).
Wiley’s third filter looks for companies with higher return on invested capital than cost of capital. This is another filter that is difficult to create in a screen, as many stock screeners do not have return on investment capital and almost no stock screens include company cost of capital. Therefore, for this criterion, we estimated the return on invested capital using the following formula:
Operating profit × (1 – tax rate) ÷ (total assets – cash)
Wiley’s calculation for invested capital includes a deduction of non-interest-bearing current liabilities in the dominator. However, Portfolio123 does not include this data point. The closest data point provided is accounts payable, but accounts payable sometimes involves interest so it is not used in our calculation. Portfolio123 also does not include cost of capital, and there is no easy way to calculate it using the service. Therefore, we used a proxy of return on invested capital greater than 6%, which is an estimated figured based on the current cost of debt and current cost of equity. After implementing the third filter, there are 80 companies passing the screen (Figure 3).
The fourth filter that Wiley uses ensures that each of the companies can easily service and pay down their long-term debt, should the need arise. The criterion looks for companies with long-term debt less than or equal to three times their free cash flow. Once again, Portfolio123 does not include a data point for total free cash flow, but the calculation is very simple. The filter used in the screen is as follows:
Long-term debt ÷ (operating cash flow – capital expenditures) <= 3
Adding this criterion to the screen leaves us with 65 passing companies (Figure 4).
The final filter that Wiley uses looks for stocks trading near their 52-week low. Wiley does not specify how close he targets a stock’s 52-week low, but he does mention that he likes to rank companies according to its price weakness over the last 52 weeks. He especially seeks out those companies that have dropped by over 25% in the past year. However, building screens is not always a perfect art. When building this particular filter, we found that no companies passed when we limited the screen to companies whose stock prices have dropped by 25% or greater. The market rally over the last few years has made it very difficult for strong companies to pass this criterion, especially its surge in the last few months. Therefore, we loosened the criterion to include companies whose stock price has declined over the past 52 weeks (with the service, the criterion is total return < 0). With the final criterion added, the screen passes 16 stocks (Figure 5).
The 16 final passing companies include stocks from a variety of sectors that include telecommunication services, industrials, informational technology and materials.
One of the benefits of stock screening is that it introduces you to companies that may not be on your radar. Before running this particular screen, I had not heard of most of the companies that made the final cut. Seeing that Wiley’s methodology is very much contrarian in nature, this really is not surprising. Besides, academic research has shown that abnormal profits can be had from investing in unknown stocks.
Stock screening is only the first step of the investment process. Though the stocks passing our screen meet the fundamental data the screen seeks, we know nothing of the companies qualitatively, such as what products or services they provide. It is prudent to perform additional fundamental analysis before making any purchase.