In Part 1 of this post, I looked at some quality screens I look at occasionally to generate ideas. In this second part of the post, I thought I’d briefly review an industry specific screen that I put together more recently that I will make a point to review every month or so.

I’m doing a lot of work on bank stocks lately, looking at a lot of cheap stocks selling for significantly less than their tangible book value. I’ll comment more on this and put up some basic notes on these soon. When it comes to banks, most of my time is spent looking at deep value cheap bank stocks and trying to find the highest quality ones from that list.

Very Simple Quality Bank Stock Screen

But I also thought it would be interesting to put together a list of quality banks that have achieved 10% or greater ROE in each of the past 5 years (2008-2012, plus the trailing twelve months). A bank that made 10% or more on their book value in 2008 and 2009 is one that might be interesting to look at. Very few banks make this list.

There are 1,025 US Regional Banks in Morningstar’s database. Only 32 make the cut of having 10% ROE in each of the last 5 years. This is roughly 3 out of every 100 banks. So we’re talking the cream of the crop. On the list you’ll find a lot of quiet, small banks that you’ve never heard of.

Many of these banks are in rural areas (think farms, mountains, countryside, etc…) with financially conservative customers with prudent spending and borrowing habits. These customers make for a strong, local, and loyal deposit base—which is a small bank’s key funding source and most important foundation.

Many of these banks are very well capitalized, pay steady and increasing dividends, have predictable earning power, and have a history of creating shareholder value despite a very challenging environment.

To paraphrase what Buffett once said, banking is a business with numerous commodity like aspects (they all sell the same basic service), but yet it also is a business where certain banks can develop a moat (a durable advantage over their competition).

This type of industry specific list can be checked occasionally, but doesn’t need to be checked often. It’s just another way to generate ideas. I’ve already gone through a few of these banks and found a few interesting ideas, but most are not priced attractively, which is understandable given their higher level of quality.

But one thing to keep in mind when using simple valuation metrics like P/B is another Buffett comment on banks:

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

I think what Buffett implies here is to not get too caught up with discounts to tangible book values if you plan to be a long term owner of the business. This quote alone can be the subject of a separate post. I have a few thoughts on this, because I think Buffett is right, even though I happen to love looking at lists of small banks selling at discounts to tangible book.

So to sum it up, here are the quality screens I check that might be of interest to you in your search for ideas:

  • Use Value Line to identify the Top 100 or so businesses
  • Buybacks (Stocks that have reduced their share count by 30%+ over the last 10 years)
  • 10 Years FCF (Non-financials with 10 consecutive years of positive free cash flow)
  • Stock Price (Stocks that have compounded at 10%+ annually for the last 10 years)
  • Book Value (My favorite quality screen: Stocks that have compounded their book value at 10%+ for last 10 years)
  • Quality Banks (Banks that have achieved 10%+ ROE in each of the last 5 years)

Remember, many of these stocks are not cheap—many of them are actually overpriced. Many of them never get cheap. These should be starting points to identify good businesses that can be tracked over time and purchased only at cheap valuations. There are lots of ideas here, but only a small handful would really qualify for further evaluation at any given time.

Idea Infrastructure

You could use these lists to build your own database of businesses you understand well. Read the 10-K’s, get the annual reports from the company websites, study the industries, and get familiar with them over time. One at a time. We’re after base hits… think of this as methodically building infrastructure. These lists are the raw materials that we can build our toll bridge with. As the database of businesses grows, you’ll have a list of ideas ready for you when Mr. Market decides to serve up some great opportunities.

Since we’re discussing quality lists here, I have a few follow up thoughts on value, quality and growth that I’ll post next week some time. I’ve had a lot of email questions on the theoretical aspects of these terms… to me, they are all intertwined and can’t really be separated. They are like the colors of a Monet painting.

I’ll discuss some brief thoughts on them, and sum up this post by saying this: Lest we forget, value is the most important factor. And by value, I don’t necessarily mean some multiple of earnings or assets. I simply mean the intrinsic worth of the business. But having said that, I tend to prefer stocks at low multiples—it helps me accomplish “Rule #1”. I tend to miss a lot of opportunities of great businesses with perpetual high prices, but I also tend to avoid a lot of losers. But in the end, as I’ve mentioned many times, I like Greenblatt’s definition of value: “Value investing is simply figuring out what something is worth, and paying a lot less for it”.

That’s what we’re after here at BHI. And we’re focused on building methodical processes to replicate this exercise over and over.