AAII Stock Ideas: John Templeton Strategy Screen

In these volatile markets, I want to make sure you have access to the best information possible to help you navigate the uncertainty. Today I focus on the stock-picking strategy of John Templeton and provide a list of stocks that currently pass AAII’s Templeton screen. Templeton used value investing concepts to identify international stocks trading at a bargain. He was also a great believer in the opportunity that volatile markets present to bargain hunters. As of June 1, our Templeton screening model has an annual gain since inception (1998) of 8.0%, versus 5.2% for the S&P 500 index in the same period.

Templeton Screen Finds Bargains in Volatile Markets

Sir John Templeton became a successful investment adviser after studying under the father of value investing, Benjamin Graham. Templeton quickly identified with the philosophy of contrarian investing and continued to train in the art of value investing. In his work, Templeton applied Graham’s ideas to new situations, showing how well value investing could work in international stocks, including emerging markets.

Templeton was given the moniker ‘the Christopher Columbus of investing’ because of his ability to discover new worlds of investing. He was one of the first U.S. money managers to invest internationally, finding value in global markets and among emerging nations. An ardent contrarian and value investor, his focus was always domestic issues, but the scope of his searches was not limited to U.S. market boundaries. Sometimes bargains were found in Japan, other times Argentina. It did not matter.

Value investing concentrates on unappreciated stocks trading at attractive prices — bargain stocks. Templeton was always out bargain hunting and looking for the best-priced stocks. His philosophy was to buy out-of-favor companies that were beginning to show signs of reawakening — regardless of the country of origin.

As a fund manager, Templeton pioneered the use of globally diversified mutual funds. His Templeton Growth Fund was among the first to invest in Japan in the middle of the 1960s, China in the late 1980s and South Korea after the Asian financial crisis.

Two books served as the basis for the creation of the AAII Templeton stock screening approach. Both books feature sections devoted to Templeton’s life and investing beliefs: “Lessons From the Legends of Wall Street,” by Nikki Ross, (Dearborn Financial Publishing, 2000); and “Money Masters of Our Time,” by John Train (HarperCollins Publishers, 2003).

Core Concepts

When implementing a value investing strategy, there are a number of factors to consider. The AAII Templeton screen uses low price-earnings (P/E) ratios as the foundation. One difficulty in implementing a low price-earnings ratio approach is separating the “good” companies — those that are simply misunderstood by the market — from the ones that the market has accurately pegged as being “losers.” Many low price-earnings ratio stocks are in the bargain basement because their industry, products or earnings and growth prospects do not excite investors.

Separating the good firms requires some additional, supportive filtering factors. For Templeton, such support and confirmation came from what he called future probable earnings or forecasted earnings growth. From Templeton’s viewpoint, for any stock selection to be considered worthy, future probable earnings need to be strongly favorable.

Today’s Templeton Approach Stock Ideas

Stocks Passing the Templeton Screen (Ranked by P/E Ratio)

Identifying Attractive Stocks

Templeton liked to compare current price-earnings ratios to five-year average annual price-earnings figures when looking for the lowest multiple stocks. There are two hidden aspects of this screening criterion: Not only does it require the current price-earnings ratio of the stock to be lower than its five-year average, but in addition any passing company must have been traded for at least five years and had positive annual earnings per share for each of the last five fiscal years.

When screening against five-year averages, useless numbers can sometimes slip through the cracks in a screening technique. Beyond negative earnings, which lead to meaningless price-earnings ratios, unusually low earnings may also throw off standard price-earnings ratio screens. Short-term drops in earnings due to extraordinary events may lead to unusually high price-earnings ratios. As long as the market interprets the earnings decrease as temporary, the high price-earnings ratio will be supported.

Because the average price-earnings ratio model relies on a normal situation, these “outlier” price-earnings ratios must be excluded.

To eliminate companies with these extreme price-earnings ratios, an additional filter was applied to the AAII Templeton approach that excluded any stocks with ratios of 75 or above for any of the last five fiscal years.

Templeton believed that the income statement should show consistent earnings growth as well. Earnings per share growth is one of the primary benchmarks used to measure company performance. The Templeton-inspired screen looks for stocks with positive earnings growth over the last 12 months and over the last five-year period. Beyond an overall growth figure, individual investors should look at the year-to-year trends since long-term growth rates can easily mask the variability and risk of the underlying figures.

Examining the expected five-year growth estimate captures Templeton’s future probable earnings prerequisite. His desire for consistent growth in the future is portrayed by a positive earnings growth estimate filter.

Templeton also sought companies with competitive advantages. This can be detected by comparing a stock’s forecasted earnings growth figures to the forecasted growth of its industry; firms with earnings growth estimates greater than or equal to the industry median more than likely have a competitive advantage.

Operating margins can also reveal a competitive advantage. The operating margin paints a picture of how efficiently the company’s management is operating within the framework of the company’s costs. Our screen requires the recent trailing 12-month and current-year operating margins to be greater than or equal to industry medians for their respective periods. Industry medians are particularly important in this area as benchmarks because operating margins tend to be very industry specific.

Templeton also compared current operating margins to previous margins. An additional filter requires current operating margin to be greater than the five-year historical average operating margin.

Financial Strength

Templeton also monitored the balance sheet, looking for companies showing good financial strength. Templeton believed a strong financial position enables any company to work through the difficult periods often experienced by overlooked, out-of-favor stocks. Acceptable levels of debt vary from industry to industry, and for that reason the last criterion screens for companies with total liabilities relative to assets in the current quarter that are below their industry norms. This particular ratio is used here because it considers both short-term and long-term liabilities.

Qualitative Factors

In addition to researching company reports, pouring over financial statements and analyzing each stock’s industry, Templeton also placed a great deal of importance on several qualitative factors: quality products; sound cost controls; and the intelligent use of earnings by management in order to grow the firm.

Templeton also looked for any potential catalyst that might change the perception of a stock and spark interest among star-gazing investors, which in turn would cause the stock’s price to rise. Catalyst-type events include the creation of new markets and products and could also extend to announced potential mergers and acquisitions, as well as favorable changes within the company’s industry.

Performance

The table below shows that the Templeton approach has outperformed the S&P 500 index over the long run, but like most value approaches has lagged the market over the last 10 years.

The Templeton approach tends to view volatility as an investor’s best ally in the search for bargains to purchase. According to “Investing the Templeton Way,” by Lauren C. Templeton and Scott Phillips (McGraw-Hill, 2008), Templeton believed that volatility presents opportunities and the greater the volatility, the greater the opportunities to locate a bargain. Volatility has increased over the past few quarters and, if the market continues to fluctuate, following the Templeton way may be a good method to find some bargains.

Conclusion

Templeton’s idea behind bargain hunting is to become not an unblinking contrarian but rather a wise buyer of out-of-favor stocks. By finding stocks with price-earnings ratios lower than historical averages and companies with strong and improving earnings growth rates, you may follow the Templeton way and “buy when there’s blood in the streets.”

It may also be helpful to remember his advice: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

Keep in mind that no matter how well a stock screening methodology has performed (or how badly it has underperformed) over the long term, stock screening is only the first step in the stock selection process.

You will want to do your homework to see why these companies are at their current levels. Only then will you gain insight into those that will continue to languish and those that may eventually flourish.

The stocks meeting the criteria of the AAII Templeton approach do not represent a “recommended” or “buy” list. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars. Keep in mind that the quantitative screens AAII has developed are based upon our interpretations of published works tied to the market gurus.

—

If you want an edge throughout this market volatility, become an AAII member.