Use a Simple Quality Value Growth (QVG) Framework to Filter Stocks

Written by

Jae Jun

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When quickly trying to go through a list of stocks, it’s important to have a process to efficiently do it. Otherwise, you run the risk of scrambling around and spending too much time on stocks you should pass up.

Here’s one way one I do it.

Fill out a quality, value and growth assessment of the company as I do for the following stocks. The goal isn’t to dig deep into every company. This is a top layer search and filtering process to find candidates for further and deeper research.

To save time, the numbers and images you see below have been pulled from the Stock Analyzer.

Quality Systems Inc (QSII)

I first read about the company from back in 2009 and it has been on my list for many years. In 2012, the company saw drops by 50% in the year due to internal board fight and slowing growth.

Additionally, Quality Systems regularly appears in Forbes Small Best Companies list.

Quality Systems offers medical practices to replace their old paper archive system with software instead.

QSII Quality

Quality Systems has lost its shine the past year and business suffered. Margins have reflected this drop.

These numbers are from 2012 to 2013

  • Gross margin: 64.8% to 58.8%
  • Operating margin: 27% to 18.8%
  • Net margin: 17.6% to 9.3%

As you can see 2013 was a tough year. Even FCF took a hit.

2012 had $66.5m in FCF but 2013 saw $28.6m.

At least FCF is still positive. To have positive FCF like that in one of its worst years shows how much of a cash machine Quality Systems is.

Looking closer at FCF, Quality Systems has increased capex. Even in the first fiscal quarter of 2014, capex has increased by 300% compared to the prior year.

Here are the quality metrics I’ll be looking at for each company.

QSII Quality Metrics

QSII Quality Metrics

There are hints that QSII has strong numbers, but the decline has turned Quality Systems into a sub-par company. Returns used to be excellent but it’s dropped by more than half.

The good side is that there is no debt.

Cash conversion cycle is also moving in the right direction.

But I’m going to give quality a rating of 3/5 at this time.

QSII Value

Running some quick numbers puts the fair value estimate in the $30 range.

However, consider whether the current margins and increase in spending is the new normal. If so, the fair value can be lower.

Several Different Valuations of QSII

The margin of safety is about 25% here for a normal case.

Being a software business, Quality Systems is still going to have fat margins, and now that the new healthcare system is rolling out, it will be interesting to see whether small practices start to adopt improved systems into their daily work life.

Value gets a 3/5.

QSII Growth

QSII Growth Components to Analyze

When talking about growth, what happened in the past doesn’t indicate the future, but in the business world, it makes a lot of sense.

A company can’t suddenly change directions and go from selling healthcare IT systems to pinball machines.

A way that I measure growth potential and direction is by comparing the 5 year medians and 10 year medians.

If the 5 year values are higher than the 10 year, the company has been improving over the short term and vice versa.

If you look at the numbers above, tangible shareholders equity has increased but the company has slowed down in other areas.

3/5 again for growth.

Quality Systems QVG Summary

As much as I like Quality Systems, at the moment, without fully digging into everything, the QVG score is average.

Quality: 2/5

Value: 3/5

Growth: 3/5

NetScout Systems (NTCT)

Despite being a billion dollar company with a history dating back to 1984, NetScout has a very low profile. It’s also a tech company which survived the dot com bust so the lack of coverage is puzzling.

But I digress.

NetScout is in the IT industry. To keep the description as simple as possible, NetScout makes products that analyzes the flow of a corporate network and then provides alerts to improve efficiency.

NTCT Quality

Let’s get straight into the numbers.

NTCT Quality Numbers

The first thing that jumps out is that this is a different picture to Quality Systems.

Business is showing small growth. Also, you shouldn’t make too much out of the TTM numbers because it only includes the first quarter for the new fiscal year. Once Q2 results are released, the TTM number will be more indicative of the numbers for the year.

If I had to nitpick, the main thing is the inconsistency of its returns. If you go back 10 years, the trend is a few good years of increasing CROIC or ROE and then it will drop again.

Overall, the numbers are good. Fundamentals outside of these numbers are also solid.

Quality? 3/5. Not good enough to get a 4.

NTCT Value

For a tech company, it has a great history of profitability and consistent FCF generation. This makes it easier to perform a DCF and to get a better feel for the company going forward.

NTCT Valuation Numbers

As a normal case, NetScout looks to be worth around the mid $20 to $30 range.

If you look at the quality numbers again, you can see FCF/Sales is around 20%. This means that for every $1 of sales, $0.20 goes to FCF. This puts NetScout in the elite class of cash flow generators.

Growth rate assumptions for the valuations varied from 10-15%. Compare this to analyst estimates of 15-16%.

The fair values equate to a margin of safety of around 20%.

3/5 for value.

NTCT Growth

Here’s a case where the 5 year and 10 year median values provide a clear picture.

NTCT Growth Rates

You can see the big slow down. The analyst estimate of 15% looks to be too rich.

2/5 for growth.

NetScout QVG Summary

Quality: 3/5

Value: 3/5

Growth: 2/5

Mesa Laboratories (MLAB)

A small company that focuses on process validation and monitoring instruments in the healthcare, industrial, pharmaceutical, medical and food processing industry.

Let’s say you work in the medical industry.

There is little room for error.

Each bottle or medicine must have the exact quantity. Maybe a syringe has to be filled with 50ml of medication. Anymore or less and it could be disastrous.

Or, maybe it’s something like monitoring the pressure of a certain environment. Maintaining a high level of quality control is extremely important in many industries and Mesa Labs provides the tools to inform the users.

MLAB Quality

For more than 10 years, Mesa Labs has increased sales every year.

The only  major slowdown came in 2010. Still, Mesa Labs increased sales by 1.8%. It’s better than 0% or negative. More impressive is the jump they saw following the great recession.

Getting to the numbers;

MLAB Quality Metrics

2013 wasn’t as good as 2012, but the numbers are still in the above average range. The key at the moment is to monitor margins because the drop is ROE is due to the drop in margins.

If you run a DuPont analysis, you’ll notice this trend. Download a free DuPont analysis spreadsheet from the page too.

MLAB 5-Step DuPont Analysis Blames Decreasing Margins

The business model for Mesa Labs focuses on going after niche markets with limited competition. This gives them pricing power and lets them build many small moats.

I’ll give MLAB a 3 out of 5 for quality.

MLAB Value

Mesa Labs isn’t the cheapest stock. TTM EV/EBITDA is 15, cash adjusted PE is 20, P/TangBV is 15.

The valuations also depend a lot on growth.

For a reverse DCF, Mesa Labs has to grow FCF at 13% with a 9% discount rate. Very possible, but difficult to judge whether the stock is cheap or not.

MLAB Valuation Range

The valuation range is from $50 – $70. That’s a large range. The current price is at the peak of this range so value gets a 1/5.

MLAB Growth

MLAB Growth Numbers

MLAB Growth Numbers

The main theme with Mesa Labs growth is that it is a great generator of cash. However growth at the top is slowing down.

There is a difference between maximizing conversion from sales to FCF and achieving earnings growth.

While the cash cushion is growing, the company growth is slowing down.

The cash growth is excellent. Earnings growth is average and so the growth score gets a 3/5.

Mesa Laboratories QVG Summary

Quality: 3/5

Value: 1/5

Growth: 3/5

Using a QVG Skeleton

A lot of the thoughts related to the business is going to be subjective. But it’s a matter of getting things down on paper. Using this type of broad template is going to help you jot down notes of what you like and dislike. You can then take the next step necessary.



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