What The HG-Type Screen Does, In a Nutshell

General Idea

The HG-Type Screen looks for companies that are in the beginning stages of substantial growth as evidenced by accelerating growth in sales and increasing gross margin, a decent balance sheet and current asset management, strong insider ownership and limited institutional ownership, and are not radically overpriced. An 8-quarter history of the company is looked at to provide this information, so turnarounds as well as fast growing small companies are equally strong candidates.

The database used for this screen is the American Association of Individual Investors (AAII)'s Stock Investor Pro (SI Pro). I download weekly updates to the SI Pro database from AAII, decode the SI Pro data for easy use by screening tools of my own development, and write custom software for the screening process. Weekly updates to the screen results are posted to the Motley Fool HG: Screening For Gems discussion board with short analyses of new companies appearing on the list (subscription required).

Use Per-Diluted-Share Numbers

Many companies use equity financing or use options as compensation, both of which dilute existing shareholders' shares of the company. The best approach to take this into account is to compute all key numbers as per-diluted-share numbers. The HG-Type Screen uses all per-diluted-share values when calculating the growth rates of sales and operating income.

Look for Accelerating Growth and Increasing Margins

The screen looks at the last 8 reported quarters of financial data. The key calculations used in the screen are the trends of quarterly year-over-year changes. For example, let's say we have a company whose sales per diluted share for the last 8 quarters are as follows:

SALES PER QUARTER, PER DILUTED SHARE
Q1
Q2
Q3
Q4 (most recent)
Most Recent 4 quarters
9.30
10.20
9.80
12.10
Previous 4 quarters
7.80
8.00
8.10
8.70
Percent increase (most recent / previous)
19.2%
27.5%
21.0%
39.1%

Although sales may have some seasonal component, as this company appears to show, finding the percent increases of year-over-year numbers smooths out such variations. This company's growth rate seems to be increasing, from a 19.2% year-over-year sales increase in Q1 to a 39.1% year-over-year sales increase in Q4. If we compute the average of the four percentages, 26.7%, we see that the Q1, Q2, and Q3 percentage growths aren't too far from the average, but Q4 is substantially above the average. In other words, the year-over-year sales growth is accelerating. This is one of the key concepts in this screen -- to look for companies whose most recent key growth indicators (such as year-over-year increases) are increasing faster than their trend. This indicates something new and very positive is happening within the company.

Technically, the screen calculates ratios instead of percentage increases (this is equivalent, just simpler) and fits a line to the four quarterly ratios. If the line's slope is positive, then the company's performance is improving. If the most recent quarter's growth ratio is above that line, then growth is accelerating. This is a more selective test than the average computation method explained above.

While revenues and operating incomes should be increasing, a very important metric that is a good pulse on the entire business is that gross margins are increasing. To test for this, gross margins are calculated for each of the most recent 4 quarters and a line fit to the gross margin percentages using a standard linear regression routine. The screen requires that the line's slope is positive and increasing by at least 1% over the year. This is the most restrictive of all tests in the screen, passing only a little over 30% of all companies.

Look for Reasonably Good Asset Management

Even though small companies or those in the midst of a turnaround may have difficulties achieving the pinnacle of asset management, doing at least a "reasonably good" job is critical. The higher the company's growth rate, the more important asset management is. The metrics include:

The HG-Type Screen requires that a company meet either one of the following:

Look for Low Debt

Many companies hold some long term debt. A large debt adds great risk and can limit the company's opportunities, in addition to being a drain on cash flow. Since the HG-Type Screen deals with companies that may not yet be cash flow positive, it is difficult to look for debt coverage ratios as might be done with established companies. Instead, the screen looks for all long term debt (straight debt plus any other long term liabilities) and requires that it be less than one full year's gross income. The ratio of long term debt to gross income is reported in the screen summary so it is easy to look for low debt levels relative to potential cash flow.

Look for Shareholder-Oriented Ownership

A key property of a "Hidden Gem" is strong insider ownership and a company that is more-or-less undiscovered by large institutions. The HG-Type Screen achieves this by looking for companies where insiders own at least 5% of the outstanding shares, and institutions own less than 50% of the outstanding shares.

Look for Reasonable Size

To eliminate very tiny companies whose stocks are usually illiquid, or which might be based on only a single product or one or a small number of people, the HG-Type Screen requires that the last 4 quarters' revenue be at least $40 million.

Look for Reasonable Share Price

To ensure a reasonable value for the price paid, it is critical to screen out companies whose share prices are far above a reasonable level, even considering growth. For this test, the HG-Type Screen computes two components of value and adds them together to form a maximum price:

The minimum required price for the shares is $1.