Find quality shares at cheap prices in volatile markets

Stockmarket volatility can be stomach churning for even the hardiest investor. Yet a disciplined focus on company fundamentals in these conditions can make it possible to pick up good quality shares at momentarily cheap prices.

During the recent wild price swings in UK equities, Neil Woodford, the highly respected fund manager, observed that it's always difficult to remain focused on fundamentals when markets fall dramatically. He said the distraction of seeing share prices fall indiscriminately can be overwhelming and distort rational perspectives. But he also said that he'd be looking for opportunities in areas of the market where the falls had been heaviest.

What Woodford meant was that good quality companies don't necessarily stop being good quality because market valuations are falling. If their fundamental strengths are intact, it could be a chance to pick up a bargain.

This view echoes the approach of a long line of legendary investors down the years - and one that's a hallmark of perhaps the world's greatest living investor, Warren Buffett. In his 2012 letter to Berkshire Hathaway shareholders, Buffett described the essence of the strategy by saying: "More than 50 years ago, Charlie [Munger - Berkshire's vice chairman] told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible."

It was also neatly summed up by fund manager Joel Greenblatt in his investment guide The Little Book that Beats the Market, in which he explained: "Buying good businesses at bargain prices is the secret to making lots of money".

Defining quality and value

A key factor in the Quality + Value strategy is the distinction between buying poor quality shares at rock bottom prices and buying good shares that are no longer expensive. The emphasis is on quality-at-a-reasonable-price - something finance professor Robert Novy-Marx describes as "the quality dimension of value".

For Greenblatt, the strategy is a simple as taking two metrics that any investor can use. He applies earnings yield as a measure of cheapness and return on capital as a measure of company quality. His system ranks the market from best to worst using each metric and then adds the scores together to get what he calls a "Magic Formula" for each stock.

At Stockopedia we took the spirit of the Quality + Value strategy further in a screen for Interactive Investor. It uses a QV rank to score and rank every company with a market cap of at least £1 billion for a combination of the two factors. The rank ranges from 0 (poor quality and value) to 100 (strong quality and value).

On the quality side, it combines several checklists and ratios that can help identify a strong franchise in good financial health. In particular, it looks for strong, stable cash generative businesses with high margins and low risk of bankruptcy and earnings manipulation. In turn, rather than relying on a single measure of value, the value part of the ranking score takes into account six common valuation metrics in measuring cheapness.

This list of large-cap stocks which rank highest for their combination of quality and value is led by Pace, a company that makes hardware for the pay TV and broadband markets. It's also currently the subject of a £1.4 billion bid by US rival Arris. It is followed by pharmaceuticals company Indivior and housebuilder Berkeley Group. Berkeley is joined on the list by fellow housebuilder Persimmon, with both stocks having the highest relative price strength over the past six months, at around 38%.

Other well-known stocks include private equity group 3i, Royal Mail, engineering contractor John Wood and Imperial Tobacco. Among the high street names are Halfords and William Hill.

Bargain hunting

It's important to remember that volatile market conditions require huge care on the part of investors, with many choosing to stay on the sidelines. However, for those that have done their research and are familiar with company fundamentals, indiscriminate market swings may offer an opportunity to go bargain hunting. Using a combination of measures to spot good quality shares that have become relatively cheap could be a useful way of quick-screening the market for opportunities as they arise.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.comand learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

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About the author

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook".

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.