In his 2005 research paper titled “Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis,” accounting professor Partha Mohanram laid out a strategy for finding promising growth stocks trading at attractive valuations. Mohanram’s approach aimed to identify the true growth winners among stocks with low book-to-market ratios.
Mohanram’s Research
Mohanram found that while low book-to-market stocks (aka growth stocks) as a group don’t generate abnormal returns, a subset of winners within the group do deliver strong outperformance. The key is separating those winners from the losers, and that’s where Mohanram’s research comes in.
Through his analysis, Mohanram developed a “G-Score” that uses eight fundamental criteria to find growth stocks that are more likely to outperform. Those eight criteria cover three broad categories:
- Profitability: return on assets, cash flow from operations to assets
- Naïve extrapolation: stability of ROA and cash flow, stability of sales growth
- Accounting conservatism: capital expenditures, R&D, and advertising intensity
By finding growth stocks with high scores across those three categories, Mohanram showed that you can develop a market-beating strategy.
Validea’s Mohanram-Inspired Model
Using the findings from Mohanram’s paper, Validea developed a quantitative stock screening model that picks stocks with the following characteristics:
- In the bottom 20% of the market based on book/market ratio
- ROA and cash flow from operations/assets above industry average
- Cash flow from operations/assets greater than ROA
- ROA variability and sales variability below industry average
- Advertising/assets, R&D/assets, and capex/assets above industry average
By combining those factors, the Validea Mohanram-based model picks low book-to-market stocks that have solid and stable profitability, conservative earnings and revenues reporting, and a commitment to growth-oriented spending.
5 Stocks Passing Validea’s Mohanram Model
Using its Mohanram-inspired strategy, Validea has identified these five stocks as currently being fundamentally attractive:
- Deckers Outdoor (DECK): Deckers designs and markets footwear, apparel and accessories developed for both everyday casual lifestyle use and high performance activities. It scores 100% on the Validea Mohanram model thanks to its low 0.10 book/market ratio, high and stable 19.8% ROA, strong cash flows, and spending on advertising, capex, and R&D that is above its industry average.
- Toro Company (TTC): Toro designs, manufactures, and markets professional turf maintenance equipment and services. It gets a 100% score from the Validea Mohanram model, with a solid 8.9% ROA and 10.7% cash flow/assets ratio, ROA and sales stability, and advertising, capex, and R&D/assets ratios that exceed industry averages.
- Deere & Company (DE): Deere manufactures agricultural, construction, and forestry machinery. It passes the Mohanram screen with a perfect score, thanks to its ROA and cash flow/assets above industry average, stable fundamentals, and growth spending ratios that outpace its peers.
- Lennox International (LII): Lennox designs and manufactures heating, air conditioning, and refrigeration products. The Validea Mohanram model gives it a 100% score, liking its strong 21% ROA and 24.4% cash flow/assets ratios that beat industry averages, solid earnings and sales, and above-average spending intensity.
- ServiceNow (NOW): ServiceNow provides enterprise cloud computing solutions that help companies manage digital workflows. The Validea model scores it a perfect 100%, due to its above-average 9.9% ROA and 13.2% cash flow/assets ratios, fundamental consistency, and capex, R&D, and advertising/asset ratios that outpace industry norms.
A Powerful Growth Approach
Fast-growing firms with high valuations can sometimes be very risky, as investors extrapolate strong past growth too far into the future. But if you combine high growth with the qualities Mohanram found to be so important — profitability, stability, and conservative accounting — you can put the odds of success in your favor. That’s what Validea’s Mohanram-inspired model aims to do, and these five high-scoring stocks could be a great place to start for growth-focused investors.
Further Research
