Download Understanding The SSG

Understanding The SSG . . . Or You Will Buy Turkeys When It's Not
Thanksgiving - by Ed Chiampi
Reprinted from the April 1998 Better Investing Magazine
Introduction
A note from Mr. Chiampi
A Primer for Beginning Investors . . . Or Experts with Poor Records
Section 1
Visual Analysis - The Front Page
The Header- An Area Of General Identification
The Chart - Where Historical Data Are Projected As Future Potential
Recent Quarterly Figures - A Comparison To Last Year's Quarterly
Figures
Section 2
Evaluating Management
Section 3
Price-Earnings History
Section 4
Evaluating Risk And Reward
Section 4A - High Price - Next 5 Years
Section 4B - Low Price - Next 5 Years
Section 4C - Zoning
Section 4D - Upside/Downside Ratio
Section 4E - Price Target
Section 5
5-Year Potential
Review Eight Key Points For Growth-Oriented Investors
Summary
These are not instructions about how to fill in the Stock Selection
Guide. Those "fill in" instructions can be located in many areas of
NAIC. This article is intended to help new investors who see a
completed SSG, and understand only that the price should be in
the buy range, and the upside-downside ratio should be three-to-
one. They see copies of the Stock Selection Guide in magazines
or are handed one at a club meeting where someone prepared the
form by hand. Some are complete while others are only partially
complete. The computer prepares several versions. Then, most
are taught the mechanics of filling in the Stock Selection Guide,
using the rationale that plugging in numbers will help them
understand the purchase process. I hope this is different. -Ed Chiampi
A Primer For Beginning Investors . . . Or Experts With Poor Records
My background taught me that there is a tendency for most people who must use
written words as instructions, or guides (as in building kits, assembling Christmas
toys, or filling in forms), to make mistakes because of skimming the words, and
attempting to go too fast. Take your time. Try to understand each concept before
going on. Read this article with a completed Stock Selection Guide (SSG) of a
growth stock as your guide. Most NAIC Stocks to Study will suffice. All growth rates
will be compound growth rates unless they are identified as simple growth rates.
The Blank SSG:
A form. A guide. A place to add notes if you wish. Your worksheet.
The Completed SSG:
Someone's idea of a company's potential. The company could be good or bad, and
the study could be good or bad. Check it out. Accept it if it's worthwhile, or file it in
the nearest round file. You have a decision to make here.
Section 1
Visual Analysis: The Front Page
Visual: To look at
Analysis: To break down into basic parts
The SSG front page consists of a Header, Footer, and a Chart. There also is a
section on the upper left side where Quarterly Information is recorded. When you
try to comprehend the whole thing at one time, it appears to be overwhelming.
That's especially true if you peek at the back side. Think of it this way. A house is
much too complicated for most of us to build without expert help. On the other
hand, I built two homes with virtually no help beyond that of my son and my wife.
You can only saw one cut at a time.
You can only hammer one nail at a time. You can only shovel one scoop at a time.
If you view the SSG in this light, you will see that many simple tasks combine to
reveal a few important concepts.
I will make you only one promise. If you keep trying, in a short time you will
understand this simple form better than you understand your spouse. We will
highlight what many believe to be the three most important questions the SSG can
answer.
The Header: An Area of General Identification
The left side is reserved for advertising. The right side identifies the company.
Here, the SSG requires the name of the company in question (see how quickly you
forget a company's name, or the date of the study, if it is left off), the name of the
person who completed the study (which also permits me to eventually assess his or
her talent), the size of the company, the insider and institutional ownership, etc.
Two items not listed that I always include are the date of the most recent published
data and the ticker symbol of the company. If you pick up a study to learn that it
was completed three months ago, but the data was six months older than the study,
you need a new study. That one is obsolete.
The ticker symbol is the unique signature of the company - recognized by all of Wall
Street. No other company has this ticker symbol. If you want to buy stock, be sure
the broker gets the right company, or the right issue, order by ticker symbol. By
using company names when buying stock, you raise the potential for errors. Wall
Street runs on ticker symbols, not company names. It is beyond my comprehension
to understand why there is no place on the printed SSG for the ticker symbol, and
yet, I have never seen the SSG completed by one of the NAIC instructors where it
has been left off.
Consider the (often-left-blank) space for potential dilution. Utilities always seem to
have a new issue pending. More and more shares of the company's stock become
available for purchase by the public. Your broker may not charge a commission on
new utility offerings. Well, all those new shares of stock dilute or erode the earnings
per share (EPS). Every time a new share is issued, each share requires its
percentage of the company's total profit.
Net profit divided by the number of shares outstanding equals earnings per share, a
much better indication of growth than total sales or total profit would be. Therefore,
we need to study growth with the EPS data, and if new shares will be added without
compensatory earnings, (such as you would find in the takeover of another
company), future earnings will be diluted.
If you cannot locate any preferred offerings, you can be pretty sure that there is no
dilution.
The Chart: Where Historical Data are Projected as Future Potential
At this point let me insert a comment you will often hear. "The past is no guarantee
of the future." A correct statement. How sad that it is so misused. Usually you hear
it stated as a cop-out or conditional statement regarding some analyst's tip on a
supposedly great stock, or as a hedge by a mutual fund telling you that a one time
success may not be repeated, but most often by a broker who is not at all pleased
that you want to do your own study instead of relying on his or her expertise.
The past may be no guarantee of the future, but it remains to be the best predictor
of that future! Projecting the future from historical data is the primary method used
by the SSG to help you select stocks for purchase. It is also the cornerstone of the
NAIC philosophy. History repeats itself. Growth companies grow, and companies
that trip, often trip again.
The chart has a right side and a left side. The sides are separated by a heavy
vertical line about two-thirds into the right side of the page. Locate that heavy line.
To the left of the line everything is past history and data there should not be
changed. The left side of the page reflects a company's past, published, record. To
the right of that line is someone's idea of the future, and you should always
question his or her judgment. The dark line itself is the last full year of published
data the company has submitted.
Let's look at that another way. On the left side of the chart, yearly sales and EPS
figures for the previous 10 years are inserted onto the chart. The points are
connected. A trendline is then drawn through those plotted points to show past
growth rates. When the trendlines are projected to the right hand side of the chart,
an estimate of future sales and EPS is accomplished.
The first, and possibly the most important item the SSG reveals is;
Is this a growth stock?
Look at the chart and determine if the lines created by plotting the sales and
earnings are straight, or if they are jagged. Pure growth stocks produce lines on the
SSG which are quite straight, and are higher each year. I recently heard one
analyst comment that the best indicator of growth next year is six previous years of
ever increasing EPS. Jagged lines (up and down, then up...) are created by stocks
which are affected by the business cycle (cyclical stocks) or by companies having
problems.
There are reasons to buy cyclical stocks. Oftentimes they are cheap when the
business cycle is starting upward again, while problem stocks provide us with
turnaround situations. Some growth stocks are affected by the business cycle, too
(cyclical growth stocks). For beginners, I recommend sticking to pure growth stocks
simply because they are easier to interpret (... harder to find in the buy range, but
easier to understand).
If this is not a growth stock, you could decide not to waste your time. You could
begin to look for another stock.
One of my favorite quotes, supposedly authored by Yogi Berra, states that, "A
person who doesn't know where he is going sometimes ends up someplace else."
Not understanding that one should purchase growth (good management) for the
long term, or buy a turnaround stock for the short term (profit), could lose you a
large part of that profit in either situation. The best way I've heard it stated is that
you buy growth companies, but you only rent special situation stocks. Concentrate
on growth while you are learning.
A second important item identified by the chart is the compound rate of growth.
Comparing the trend lines (plotted) to the existing guidelines (printed) describes
how fast the company is growing in both sales and earnings (or whatever else you
might wish to plot). All growth lines created by the SSG are compound growth lines.
The steeper the angle, the faster the growth. The vertical row of numbers along the
very right hand side of the chart shows the compound growth rate of the slanted
line, which intersects the chart near the number.
Item number three: Since both EPS and sales are plotted, you can compare the
growth lines (rates) of Historical EPS to those of Historical Sales. As a company's
management team learns how to best run a new company, EPS often grow more
rapidly than sales. The EPS lines will be a little steeper. This cannot continue
forever. For the beginner, it is often safer to slow down projected EPS growth rates
to mirror projected sales growth rates.
More experienced investors, correctly and incorrectly, will make their own
decisions. Outstanding management may continue to grow EPS more rapidly than
sales for years. The NAIC guideline here is to project future EPS at no more than
15 percent. This requires a company to double its operation every five years. That
is very difficult to do. Yet, the great ones IBM, Xerox, AFLAC, RPM, McDonald's,
and a host of other great companies did double EPS for five years . . . many times.
And, in the early years of their corporate lives, they did it at higher than a 15
percent growth rate.
Which brings us to two very important constructions, the projections of sales and
EPS five years into the future. History determined the past growth rates. We must
determine the future growth rates. This is called adding our judgment. For growth
stocks, the most recent years should influence our judgment more than the earlier
years. We should seek stocks where sales and EPS are growing at 15 percent.
(Nine percent seems almost too easy to find, 12 percent is approximately the
average of Wall Street professionals. At 15 percent growth, your investments will
double every five years.)
If this does not seem rapid enough for some beginners, they have not yet
experienced the almost magical compounding which takes place over the years. If
you seek more than that, you are gambling, and luck will play a larger role in your
future. NAIC provides a logical, safe method of investing in growing companies as
compared to the large percentage of people who simply play (gamble) the market.
NAIC does not embrace Get-Rich-Quick schemes. It is a slower, more certain road
to financial independence.
The end result of those projection lines creates a point on the very right hand side
of the chart where the anticipated sales and EPS, five years into the future, are
listed. Those points are read as dollar amounts, which should be printed near the
point. This projected EPS result is transferred to the back page in a later step where
it is used to create the forecast high price. The sales projection is used in creating
another future EPS projection called the preferred procedure.
This preferred procedure process starts with the five-year estimated sales
projection, and uses a formula to transform future sales into projected (future) EPS.
It is an excellent way to determine projected EPS, but you will have to find the
formula outside of this article. Since many beginners read Better Investing
Magazine, it is seldom used in a Better Investing column.
All bits of data are probably more useful than you might think. Look at any of them
and consider them for a few seconds. For example, find the dates on the bottom of
the page. There was a small recession in 1990-1991. How did the sales and EPS
respond near those years? Could this explain a timely dip in an otherwise solid
looking growth company? Software developers might consider inserting such an
indicator in future software versions.
Finally, the yearly high and low prices for the past 10 years are shown as vertical
bars on each line, in the historical portion of the chart.
Recent Quarterly Figures: A Comparison to Last Year's Quarterly Figures
Since this information may not show up on the plotted lines, you might think it is not
too important. It can be very important. Many investors always plot the most recent
quarterly information on the chart. Sometimes it changes the starting point for a
future trendline projection, and sometimes it confirms the original projection by
falling on the line, which may have been plotted earlier. There is another reason.
I've seen studies that looked beautiful, except that the latest quarter of data
decreased instead of increasing, or increased too slowly. On several of those
studies, it was the only indication of a collapse which followed, and I emphasize that
the collapse could not be anticipated anywhere else on the SSG. Why look here for
the possibility of a future problem? Because this is the latest corporate information
available, and if a slowdown is about to take place, this is where you see it first.
Look for a minimum of a 10 percent increase over the past year's quarter (if you
seek 15 percent growth).
Don't be concerned about the price action of the stock after you purchase it. It is
hard for beginning investors to ignore a downward movement in a stock's price.
However, daily movements and market swings make the price fluctuate up and
down. Be concerned here about growing earnings per share. A dip in earnings per
share should be disturbing, especially when it is unusual for the company to have a
shortcoming here. If there are several unusually low quarters in a row, it is even
more disturbing. This becomes particularly serious when management has
previously stated, "The problem is minimal, and all will be well soon."
Don't confuse the above paragraph with the following scenario. A nice earnings
increase is reported by the company, but some analyst comments that the increase
fell short of his (the analyst's) expectations. This happens very often. Following the
analyst's comment, the news media broadcasts his or her horror of the situation to
all the traders listening that day, and the price rockets downward . . . presenting the
long-term investor with an excellent buying opportunity. My comment regarding this
situation is, "Wall Street just shot itself in the foot . . . again."
I've made it my own rule that I will not purchase a stock where the most recent
quarter's data has not increased to my satisfaction. (I guess that sounds like the
analyst in the above paragraph.) Maybe this rule is better: don't buy until you
understand what is going on.
The Footer
Once the preparer determines the historical and projected growth rates of sales and
earnings per share, they are written in the space provided in the footer for easier
recognition. If a trendline or projection line shows a 12 percent growth rate, 12
percent is written in the space provided.
To summarize the front page, look for the plotted lines to be straight. Seek 15
percent growth. Be careful with your projections both ways. Don't be too generous
with your predictions, but being too conservative can keep you out of a good value.
Compare EPS growth to sales growth. All the little bits of information can be
important. The biggest mistake beginners make is to turn the page over and let their
eyes rove to the Upside/ Downside Ratio without understanding a thing about how
the preparer made his or her decisions.
Section 2
Evaluating Management
(This is still a visual analysis technique)
Section 2 answers the second important fact about this company.
What kind of a job is management doing for the shareholders today?
Again, the first line shows the company name and the date.
Too many beginning pencil-and-paper users of the SSG ignore Section 2. Perhaps
it is because of the calculations that need to be made, or maybe they don't see the
importance. Do not over look this area. If you are investing for the long term, try to
name one thing that is more important than increasing management efficiency. (By
the way, on the front chart when EPS is shown to be increasing faster than sales,
those EPS to-sales comparisons show up here as improving management
efficiency.) If you were thinking that product may be more important, let me relate a
personal incident. When my son was two, he had a beautifully built little plastic and
metal jeep on which he scooted around the house. As I was a beginning investor I
decided to look up the company making that great toy. It was in bankruptcy.
Below the company name, etc., you have two rows of boxes labeled A & B. The
information placed in row A is a 10-year record of the company's "% Pre-tax Profit
on Sales." This is one of the better indications of management efficiency that is
available to us. The "Pre-tax" part removes one of the variables over which
management has no control. It is more fair and accurate to judge management with
pre-tax profit than to judge them with profit after taxes.
Look across that top line to the right. You can see at a glance if the numbers are
increasing or decreasing. The higher the numbers, and the bigger the change, the
better the job management is doing. The "Last 5 Year Avg." simply averages the
last five years of information. Comparing the last year's data (immediately to the left
of the average), visually shows if last year's pre-tax profit was higher or lower than
the five-year average. That up/down trend is noted in the last two boxes on the
right. The trend you require is upward, or at least level.
Row B is similar to row A, except that it uses "% Earned on Equity," often referred
to as ROE, as an efficiency test.
Item One: We compare the last year of data to the most recent five-year average,
not the 10-year average. It was previously stated that the most recent figures
should influence our judgment more than the earlier years.
Item Two: The numbers themselves can be very different from industry to industry.
Supermarket chains operate on very small profit per item, but have very large sales.
High tech companies have large profit per item, and not all have very large sales.
You can't compare these numbers between industries. Low profit (per item)
companies show low figures here, while high profit (per item) companies have
larger figures. Some industries are more labor intensive than others are. Some
industries have higher fixed costs than others do. A study suggestion is to consider
studying an industry rather than a company and seek to find the leader in that
industry. That is the stock you should consider for purchase. Look for the
companies on the leading edge of their industry. Sticking with them over the years
will make you a wealthy investor.
Section 3
Price-Earnings History
This section could conceivably be considered the genius of the SSG. To go back to
the beginning, the SSG is really a 10-year study of relationships between prices
and earnings, with sales added to include management efficiency. Studying sales
also helps to answer the question of stability. However, 10 years of daily price
changes and relationships (ratios) to those prices, make using the raw data
monstrously difficult. This section changes all those years of data into a few
understandable ratios. What we need to know is, "Can we buy this stock today?"
And, "How much profit can we expect in five years, beginning at today's price?"
Going beyond that, future studies may well show you that you could continue to
hold your investments for 10, 20 years, or maybe longer. I have such stocks, and
the information I need starts right here. It is not hard to find good or even excellent
companies. Ask your broker and he will hand you a list of a hundred. Now ask him
what is a good buy today, but check his answer before you buy! You not only have
to find great companies, but you have to find them at a price that is reasonable.
This area calculates the ratios, which help to provide those answers.
The top line shows the yearly high, low and present prices. A quick visual
inspection tells you if today's price is near the yearly high or low. Some investors
are interested in shares that are high and running. Others look for value in shares
where the present price has retreated from its highs. If the price is down, there
should be a reason. Has there been bad news such as a decrease in latest
quarterly earnings? Has some brokerage house lowered a buy rating? Has a
governmental decision affected the company, or is the business cycle changing?
When the price drops considerably, the SSG quickly shows the company as a buy,
often too quickly . . . before the new Quarterly Data is published.
Columns A, B, C, and YEAR are places where the year, high and low prices, and
the EPS for each year are listed. Remember the EPS is "net profit divided by the
number of shares outstanding." When you divide the high price for each year by the
EPS, you come up with a theoretical calculation called the (yearly) high P/E ratio.
They are placed in Column D. The low price divided by the EPS gives us the
(yearly) low P/E Ratio, another theoretical ratio. The low P/Es are placed in Column
E.
Once all 10 high and low P/Es have been placed into Columns D and E, you must
scan the numbers in each column and look for two details.
First, are all the P/Es similar, or does one seem to be too high or too low as
compared to the others in its column? When a P/E is four - five points higher or
lower than the others in that column, you could remove it from the calculations, and
average only the remaining four P/Es. Deleting one of the P/E figures from our
averages is another example of adding judgment.
Second, notice if the P/Es seem to be growing higher in the more recent years.
Many shares of growth stocks, as they become noticed, are purchased by investors
and locked in a drawer This has an effect of making the supply of available stock
smaller, and market forces require buyers to pay a premium for their ownership.
The P/E ratio begins to get higher. The process is called P/E expansion. The
primary way to earn a profit in the stock market is to buy stocks in companies where
the EPS rises continuously. The second way to gain profit is to buy stock in
companies where the P/E has a chance to rise. This is an excellent reason to buy
stocks with low P/Es as compared to stocks where the hype on Wall Street has
already priced the stock out of any realistic measure of a buy range.
The theory behind buying a stock that is priced too high is that another fool is out
there that will pay even more for it than you did. It even has a name: "The greater
fool theory." It is a cliche used by traders. I prefer to fill in the SSG. This does not
mean that you should never buy a stock with a higher than normal P/E. Many
excellent companies begin their life with high P/E ratios, and seem to hold them for
years. There is a difference in "high P/Es," and a "P/E which is high for that
company." I wish there were a way for all new investors to have five years of prior
investment knowledge.
Try to remember that traders are often right. Wall Street is full of very bright MBAs.
You are not going to outmuscle them with brainpower, or find some thing that they
overlooked. They have a discipline of investing to follow also, and 90 percent of socalled investors are traders. You are the minority on Wall Street. The difference is
found in the time the investment is held. Many traders think that holding stocks for
more than a few months is a very long time. "Day traders" go berserk when they
own a stock over the weekend.
Remember that you cannot use short-term philosophy to intelligently purchase for
the long term any more than the trader can use an SSG report to determine today's
price swing. That's why brokers often cannot give us good advice. They become
very short-term oriented since their analysts as well as their clients are short-term
oriented. Since we are trying to invest for the long term instead of looking for a
quick profit, we need a discipline such as the SSG provides.
By averaging Columns D and F, the SSG provides two more P/E ratios, the
average high and average low P/E ratios for the five-year period. They are placed
on Line 7 in Columns D and F. Suddenly, you have a range of P/E ratios from high
to low, which, when you look at the present P/E ratio (often available in the
newspaper), you can (immediately see how the present (current) P/E compares to
those historical 5P/Es. By averaging the high and low P/Es from Line 7, you get the
"Average Price Earnings Ratio" (actually a five year average P/E ratio) which is
listed on Line 8. We strive to buy when the present P/E ratio is at or below this
average P/E.
Why do these few formulas deserve to be called the genius of the SSG? Because
virtually no one else uses them. Everyone has present P/Es, estimated P/Es and
average P/Es, and constructs too numerous to mention, but I never see anyone
else compute them as on the SSG, or create a range of P/Es which can be
compared as carefully with the present P/E. The SSG also uses the average high
and low P/Es in the construction of future high and low prices.
Many analysts, including NAIC analysts, sometimes compare the coming year-end
anticipated P/E to the average P/E. Brokerage houses do this regularly. Comparing
the expected EPS or P/E at year's end, to today's price, or today's P/E, makes the
stock appear to be cheaper than it really is. In other words, are you looking at actual
EPS figures, or has the analyst inserted year-end estimated EPS? The use of
estimated EPS is of value. It can help you to make the difficult decision when a
stock is on that thin line between buy and hold, but as an investor, you must know
which P/E you are observing.
One thing happening here is that the SSG is weaning you away from thinking about
prices, and is leading you to thinking about P/E ratios as value indicators. Let's look
at an example. A company with a price of 10, and EPS of 18 cents last year, had a
P/E ratio of 55.56. That means you had to pay $55.56 for each dollar of earnings
(EPS) the company made. Another company with a market price of 75 had EPS of
$5.50 per share. That produces a P/E ratio of 13.64. You only have to pay $13.64
for each dollar of company earnings. Looking at it this way, the company with a
market price of 10 is about four times as expensive as the company with a market
price of 75. The $75 company had four times the value of the $10 company for
each dollar invested.
Of course, there's more to it than that. When growth rates are added in, you find
that investors will pay a higher price (in P/Es) for a rapidly growing company, as
compared to a slower moving company. Start to think P/E ratios when you study
stocks, not price. It is much wiser to own 15 shares of a more expensive stock in
the buy range, than to have 100 shares of a lower priced stock that is overvalued.
To complete Section 3, scan Columns F, C and H. They tell you about the
company's history of dividends. You will study many companies that pay no
dividends. That's not all bad. Uncle Sam requests that you pay taxes on dividends.
Column F tells you the size of the dividend that was actually paid for each share in
the year indicated. Look for increasing dividends. The other side of the coin
involves companies that lower dividends. This happens regularly with mature
companies like GM, where dividends dry up in recessions and spring back when an
economic recovery is proceeding strongly. When small companies lower dividends,
problems are not coming, they are here.
Column G shows you what percentage of EPS was spent for dividends. Why? Well,
growing companies need as much money as they can get for expansion. Generally,
a company that pays more than 30 percent of its earnings as dividends is maturing
and slowing down in its growth.
Dividing the earnings per share by the low price in Column B shows the highest
yield you could expect when you buy. Those figures are placed in Column H. All of
these dividend figures will be used again in later portions of the SSG.
Section 4
Evaluating Risk And Reward
Section 4 answers the third and last very important question to be answered by the
SSG.
Is this stock a buy today?
It does that by calculating buy-hold-sell zones. Then it uses the same prices used to
construct the zones to advise you how risky the purchase will be today.
Section 4A: High Price - Next 5 Years
The "Avg. High P/E," taken from Section 3 above, Column D, Row 7 (hereafter
referred to as 3D7) is multiplied by the "Estimated High EPS" (turn back to the chart
and locate the future estimated high EPS. That's the point where the earnings were
projected to the extreme right of the chart. A dollar figure was written there. The
result (of the high P/E times the high EPS) was placed at blank 4A1, where it is now
called the Forecast High Price. The only time you ever need to add judgment to this
forecast high price is if you feel you made an error establishing the projected
trendline on the chart, or if you miscalculated the average high P/E. The price at
location 4Al is one of the three key prices used in this entire section.
Section 4B: Low Price - Next 5 Years
Line 4B(a): The output from this line will become the "Selected Estimated Low
Price" in over 90 percent of the studies you will see from an NAIC source. It is the
second of three key prices used in this section. The third key price is the present
price and does not need to be calculated. That makes Line 4B(a) very important.
The "Avg. Low P/E" (from 3F7) times the "Estimated Low EPS" gives a potential
low price for the next five years. Where did we locate the estimated low EPS?
Typically it is found at location 3C5. Why isn't that spot identified on line 4B(a), as
many other spots are so located throughout this section . . . especially if this line is
so important?
Lines 4B(b, c, d): Lines b, c, and d, create three low prices used for determining
cyclical stocks, turnaround situations, and dividend producing stocks. Since they
are not used in the study of growth stocks, I will ignore them for this article.
(Studying cyclical and turnaround situations requires that you go outside of the SSG
for additional input of data, and, I'm sorry to say, timing. It becomes necessary to
determine how the company fits into the business cycle, and what management is
doing to repair existing problems. It may even become necessary to determine if
the company can repair itself.)
Notice that the result of Line 4B(a) has been transferred to 4B1, the Selected
Estimated Low Price (at the bottom right of Section 4B). If not, the preparer may not
consider his or her study to be a growth stock, or may have included personal or
outside information with which to make the judgment.
Section 4C: Zoning
The high and low forecast prices are used in a formula to create buy-hold-sell
zones. The present price is compared with the zones to see if it lands in the buy
zone. You should be able to follow the formulas with a minimum of instruction.
Section 4D: Upside/Downside Ratio
This is another simple formula that does an important job. It helps you determine
the risk involved in buying at the present price. NAIC recommends having an
upside/downside ratio of at least 3-to-I so that you have a good chance of attaining
your 15 percent growth target. Generally, upside/downside ratio discussions end
here, but . . .
Let me deviate at this time. I happen to be looking at a study of Praxair Inc. dated
December, 1997. I will use three figures from that study, but you should use figures
from the study you are following and acquire a similar conclusion.
I took the selected low price (4B1), the present price, and the forecast high price
(4A1) and set them up as if I were going to add them:
Selected Low Price 33 40 - 33 = 7
Present Price
40
Forecast High Price 94 94 - 40 = 54
These are the three prices used in the construction and application of the
upside/downside (U/D ratio). Notice that the low price is only seven dollars different
than the present price, but the forecast high price is almost 54 dollars different than
the present price. What does that mean? First of all, it is partly how the U/D ratio is
constructed, but it also means that adjusting the forecast low price will change the
result of the U/D ratio formula, almost eight times as much as if the high price were
changed. Put another way, setting the low price is critical to a correct U/D ratio. If
someone shows you a study, and the low price is not correct, the U/D ratio is
meaningless. If the low price is set too low, it lowers the U/D ratio and you could be
missing a good buy. If it is set too high, it might look as if there were no risk at all.
Since the low price is so important, we must learn to zero in on it with a rifle instead
of a shotgun. Let's go back to that question I left dangling a few paragraphs ago. It
follows:
The "Avg. Low P/E" (from 3F7) times the "Estimated Low EPS" gives a potential
low price for the next five years. Where did we locate the estimated low EPS?
Typically it is found at location 3C5. Why isn't that spot identified on Line 4B(a), as
many other spots are so located throughout this section . . . especially if this line is
so important?
Yes, at that point we were talking about setting this critical "Estimated Low Price."
What if the figure you see as the estimated low EPS is not the same as the one at
location 3C5? Has someone taken liberties with the SSG? Not necessarily so. Is
the figure higher or lower than the one at 3C5? Look at the quarterly information on
the front of the SSG. Is the answer to be found there? Can it be a mistake? All you
know is that it is different from what you have been taught. Here is one good reason
why it could be different.
The figure at location 3C5 is the last full year data. I am writing this article in
December. In all probability, depending on the company's fiscal year, we have three
quarters of information, including a potential for increased EPS, which is
unaccounted for at location 3C5. Suppose your upside/downside ratio is just below
the 3-to-1 figure that NAIC recommends, which may place the price into the hold
range, but you are really interested in purchasing the stock of this company. You
may wish to "fine tune" the low EPS figure.
If you can locate a source of "the last 12 months EPS" for the company, and this is
even available in some newspapers, you may wish to use the newer figure. I
suspect that 3C5 was not used as a requirement for establishing the estimated low
price in order to give the student who has learned the importance of calculating this
key decision a little leeway. Why would a difference of (example) 30 cents be
important? Because, when the low EPS figure, inflated by only 30 cents, is
multiplied by the average low P/B, the result will create an estimated low price a few
points higher than without the 30 cents. That in turn could swing the
upside/downside ratio much more than many realized.
Since so many NAIC members are bound to the upside/downside ratio, those
people must understand its construction, and do whatever they can to make it
accurate. My thinking is that we are investing today, not at the end of the last full
year of printed data. Why not use today's figures? If the present price already
produces a 3 to 1 upside/ downside ratio, it is unnecessary to consider this
procedure.
If you take the forecast high price, and add five years of dividends, then divide the
result by two and compare that figure with today's price, you will see at once if
today's price will double your investment in five years. If so, you could purchase the
stock, even if someone set the low price incorrectly. Let's hope the forecast high
price was set correctly! Remember, you just decided the low price was incorrect.
Section 4E: Price Target
This formula shows the potential percent appreciation over the next five years in
simple interest terms. Look for 100 percent or better.
Section 5
5-Year Potential
Section 5 offers three formulas. Formula A gives the present yield at today's
purchase price. Yield figures are always available in the newspaper.
Formula B provides the average yield over the next five years. This output is usually
a little higher per year than Formula A as it includes consideration for rising
dividends. Neither formula is as important as they were in the past when much
more emphasis was placed on dividend investing. Dividend investing is still
important to those investors contemplating retirement.
Formula C combines the potential appreciation over the next five years with the
average yield, to provide a total annual return on investment. This is stated in
simple interest terms and must be converted to compound terms by using the chart
on the lower right hand corner of the page. In simple interest terms, you want to see
a 20 percent growth rate per year, and in compound interest terms, the rate you
want is the typical 15 percent. Either way, your money could double in five years,
which is really the standard you should seek.
Review
Eight Key Points For Growth-Oriented Investors
Here are eight key points for growth oriented investors to check, in reviewing their
analysis of a company on the NAIC Stock Selection Guide.
Is the company a growth company? Check for straight lines.
Are the quarterly figures improving? If not, are you gambling that they will
improve? A company that has been successful, and is now having problems, may
be on the way down. Leave the turnaround situations alone until you gain
experience.
Is the company growing at 15 percent, or do you believe that P/E expansion can
make up the difference? Also, add the average dividend for each of the five years
ahead (Section SB) to the forecast high price. If a company is growing at 12
percent each year and pays an average dividend of 3 percent, you still have a total
of 15 percent growth.
Are your projections realistic?
Is management efficiency stable or improving? This again ties in with item 2
above.
There are three very important P/E ratios to observe. Are the average high and
average low P/E ratios correct? Confirm that by checking to see if the yearly high
and low P/Es are within realistic ranges. See that the present P/E is the same or
lower than the five-year average P/E.
Check to see that the estimated high EPS is properly transferred from the chart.
Be certain that the estimated low EPS figure on the study is one that satisfies you,
before accepting the selected estimated low price.
If these eight points are correct, considering that the math was done properly, the
price zones and the upside-downside ratio should be correct. Check this by
doubling the present price plus all dividends, and comparing that figure to the
forecast high price. The present price should double in five years.
Summary
Concentrate on growing companies. Throughout this article, growth stocks have
been emphasized. There are other ways to make money in the stock market, but for
beginners, growth is the safest, and probably the most profitable method of adding
wealth. That is because growth stocks are the easiest to identify. It takes three
simple steps: Check the chart to see that EPS and sales are growing each year at
the rate you seek. Quarterly EPS and sales must show new growth, and
management efficiency ratings must show an upward or stable trend. The hard part
is finding them in the buy zone. But it can be done.
If you stray from those standards, and you will, don't invest the family jewels. Here's
why. As soon as sales and/or EPS falter, growing stocks often react as if their
growth vehicle hit a brick wall. This happens to new companies, where great
entrepreneurial spirit made the company sprint from the starting line, but now that
leadership team is having problems and needs professional management.
Sometimes longstanding growth companies with previously high ratings slow down
and the price can fall by 50 percent. They are often referred to as "fallen angels." In
either case, they pass our SSG test as if they were the greatest buys in the world
(except that the most recent quarterly figures will be down). Many of those fallen
companies recover and continue to new highs, but others cease to be growth
companies.
Every company is like an individual. They all react differently to success as well as
to difficulties. Typically, it takes a company years to turn around. You can always
wait for one quarter before purchasing to see the gravity of the problem.
What you must do when EPS fall is to continue to check new quarterly earnings,
and read all the news available about the company in question. Then check the
management efficiency ratios to determine if this downward trend could have been
detected, and if it is now improving.
You could consider making a two-dollar phone call to the company's director of
shareholder relations and ask why the EPS dropped. Then ask when they expect to
get back on track. Sometimes you get a straightforward answer, and sometimes
you don't. If you are not satisfied, ask what the analysts who follow the company
are saying, or how you can get in touch with those analysts. Generally, with a little
experience, it makes the phone call very worthwhile. Two dollars is good insurance
for a new investment.
The SSG may be the finest tool for selecting growth stocks that is available to the
masses. The professionals have their buy/sell computer programs, and their
reliance on which gurus they respect, etc., but on the average, the investment club
member does as well as the average professional at a much lower cost, and he or
she does not work at investing "all-day-everyday" either. Some of that success is
attributable to the SSG. However, the SSG is not infallible. You will buy turkeys at
times other than Thanksgiving. It is impossible not to do so. You have no control
over false corporate publications, disasters, governmental decisions, or pure
chance.
NAIC states that one purchase out of five will go sour. That's a very high 20 percent
failure rate! Even so, it does not matter. If the rate was doubly bad, I would still say
that it does not matter. Why? Because the rest of the story lies in the fundamental
beliefs that also act as your guide. NAIC has three principles that cover most
problems.
 Invest regularly, and stay fully invested. Supposedly, most of the year's profit is
attributed to the market action of a few days each year. If that is so, you lose
if you are not in the market every day. Market timers work much harder, and
most of them work for much less profit than the investor who buys growth
and holds for the long term. I have been told that it is boring to just hold onto
growing investments and not trade.
 Reinvest all dividends. This is a statement on compounding. You must
experience the effects of compounding over a long time. New investors
cannot know what good things compounding does to their portfolio until they
see it for themselves. Compounding says something about the term of
investing. The longer you invest, the more compounding will influence your
profit. I recently saw an older woman working in a supermarket. She was
working past what looked like her time to retire. My thought was one of
sorrow for her. I guess she noticed me looking, and said, "I wish I started to
save earlier." I had no comment to offer her, but you must grasp the
importance of how important it is to invest early.
 Buy growth companies. There is much here that is implied rather than stated.
For example, growth companies are purchased for long periods of time.
Time and good management often erase problems that all companies
encounter. Even a steep loss in an initial investment could provide an even
better buying opportunity. Some of your success depends on your
confidence in yourself. But most important is an implication about buying
and selling in general.
NAIC says not to sell for a profit. Taking a profit could take you out of an
exceptional long-term upward move of the company. Some of my earliest mistakes
were selling my investment without requiring myself to do another SSG study
before selling. I guess I sold for a profit, and I don't do that any more. The opposite
side of that coin is, "When do you sell?" The only answer is that your company no
longer fits your criteria for purchase. Basically, if you loose faith in management, it
could be time to sell. A new SSG study will help you to make a sell decision. Forget
about "buy low and sell high." That is trading. "Buy well, and don't sell." I would like
to acknowledge the author, but I do not know who said it first.
Another NAIC statement fits into this broad area. If you sell your winners, you will
end up with a portfolio of losers. Conversely, if you sell your losers, you should end
up with a portfolio of winners. So, sell the 20 percent of losers, and take the loss. As
the years pass, you will have only winners in your portfolio, and you will be buying
those same winners again and again, and your portfolio will grow very nicely even if
you pick a few losers now and then. Have confidence in yourself and in your
Guides. Besides, when you sell a loser, for once, Uncle Sam gives you a break on
your taxes.
Obviously, the SSG cannot do the whole job by itself. The entire process is
required.