BI > APRIL 1998

Understanding SSGs (Sections 3-5) and Avoiding Turkeys (Pt. 2)

Learn and Earn Feature -- Part Two

Continuing on with Sections 3 through 5 of our Stock Selection, we'll finish the lessons we started in Understand SSGs or You Will Buy Turkeys.

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 something that they overlooked. They have a discipline of investing to follow also, and 90 percent of so-called 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 E, 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 E. 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 P/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, G 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 4A1 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 3E7) 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-1 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 minus 33 equals 7)

Present Price -- 40

Forecast High Price -- 94 (94 minus 40 equals 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 3E7) 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/E, 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.

1. Is the company a growth company? Check for straight lines.

2. 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.

3. 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 5B) 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.

4. Are your projections realistic?

5. Is management efficiency stable or improving? This again ties in with item 2 above.

6. 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.

7. Check to see that the estimated high EPS is properly transferred from the chart.

8. 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.

1. 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.

2. 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.

3. 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.

Ed Chiampi is the founder of NAIC's BetterInvesting Computer Group and a valued contributor to the pages of BetterInvesting Magazine and BITS for years.