BI > APRIL 1998

Understand the SSG Or You Will Buy Turkeys When It's Not Thanksgiving

A Learn and Earn Feature

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, a Chart, a section on the upper left side where Quarterly Information is recorded, and a Footer. 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

Note: 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 onetime 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 turn-around 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 trendlines (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 (on the reverse side) 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 overlook 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.

Establishing Value and Putting it All Together (Part Two)

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.