BI > AUGUST 2005

Track Profit Trends

PEP Investment Group

Looking back at their club's founding in 1994, members of the PEP (Patience Equals Profit) Investment Group may have felt gratified that they organized just in time to participate in the great stock market boom of the 1990s. In reality, that may have been one of the worst times during which to obtain an investment education.

Starting in November 1994, the market went up for more than five years before peaking in March 2000. Picking winning stocks in the 1990s was like finding a rainy day in April -- it was just that easy. It's tough to hone skills when success comes effortlessly.

In contrast, the past five years have been discouraging and humbling for many individual investors and clubs. Members of PEP feel they aren't doing as well as other clubs and "sincerely want to learn how to do better."

Disciplined Approach

One of the club's greatest assets is the active participation of six of its seven members. These members do their own Stock Selection Guides and attend the monthly meetings. This is a tremendous participation rate and a sign that members indeed want to learn and improve.

The club admittedly has a bias in favor of large-capitalization stocks. Its members like to see dividends; mature companies are likely to have excess cash flow and fewer internal growth paths to consume the cash. Large-caps are also much easier to follow -- and generally safer -- than small and mid-sized companies.

Members of the southeastern Pennsylvania club research every company in which they invest. Monthly follow-up consists primarily of monitoring major periodicals for news about the holdings and reviewing stock charts for signs of price movement.

It's important to continue following stocks once they've been purchased, and PEP is to be congratulated for having a system for doing so. Big companies make big headlines, and following these stocks through the newspaper is probably sufficient. Smaller companies may not generate such headlines, and one or more club members should monitor a Web portal such as Yahoo! for news on small- and mid-cap holdings. The club also produces a new SSG for each holding at least once a year, another wise and appropriate move.

It's not enough just following price movements of an investment. Monitor the sales and profit trends of a company on a quarterly basis. Determine whether sales are growing and profit margins are stable or improving, leading to higher earnings per share. This is the fundamental driver of long-term investment success.

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Earnings Are Paramount

It's hard to double a stock's return in five years if earnings don't approximately double as well. A doubling of earnings in five years can translate into the hoped-for 15-percent annual growth in total return. The normal rate of annual earnings growth is just 7 percent to 8 percent, so achieving 15 percent takes some work.

With a portfolio packed with blue chip stocks, PEP has its work cut out for it achieving above-average growth. Consensus annual earnings growth projected by analysts is around 11 percent for the entire portfolio, several points short of the goal. There's nothing wrong with 11-percent growth, but Wall Street analysts are notoriously rosy in their outlooks, and investors must discount the published growth rates to get back to reality.

Growth Equation

Will Wal-Mart Stores, Inc., really grow 14 percent a year? Consider that to grow its sales by 10 percent over the next year, Wal-Mart would need to add $29 billion in new revenue. This is approximately the size of Best Buy Co., Inc., and would need to be repeated every year. Size makes it tougher to grow a business. At a price-earnings ratio of 20 times trailing EPS, Wal-Mart is not particularly cheap, either.

Stryker Corporation is expected to grow 20 percent a year. PEP notes that Stryker was a recent purchase intended to expand the club portfolio into the health-care industry. Stryker's earnings have historically grown by more than 20 percent a year, and health care is an area of rising demand. It's easy to see continued strong growth as America's aging population requires more of Stryker's replacement hips and knees.

Although we might question Stryker's typically lofty P/E ratio of 31 times trailing earnings of $1.52 per share, this is a high-quality company that should continue growing at a reasonable rate. It can be better to pay a little higher price for stronger growth than to pay less but receive little growth in return.

Several of the club's other holdings have been owned for many years with little payoff. Some of these are companies that were market darlings in the big-cap 1990s but were vastly overpriced by the end of the boom.

Consider that The Coca-Cola Company is no higher today than it was in 1996 and at just half its peak in 1998, Value Line reports. Why did Coke go flat? Annual earnings growth has averaged just 5 percent, with 2-percent sales growth, over the past eight years. Not only has earnings growth been subpar, but the stock was trading at a P/E of 38 by the end of 1996. Blue chips are nice, but overpaying for moderate growth is not a recipe for investment success. How does one detect moderating growth? By faithfully monitoring quarterly results.

Similarly, The Walt Disney Company's stock price is still about where it was at the end of 1996. Why? Again, the answer is 5-percent annual growth in sales and profits over the past eight years coupled with overvaluation. At the end of 1996, Disney's P/E was 35. It's now a more reasonable 23, but is this sufficiently low for investors to profit if 5-percent earnings growth continues? The club has seen almost no price appreciation in either Coke or Disney despite owning them since 1995 and 1996, respectively.

Better Results

Many of the club's other holdings have fared better. The club has a nice profit in Aflac Incorporated, which remains reasonably priced at a trailing P/E of 17, with expectations of mid-teens earnings growth.

While McDonald's Corporation may have seen its best growth days already, it too is reasonably priced at a trailing P/E of 15. Earnings have grown 9 percent a year over the past decade, and investors can reasonably look for more of the same. If the P/E of 15 holds and earnings grow 9 percent a year, investors should expect annual appreciation of 9 percent, plus a dividend yield of almost 2 percent. While the total of 11 percent falls short of the BetterInvesting target of averaging 15 percent over the next five years, there's nothing wrong with an 11-percent annual return.

Similarly, Intel Corporation may also have seen its best days, but a P/E of 20 times trailing earnings is probably acceptable for one of the world's great franchises. General Electric Company, however, has barely grown its earnings since 2001 but still trades at a trailing P/E of 22 because of a solid forecast for 2005 growth. This might be a candidate for replacement if a better alternative emerges.

Unpopular Industries

The tobacco industry hadn't yet lost a court case over smoking, and cigarette makers have been able to raise prices in the United States to offset the costs of litigation. But smoking continues to fade in this country.

Only 19 percent of 2004 revenue for PEP holding Altria Group, Inc. (previously known as Philip Morris), came from U.S. tobacco, however. An additional 44 percent came from its fast-growing international tobacco business, and the remaining 37 percent came from investments and its majority ownership of Kraft Foods Inc. While many investors may shun tobacco stocks for philosophical or legal reasons, the growth of its non-U.S. business and the stability of Kraft may make Altria a worthwhile, if controversial, choice.

Southwest Airlines Co. is the best of a bad lot. The domestic airline industry is saddled with intense competition, overcapacity and high costs. Southwest has managed to avoid many of the industry pitfalls by using nonunion employees, hedging its fuel costs and deploying a single type of aircraft to reduce maintenance and training costs.

Although the industry has been terrible, a portfolio would do well if it contained some companies as superior as Southwest (but preferably in better industries). The club has a very small position in Southwest; members may want to discuss whether to increase it or sell.

Selling History

PEP finds selling difficult, as do many clubs and individuals. One sure sign that a club has difficulty deciding when to sell is the retention of shares acquired in spinoffs. The club has had three of these: Agere Systems Inc., B; Avaya Inc.; and Medco Health Solutions, Inc. (The club recently sold Medco.) The Agere position is too small to cover brokerage commissions, but Avaya can be sold just to eliminate the distraction over such a small holding. Members admit they don't even follow these spinoffs.

Over the years the club has sold Clayton Homes, Inc. (acquired by Berkshire Hathaway, Inc., in 2003); JPMorgan Chase & Co.; Motorola, Inc.; Oracle Corporation; Sara Lee Corporation; and Wendy's International, Inc. Most of these sales were initiated to raise funds to pay departing members, but the club also admits that these "seemed to be stocks that weren't going anywhere major."

Medical Territory

The club has become somewhat frustrated over its shares in Merck & Co., Inc. Members note that "we live in the heart of Merck country, and some of us have a personal, emotional bond with Merck, which makes selling hard although we know better."

It appears about 44 percent of Merck's 2004 revenue could largely evaporate over the next three years as many of its patents expire. Zocor, with $5.2 billion in annual sales, becomes subject to competition from generic versions in June 2006, for example. Fosamax, with $3.2 billion in annual sales, goes generic in February 2008.

Merck's research laboratories have developed no blockbuster products for many years. The pipeline of new products appears weak despite the almost $10 billion spent on research and development over just the past three years.

It was recently reported there might be as many as 100,000 lawsuits following the company's withdrawal of the drug Vioxx last year. The estimated cost to settle these suits is $18 billion to $20 billion and perhaps even higher.

Any of these issues might be valid reasons to sell the stock. Taken together, these challenges are potentially devastating to the company's future stock price.

Good Hunting Grounds?

If the growth outlooks for many of the club's companies are moderate and their prices are high, where should PEP look for better alternatives? The club currently obtains most of its ideas by perusing Value Line for "timely" industries and then looking at stocks within those industries. It's good the club has a system for identifying new prospects. The downside is that timely industries may be overpriced or attractive for only a short time, not over the long run. The club recently discovered this when it looked into steel stocks, which were considered timely but "priced way beyond us," members report.

Energy stocks were also labeled timely by Value Line, and the club purchased a new holding -- AmeriGas Partners, L.P. -- with just 3-percent to 5-percent growth but with a nice 7-percent dividend yield. AmeriGas is a propane distributor and pays out its cash flow to investors in the form of a dividend. Investors shouldn't expect to make 15 percent per year on an investment like this, but it can still provide a worthwhile, conservative return.

Value Line's timeliness rankings for stocks and for industries focus on near-term momentum rather than on long-term growth and value. Although Value Line's stock selection methodologies aren't consistent with those of BetterInvesting, the data provider is a great source of information. Its Small- and Mid-Cap Edition provides information on companies that are less well-known.

Thinking Small?

Small-capitalization stocks can be scary for many clubs. They frequently have just one principal product or line of products and possess limited resources to seek out new markets. There is, however, a broad middle ground between the giant blue chips and the small fry: mid-caps.

Many mid-cap stocks have been around for 10 years or more, so they can be fairly stable. They frequently have better growth opportunities than the big guys without the one-product risk of the smallest stocks.

Consider for a moment Aeropostale, Inc., Copart, Inc., and FactSet Research Systems Inc., plus emerging large-cap stocks such as Affiliated Computer Services, Inc., and T. Rowe Price Group, Inc. Income-oriented investors may shun these stocks because they tend to have low or nonexistent dividend yields, but the total return prospects can be sufficiently enticing to warrant including some in even a conservative portfolio.

Let's summarize all these observations:

Stay on top of existing investments by monitoring quarterly sales and profit trends.

Diligently search out new stock ideas. Have the courage to venture into new areas as the club has started to do with Stryker and AmeriGas.

Challenge your existing holdings with new ideas and trade when substantially better alternatives appear

Don't measure yourselves against pure-growth investors when members seem satisfied to see conservative growth plus income.

Perhaps BetterInvesting's philososphy that a growth stock should double in five years requires taking steps you're unprepared to take. Relax. There are many ways to make money as an investor. Don't hide behind conservative growth as an excuse to stay with well-known companies that may be overpriced, however.

The opinions expressed in this article are those of the author and do not necessarily reflect positions of either this magazine or BetterInvesting. No investment recommendations are intended. Portfolios are reviewed only in "Repair Shop." Send portfolio, current valuation statement and description of club challenges to "Repair Shop," c/o NAIC, 711 W. 13 Mile Rd., Madison Heights, MI 48071.

If a sharp photograph is available, send it along with the members' names, in order, and preferably in the form of a JPEG (RGB) electronic image set up as a high-resolution (300 dpi) or large (72 dpi) file. Include names of those not pictured.

Scott D. Horsburgh, Chartered Financial Analyst, is president of the investment management firm Seger-Elvekrog Inc., Bloomfield Hills, Mich. The author and clients of his business may own stocks mentioned in this article. Views expressed in this feature are those of the author and don't necessarily reflect positions of either this magazine or BetterInvesting. No investment recommendations are intended.