BI > DECEMBER 1997

Should There Be One Stock For Each Member to Watch?

A Systematic Method for Follow-Up

"Our objectives at this time are to have a good time, to expand our knowledge and to grow our portfolio," writes a member of the Learn and Earn Investment Club of Beardstown, Illinois.

"It is our goal to have one stock for each of the 16 ladies to 'watch.' We would be most interested in knowing if this goal is realistic," they conclude. They also would like to know if they have sufficient diversification in their portfolio.

By my count, the club has 12 different industries in its portfolio (see table below), but the distribution is somewhat skewed toward four stocks: Ameritech, Deere & Company, PepsiCo, and Wal-Mart Stores. They need to work toward adding to other stocks -- those with good prospects.

Adequate diversification is achieved by having about equal market value in at least 10 to 12 different industries. Further diversification is not necessary until the portfolio value rises to around the $150,000 to $200,000 level. Actually, I think all of the risk minimization is achieved by diversification among 10 to 12 different industries. Beyond that, the fluctuation in value is defined by some people as a measure of risk. My feeling is that there is more to risk than just market fluctuation, but space does not permit a full discussion at this time.

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It is an excellent goal to have each member follow one or more stocks. By "follow," I mean more than just review the price. The member should have a systematic method for follow-up on each stock in terms of the factors that led to the purchase and addition to the portfolio:

• Sales growth
• Pre-tax profit growth
• Pre-tax profit margin
• EPS growth
• Valuation
• Management's ability and competence

In other words, how do the company's actual results compare to the assumption made in your five-year forecast on the BetterInvesting Stock Selection Guide (SSG)?

BetterInvesting has several useful tools in this respect and they complement each other to help the portfolio management process.

Portfolio Evaluation Review Technique (PERT)

Gather, record, and make the necessary simple calculations to record sales, pre-tax profit and earnings per share (EPS) results both on a quarterly and latest 12-month basis. The data can be obtained from company quarterly reports, quarterly financial releases and from various printed and online sources.

I have adopted the practice of going on the Internet to get expanded details on companies of interest once I see their earnings report in the daily paper. The EDGAR data base by the Securities and Exchange Commission is particularly useful in that it makes available the 10-Q (quarterly) and 10-K (annual) reports filed with the SEC about 45 days or less after release. Don't count on much less than 45 days.

Giant Stock Selection Guide

The trailing 12-month sales, pre-tax profit and EPS should be plotted by quarter and compared to the past 10-year trend plus your future five-year projection. As with the PERT-A data, look for positive or adverse changes that will be reflected in investors' perception of the future value of the stock. Of course, if all is going well, that's good.

PERT Report

Use the PERT report to present the numerical data to the club members. The report provides a display of quarterly results and 12-month EPS compared to a year earlier. Valuation calculations of relative value, price-earnings ratio (P/E) and the upside-downside ratio indicate whether the price is attractive or not if the other fundamentals are on track.

The book, Starting and Running a Profitable Investment Club, BetterInvesting's Official Guide, has a chapter on PERT (Portfolio Evaluation Review Technique) that can be helpful, although there are a number of errors in it. (Editor's Note: We will note them in a special article on PERT coming soon in BetterInvesting Magazine.)

Reading

Each member should read business publications such as The Wall Street Journal, Business Week, Fortune, and The Economist to learn about plus and negative stories about management, the industry and the company.

As noted earlier, each member should have one or more stocks to follow. That doesn't mean if you have 16 members, you must have 16 stocks. Some of the members and officers have other duties, and more than one member can follow a stock. The important point is to have someone put it all together for the giant SSG and PERT report for the monthly meeting.

The STB Stock Analyst computer program has a PERT capability. The Investor's Toolkit software is being revised and should soon be able to produce the results formerly available from the PERT for DOS software. However, I started out by conceiving PERT and putting it to use using manual methods. A computer is not necessary to put PERT to work for you. Try the manual method if you don't have a computer and software. The important thing is to have the data and use it.

As for future growth of the portfolio, I find it very helpful to look at the growth characteristics of each stock and then ranking all the stocks by their estimated long-term earnings growth rate, as shown in the accompanying tabulation below.

Price appreciation comes from a combination of two factors:

1. EPS growth
2. Expansion of the P/E ratio

If you select stocks at a current P/E ratio, based on estimated EPS about 12 months in the future, that is less than a reasonable historical average and the EPS growth meets investors' expectations, then the price should rise. The combination of a P/E ratio expansion and growth of EPS is a powerful force for increasing shareholder value.

The goal should be to try to double the market price in five years from a combination of these two factors. That's a compound annual rate of return of just under 15 percent. If you have EPS growth at least in the teens, it certainly helps.

The Learn and Earn Investment Club has a set of stock selection guidelines that take into account Value Line timeliness, Value Line safety ranking and beta. These are in addition to the usual criteria emphasized in the SSG. I consider Value Line a very useful source of reliable data, however I ignore its timeliness rankings because they are based primarily on technical factors rather than fundamental ones. (As the quip goes, the way to end up with a million dollars is to start with two million and use technical analysis.)

I find S&P earnings and dividend rankings to be more useful than Value Line safety rankings. S& P uses absolute values for establishing rankings whereas Value Line forces a fraction of their total universe to be ranked 1 for safety and a somewhat larger population to be ranked 2. Safety, in my view, is a function of earnings and balance sheet strength, predictability of earnings and management competence.

It is not realistic to expect a doubling of price in five years from stocks having less than double-digit EPS growth. A look at General Mills shows no growth of EPS since 1993. Deere & Company tends to be cyclical, hurt by economic recessions. Even factoring out these big drops in EPS, long-term EPS growth does not seem to be in double digits.

Wal-Mart Stores' EPS growth has slowed from the rapid pace when Sam Walton ran the company. It is difficult to grow at a rapid geometric pace from a $100 billion annual sales base. Profit margins have been declining. I don't expect investors to be willing to pay future P/E ratios that are equal to what they paid when Wal-Mart Stores was growing its EPS at a 20 percent annual clip.

PepsiCo has spun off its KFC, Pizza Hut and Taco Bell restaurants to shareholders on a 1-for-10 basis. The new company is called TRICON Global Restaurants. The cost basis has to be adjusted to reflect the relative prices on the day of distribution which was Sept. 19, 1997. To calculate the cost basis of TRICON, multiply the original cost basis of PepsiCo by 0.075932. Then change the cost basis of PepsiCo by multiplying the original cost of PepsiCo by 0.924068. (See related article)

For the Learn and Earn Investment Club, the portfolio value is too small to contain two restaurant stocks, McDonald's and TRICON. At this point, TRICON is an unknown situation, but does not look attractive on a historical basis. However, who knows what a new independent management team can do?

The August, 1997 purchase was Walgreen. The stock is an excellent company with a predictable growth rate. However, I think the P/E paid probably discounted the future growth prospects too far into the future. At a price of 28 5/8, the P/E was 28.6 times estimated 1998 EPS of $1.00; that is 220 percent of the estimated 13 percent growth rate, which to me looks like an overly generous valuation.

A few adjustments in the portfolio as described above, combined with the suggested stock follow-up techniques, should greatly help the Learn and Earn Investment Club become a profitable organization, continue to have lots of fun and, more importantly, really learn what investing is all about.

Ralph L. Seger, Jr., CFA, serves as chairman of Seger-Elvekrog, Inc., a Bloomfield Hills, Mich. investment management firm (www.seger-elvekrog.com). He is also president of the Investor Advisory Service.

Portfolios are reviewed only in "Repair Shop." Portfolios are selected for review on the basis of human interest considerations, problems to be "repaired" that will teach a lesson, and other factors that can help us craft interesting columns. Send your portfolio, together with a current valuation statement and description of problems, to "Repair Shop," c/o BetterInvesting, 711 W. Thirteen Mile Rd., Madison Heights, MI 48071.