BI > MARCH 1994

'Old College Buddies' Need to Set Objectives

"We are a young investment club, roughly three years old, and having some difficulty in determining where the club is headed," writes a member of the 1911 Investors of League City, Texas. "Some members want to get much more aggressive and invest 25 percent of the club's assets in small capitalization stocks whose prices are below $10 per share. Others want to take a more conservative approach and believe we are headed in the right direction. What do you think?"

Part of the club's problem is communications. The 12 members are old college buddies who thought that forming an investment club would also provide a means of keeping in touch. All of the members are about 30 years old and most feel they can afford to take some risks and try more aggressive stocks.

The points raised by the 1911 Investors are important considerations for all investors, clubs and individuals. One of the first things we do with a new client is to sit down and mutually agree on investment objectives. Some of the consideration that must be dealt with are the following:

• Is the primary objective growth or income, or a combination of both?
• Aversion to risk. How much volatility and price fluctuation can be tolerated? Does the investor say he or she is long-term oriented, but gets very concerned when some stocks in the portfolio decline in value? What quality of issues should be emphasized to trade off potential gains vs possible losses?
• If income is needed, how much?
• How will the investor's principal and income be protected from the ravages of inflation? At a 3.5 percent annual rate of inflation, the cost of living rises 41 percent in 10 years. Can the investor afford a 4 percent erosion in his or her standard of living?
• Does the investor wish to leave an estate or can the capital gradually be consumed in part or in total?
• What tax bracket is the investor in? Can he/she afford to pay capital gains taxes on securities that have a low cost, have appreciated, but are no longer suitable for meeting the investment objectives?
• Finally, and most importantly, is the portfolio to be an investment account or a vehicle for speculation? Can the investor afford the losses if speculative investments turn out to be big losers? If there is speculation, how do we decide when and how to cut losses?

These concerns may go above and beyond the interests of the 1911 Investors, but it has been my experience over the past 40 years that the reason most investment clubs fail is because of disagreement on investment objectives.

There are investors and there are speculators. There are "study and learn" investors and there are "hot tip" and "shoot-from-the-hip" investors. There are those who are serious about operating an investment club in a businesslike way, and those who view the club as primarily a social gathering with an opportunity to "shoot for the moon."

There is nothing wrong with the 1911 Investors agreeing on an aggressive investment approach so long as they understand what the consequences are most likely to be. And if some elementary, simple precautions are not taken, those consequences are likely to be disappointing.

When deciding whether to buy or sell these higher risk stocks, or any stock for that matter, use the NAIC stock selection tools to enhance the odds of gain and to reduce the odds of loss. For example, in using the NAIC Stock Selection Guide, make sure a stock meets a few requirements before you buy it:

• It should have an upside-downside ratio of 3 to 1 or better. This means that the odds of price appreciation will be at least three times as great as the possibility of a loss.
• The current price-earnings ratio (P/E), based on estimated earnings per share (EPS) approximately 12 months into the future, must be equal to or less than the historic five-year average P/E. The opportunity for price appreciation in such cases will come from a combination of EPS growth and a rise in the price-earnings ratio.

If a source of estimated future EPS is not available, make an educated calculation. Determine the realistic future growth rate of EPS. Multiply the last 12 months EPS by one plus the growth rate where the growth rate is expressed as a decimal. For example: Assume the EPS of Home Depot for the last 12 months is 98 cents and its expected growth rate is 20 percent. Then an estimate of EPS 12 months in the future could be:

$1.20 x 0.98 = $1.18

If the current price is 38 1/8, then the current P/E is 38 1/8 divided by 1.18, or 32.3. This is somewhat less than the P/E of 39 that we see in the newspaper, which is based on trailing 12 months EPS of 98 cents (38 1/8 divided by .98 equals 38.9). The stock market looks forward, not backwards.

Whether to buy $10 stocks or not is not the important question. The real question of importance is what value do your receive for your $10 in terms of a price-earnings ratio and other fundamentals? What about the quality of management? The NAIC Investors Manual tells you how to use the NAIC Stock Selection Guide to assist you in evaluating management. It is superior management that produces or fails to produce results. Increase your odds of favorable investment results by trying to determine if management has a game plan and is executing it. Look back on management's statements in past reports to shareholders and see how actual strategy and results came out compared to discussion. Talk is cheap. Results take lots of effort.

Communication may be a problem. I know of the Signal Watchers Investment Club whose members are scattered all over the United States. They have a systematic method of communication. They subscribe to the NAIC Investor Advisory Services (IAS). Each month copies of the service are mailed to all the members together with any NAIC Stock Selection Guide analysis a member chooses to contribute to nominate a stock. A ballot goes out with the mailing. There is a small group of members who guide the process, tabulate ballots, and implement buy and sell action. More frequent communication would serve to bind together the 1911 Investors.

With only one winner out of seven stocks during a rising stock market period, the 1911 Investors need to pause and reflect on the systems and techniques they are using. They do not appear to be working.

Home Depot has an excellent business. Earnings have been rising at 30 percent a year. During the past year, its market price has gone sideways. The club bought at 37 1/8 in April 1992 which was 62 times 1992 EPS of 60 cents and 45 times 1993 EPS of 82 cents. The P/E paid was so high as to discount future growth of EPS too far into the future. Even at 45 times earnings, the P/E as a percentage of the expected growth rate was 150 percent, a rather hefty premium. Home Depot is a good stock, but the P/E paid for it was too high.

Amtech Corp. designs and sells hardware and software used in radio frequency electronic identification of cars, trucks, rail cars and other modes of transportation. It experienced a string of losses from 1987 to 1991. Since then EPS growth has been rapid. I have two concerns: Four customers accounted for 56 percent of sales. It is not prudent to have so many eggs in so few baskets. And secondly, the percent earned on equity capital seems to be a modest 12 percent or so. (I do like the fact there is no debt.) Question: Did the 1911 Investors buy Amtech Corp. because of the "Whiz Bang"' character of the business, or was the decision to buy based on valuation?

EMC Corporation designs, manufacturers and sells computer storage products mainly for IBM and Unisys mid-range and mainframe systems. The earnings history has been cyclical. However, starting in 1991, earnings growth has surged. The club may have a big winner or a shooting star.

Oracle Systems Corp. provides software for data base management and networking personal computers, plus other software. Earnings have been up, down and up. Growth could be great depending on what the competition develops. If all goes well, the company could be a real winner.

My recommendations are:

• Develop and establish investment objectives.
• Improve and increase the frequency of communications among members.
• Learn and use NAIC stock study tools.

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.

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