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Picking Good Stocks in ANY Market

A Legacy of Strategic Stock Selection

by Mark Robertson, Senior Contributing Editor

"How do we know when irrational exuberance has unduly escalated asset values?" -- Alan Greenspan - December 5, 1996. There's a large element of rational exuberance in every stock study NAIC investors perform.

The Fed chairman's musings rocked the markets the next day. Stock prices plummeted. It's a distant memory now, but the S&P 500 declined 2.3 percent on Dec. 6, 1996, reaching a low of 726.98. In contrast, by March 24, 2000, the S&P 500 reached an all-time intraday high of 1553.11 -- an annualized price appreciation rate of some 26 percent following Mr. Greenspan's pronunciation. But 1553.11 has become yet another distant memory, hasn't it? The S&P 500 ended April 2001 at 1249.46, a decline of nearly 20 percent from the peak.

In a market with such extreme ups and downs, what's an investor to do? Is it really possible to pick good stocks no matter where the stock market pendulum is swinging? The answer is, "Yes." National Association of Investors Corporation stock selection principles have guided our practitioners for decades, allowing them to discover and own good companies at good prices with little regard for the volatility of the stock market.

How do NAIC investors do it? How well does it work? What's important? In the following dialogue -- consisting of Associate Editor Kevin Lamiman's questions and Senior Contributing Editor Mark Robertson's responses -- we explore our traditions and methods.

I'm fairly new, having recently joined the Better Investing staff. But you've been doing this for a few years and have probably prepared thousands of Stock Selection Guides (SSGs).

True enough. And after "thousands" of SSGs, I changed how I make assumptions just last week. I did so after comparing some of my SSGs in the "GroupThink" exercise featured in our May issue.

What was the change? And what did it affect?

We'll certainly explore this a little deeper as we continue, but what it boils down to is that I'm inclined to use more conservative price-earnings (P/E) ratios for my high-price forecast. The result is a more conservative outlook on expected returns. In a nutshell, this change will make me substantially more selective in picking stocks, and I'll have a slightly larger challenge finding stocks in my buy zone.

We're jumping ahead a little bit -- we ought to start at the beginning. Why should people be buying stocks now -- and always?

This question probably represents the greatest mystery and challenge of all with respect to investing. NAIC investors discover that "time in the market," as opposed to futile efforts to conquer market timing, is the key to success. The tragedy is that so few individual investors ever discover this truism.

When is the best time to invest in stocks? Ken Janke, president and CEO of NAIC, always answers without hesitation, "Now. Today." Note his choice of words. We don't invest in markets, we invest in quality companies. The best NAIC investors are somewhat oblivious to the stock market roller coaster, choosing instead to focus on discovering good companies with substantial expected returns. It doesn't matter whether the bear is scowling or the bull is on a rampage.

NAIC's first principle is, "Invest regularly." The biggest challenge that most investors face is developing and maintaining discipline and patience. The NAIC approach sets us free to take advantage of stock-price fluctuations and accumulate solid opportunities. We invest regularly -- not in any company at any price -- but in good companies at good prices.

There is no crystal ball with respect to the best time to get in and out of the market. And it wouldn't deliver all that much of an advantage if it did exist. Ken Janke often cites a study performed by T. Rowe Price about the allure and nonsense of market timing. The study had a simple premise: What would returns be if investors invested on the worst possible day in every single year over a period of time? Let's take a closer look at the last 10 years.

The accompanying graph shows annual ranges for the S&P 500 for the 1990s.

Click to enlarge.

Purchasing the market (S&P 500) on the worst possible day (highest price for the year) during the 1990s still yielded an average annual return of approximately 11 percent. So even with the worst possible timing, an investor would still achieve a respectable return. Taking it a step further, purchasing on the best possible day (lowest price) yielded an average return of 14 percent. The bottom line is that our perfect but mythical crystal ball would deliver only a three percent advantage.

When is the best time to invest? No time is better than the present. Do it now. Bring patience and discipline to the process. Grab a Stock Selection Guide and make a decision.

Ken Janke recently reminded us that you're not really a long-term investor until you've regularly invested throughout a bear market. How does the SSG enable this discipline?

Stock investors seem particularly susceptible to herd behavior. Common stock may be the only asset that customers avoid when it's on sale, yet investors fall prey to the pressures of price momentum. The market over the last year or so has reflected these puzzling characteristics.

In context, our SSG provides a prompted, fundamental analysis with respect to the characteristics of any company. We build expectations based on the inherent tendencies of the company.

The tool is a guide to effective study of companies. But it's only a guide. When we complete our SSGs, we're prompted for the conclusions and estimates of three important factors: expected growth, profitability and value.

The first stop is growth. Historically, how has the company grown? What has the growth rate been? How fast are the competitors growing? What is a reasonable expectation for sales growth over the next five years?

Making an estimate of expected sales growth is probably our most important decision as we perform our stock studies. Our selected growth rate will influence virtually all other assumptions that we make. Will the growth come from new products, geographic expansion or acquisition? What are barriers to growth?

The second stop is profitability. Warren Buffett has suggested that he buys stocks as if the stock markets will be closed -- with no transactions possible -- for the next five years. It's important that his chosen companies demonstrate an ability to make profits. More importantly, Buffett forms an opinion about the likelihood that the company will remember how to make profits over the next five years. Compare the profitability of any company to its peers. Form an opinion about continued profitability.

The third stop is value. Our forecast requires that we form an opinion about the expected price-earnings (P/E) ratio for the company.

P/E ratios are affected by growth expectations and perceptions of investment grade or quality. P/E ratios are also like fingerprints, in that companies tend to exhibit a signature that is unique. In some ways, a P/E ratio is a measure of respect. It is common for an industry leader to have higher P/E ratios relative to its competitors. The SSG examines the trends (highs and lows) for a company's P/E ratio over a range of years.

As prices and markets fluctuate, we can concentrate on the expected return for a company. Using the elements of expected sales growth, profitability and valuation, we build an expected return for the company. This expected return becomes the basis for the actions that we take.

In short, our portfolio management efforts are based entirely on the guidance provided by our Stock Selection Guides. We identify and monitor collections of good companies -- whether we own them or not -- and use the SSG to guide when to buy, accumulate or sell.

Click to enlarge.

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Company Chronicle. This "journal" provides historical perspective for split-adjusted stock prices, quality ratings (QR) and projected average returns (PAR). The figures represent SSG and QR calculation results based on quarterly company reports in the Value Line Investment Survey. Stock Prices (left axis) - Split-adjusted historical prices at the time of the Value Line report. Quality (left axis) - Calculated quality rating based on relative sales growth, relative profitability, financial strength and EPS predictability. (Ranges from 0-to-100, Excellent = >65) Projected Average Return (right axis) - PAR is based on TTM sales, sales growth, expected net margin, expected shares outstanding and expected average P/E ratio. Includes average annual dividends. Sources: Value Line Investment Survey and company/industry studies done by Mark Robertson.

Case Study - Home Depot, Patience and Pouncing

NIA director and Puget Sound volunteer Gary Ball shares a number of SSG 'bloopers' at educational seminars. During his presentation, he describes a 1995 conversation with an individual investor who had invested in Home Depot. "Gary, this company is a 'dog'. What should I do with it?" Gary knew in an instant that this individual had likely invested in Home Depot after 1992. He asked for a specific description of the canine features, adding that Home Depot has long been a quality company and resides near the top of the BI Top 100. "Well, the darn stock price never seems to go anywhere. We hear and read a lot about patience, but this is really tough." The bottom graph provides SSG results (in the form of projected average returns) for Home Depot for the period 1994-2001. Note that the return forecast was fairly high in late 1995. As Gary emphasizes, "Over the long haul, prices follow earnings. Over the short haul, anything goes." A rapid price appreciation generated lower expectations in 1992-93 while the stock price "paused to wait for earnings to catch up." The flat spot in the price chart (above) from 1992-96 provided a test of patience for Home Depot shareholders. But quality remained constant, and price appreciation resumed in 1997. Note the expected return during the flat spot. Earnings were consistently increasing while the stock price was in a holding pattern. The forecasted returns dipped again (following a surge in price) during 1999-2000. "Pouncing" and accumulating when expected returns are sufficient is what NAIC's Stock Selection Guide is all about.

You've used the phrase "quality company" and "good company." What's a good company?

We use the two interchangeably. The characteristics take shape on an SSG in the form of what our chairman and founder, Thomas O'Hara, has dubbed, "strength of management." We seek companies that are committed to growth. We do this by comparing their historical growth rates to those of their competitors.

Strong management focuses on discovering opportunities that it can translate into profits and shareholder value. The visual analysis (front side of the SSG) provides a picture of how the company has historically performed with respect to sales growth. Our studies of the companies and their industries lead to conclusions about future sales growth. Our management analysis then provides a report card for how well companies convert opportunities into profitability.

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Home Depot - Visual Analysis. "Over the long haul, stock prices follow earnings. Over the short haul, anything can happen." Note the stock price plateau from 1992-96 (black vertical bars) with special attention to the earnings-per-share trend (rising blue line) during this time period.

What are the main attributes of quality?

NAIC investors seek strong relative sales growth, strong relative profitability, financial strength and predictability. We favor companies with straighter lines (consistent growth) and steady or increasing trends on our SSGs.

Is historical revenue and sales growth really that good a guide to investment decisions?

Track records are important. Sure, past performance isn't a guarantee of future results -- but we'd argue that it's a compelling factor when we're building a forecast.

There's a human side to the equation, too. People generally are fairly consistent. Old habits, good and bad, die hard. Companies quite often also exhibit predictable tendencies. When it comes down to building expectations about future returns, a steadier track record can mean a more confident forecast.

How does the SSG allow picking good stocks regardless of market conditions?

The Better Investing Top 100 clearly includes a number of quality leaders in terms of balance sheet strength, market share and growth rates. The most widely held stocks include many "good companies." But the second half of the tag line is, "at good prices."

NAIC investors depend on the reliability of the long-term relationship between stock prices and earnings. Many practitioners emphasize the expected sales growth rate and use their profit margin expectations to build an earnings forecast. Known as the "Preferred Procedure," this is a useful method to gain a better understanding of the business model. I've described the Preferred Procedure as an expected income statement. The accompanying illustration for Home Depot provides an illustration of this approach.

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Building an Expected Income Statement. The Preferred Procedure is an effective method for building an earnings-per-share (EPS) forecast. All of the NAIC stock analysis software tools include this feature. But you don't need software to perform the analysis. Mark Robertson thinks of this approach as an expected income statement. In other words, based on a sales growth forecast, and factoring in the cost and profit characteristics of a business, what are expectations for EPS in five years?

In the example shown, the current sales results for Home Depot are growing at a rate of 18%, reaching a total of $104.6 billion in five years. The 5-year historical pre-tax profit margin has been 8.7 percent. Mark chose a pre-tax profit forecast of 9.5 percent -- giving more weight to recent years and analyst expectations. The graph displays a 10-year history of pre-tax margins for comparison purposes and forecast judgments. The expected tax rate is 38.5 percent and expected outstanding shares is 2.325 billion. This generates an EPS forecast of $2.63 and an expected EPS growth rate of 19 percent going forward.

What do we mean by "understanding the business model?"

Growth rates and profit margins vary by industry. Understanding the business model involves studying the relationships between sales, profit margins, tax rates and outstanding shares to develop an earnings-per-share (EPS) forecast. It's useful to compare the company's historical and expected sales growth rate and profit margins versus those of competitors. It provides a closer look at the efficiency of converting sales to EPS.

The comparisons and trends that we discover during our company studies help us to understand competitive advantages, which translate into higher profit margins.

Does the NAIC SSG and long-term investing help us avoid the natural human tendency to follow the herd and focus on short-term tendencies fueled by the mass media?

I can't say it any better than investing legend Ben Graham did: "You are neither right nor wrong because the crowd disagrees with you, but because your data and reasoning are right. The right kind of investor takes added satisfaction from the thought that one's operations are exactly opposite to those of the crowd." It would be nice if the sentiment were a little more contagious.

Do NAIC investors actively use the tools?

Like anything else, it happens by degrees. The tools help to focus our attention on what's really important -- and interpretation can vary. We have a perception that usage could be a little broader. But I recently discovered some information that was a little stunning. We conduct an annual Value Line survey that examines overall performance of investment clubs. The survey includes the following question: "Do you use NAIC-based tools for stock selection?" Eighty-five percent of participating clubs have answered "Yes" to that question over the last five years.

Clubs that reported using the tools have outperformed clubs that didn't report using them by 6 percent per year. It's important to qualify these results, which are reflective of only those clubs that chose to participate. The sampling was not random and the survey is nonscientific. It's possible that only the best performers respond to the survey.

Using the tools. Eighty-five percent of the clubs responding to the Investment Club Earnings Survey over the last five years indicated that their club utilizes NAIC tools in selecting stocks. The overall rate of return for the affirmative clubs was 33 percent, an approximate 6 PERCENT ADVANTAGE over clubs that answered no to the survey question. Source: Value Line Club Earnings Survey (1996-2000)

Any other points that might help convince a newcomer that learning the method is worthwhile?

The evidence is anecdotal, but we share the results of the Better Investing Top 100 Index versus market benchmarks in every issue. The long-term performance of the Top 100 Index (see page 10) has persistently exceeded the S&P 500 since its inception. The NAIC Growth Fund, which uses SSG analysis extensively, also serves as a demonstration of the principles in action. The annualized total return for this closed-end fund for the five years ending Dec. 31, 2000, is 20.8 percent. We feature the long-term track record of the Better Investing Stocks to Study in our tortoise and hare competition, featured annually in our March issue. Over the last 50 years, the magazine selections have delivered a 14 percent return versus 11 percent for the Dow Jones industrial average.

So how do we know when irrational exuberance has unduly escalated asset values?

I would argue that for a long-term, growth-oriented investor, there's no such thing as irrational exuberance. I've diligently searched for any point in history when it was extremely difficult to discover companies with at least 15 percent total return expectations. I've been unable to do so. Even during the most powerful bull markets, quality companies seem to be available at good prices. They become only a little harder to find.

For nearly five decades, millions of individual investors have become NAIC members. The message and principles have remained constant and have served our community well.

Anybody can do this. Good companies, good prices. It's important to invest regularly and to do so no matter which way the market winds seem to be blowing. Focus on the nature of growth and profitability. Build expectations about future value and use the NAIC tools to decide if prices are right. Prices do matter.

NAIC investors are naturally optimistic. We focus on industry leaders in an effort to discover and own leadership growth companies. There's a large element of rational exuberance in every stock study that we perform.

Home Depot - Research Zone

Mark Robertson is director of online resources and senior contributing editor for BetterInvesting. He serves as a member of BetterInvesting Magazine's Editorial Advisory & Securities Review Committee. Mark can be reached at Robertson_Mark@comcast.net.