BITS > OCTOBER 2000

Analyzing an SSG from the Bottom Up -- the Sources of Return

Editor's Note: Special thanks to Computer Group Associate Director Diane Graese for sharing her comments and stock study on ABM Industries. We remind readers that her comments are presented, not as an investment recommendation on the company, but rather as an example of how investors are using stock study tools, together with their own personal assumptions and judgments, in the process of analyzing common stocks.

Why do we invest? The answer is simple . . . to make money. By putting our money to work, we don't have to work so hard at our everyday jobs. When investing, we seek not only the return OF our money; we expect to earn a return ON our money. Return is the bottom line.

As NAIC investors, we share a common goal: to double our money in five years. In number terms, we seek average annual compounded returns of 15 percent. As you will see in this article, the ways to accomplish this goal vary; as do our individual jobs or the stocks we own.

I will show you how I analyze a Stock Selection Guide (SSG) to determine the sources of investing return. This knowledge helps me review my critical judgments, know which future performance factors I must critically monitor and balance the diversity of returns within my portfolio.

In preparing an SSG, we first evaluate Sections 1 and 2 to determine if we have identified a good company. Only when the answer is YES do we proceed to complete the SSG to determine if this good company is available at a good price.

The concepts of risk and return are imbedded in the valuation sections of the SSG -- Sections 4 and 5. At each SSG judgment point, we are asked to make reasonable estimates. What we deem to be reasonable is influenced by our own perceptions of risk. Beginning investors often make risk-adjusted (conservative) decisions at each point to counter their lack of confidence. Experienced investors will have developed their own methods for factoring risk into their SSG judgments.

Having made all our decisions, Section 5 of the SSG is designed to show us the annual rate of compounded return an investment will produce if all of the estimates we have made actually occur. On the SSG, the Section 5 total return is the bottom line.

If the return is acceptable, we evaluate the risk as calculated in Section 4 before finalizing our investment decision. We look for at least a 3-to-1 upside/ downside ratio.

Starting at the Bottom

Have you ever been to an investment club meeting where someone just lines up the SSGs for study by the size of the total return calculations in Section 5? If we seek 15 percent returns, then 20 percent returns must be SO much better, right?

We all know we cannot rely on these numbers until we have evaluated the "quality" of the judgments used to arrive at the respective returns. The club goes through the SSG details and draws conclusions. Even after this process, I suspect many of you still don't believe the numbers. You are more confident about some of the returns even if they are lower than others presented. Even among stocks with similar overall returns, you sense they are not the same. Your doubts are likely a result of the varying degrees of risk associated with the different components of return.

The Components of Return

Let's look at the components of return using one of my recent stock purchases: ABM. I purchased ABM Industries on July 20 at a market price of 25.81. ABM provides janitorial and window cleaning services, heating and air conditioning system maintenance and other engineering and maintenance services to commercial and industrial customers.

It fits many of Peter Lynch's definitions of a perfect stock -- it's dull, boring, does something slightly disagreeable, has a niche and people keep buying its services. (Lynch defines his perfect stock criteria in his book, One Up on Wall Street, (Simon and Schuster, 1989). I will be leading an online chat on this book at the Yahoo! SampleNAICclub site on Oct. 30 starting at 10 p.m. ET.

I will not be discussing the company or my SSG judgments. They are not critical to this article. I will happily answer any questions posted to NAIC's I-Club-List.

My SSG was prepared using STB Stock Analyst PLUS! (SA+). This same information is available on SSGs prepared using Investor's Toolkit or NAIC Classic. I have drawn some lines on side 2 of my SSG (chart to the left) to highlight relationships I will be discussing.

Section 5 of my SSG says I would achieve a 17 percent return if I purchased ABM at 24.75. Of that return, 2.8 percent would be achieved through receipt of dividends; 14.2 percent of the return would come from the stock price increasing from my study price (24.75) to my forecasted high price (48.09) as calculated in Section 4A.

SA+ does not show the detailed calculation of each component of total return in Section 5. On the SSG form, the dividend yield contribution to return is calculated in Section 5B. My SSG dividend yield of 2.8 percent is derived from maintaining an expected payout rate of 33 percent times the average of estimated earnings per share (EPS) during the five-year evaluation period.

I am very confident about this source of return. ABM just declared its 137th consecutive quarterly dividend. This long record of consecutive annual dividend increases ranks ABM 43rd in Moody's Handbook of Dividend Achievers (FIS, 1999). (This book is a great source of ideas for stocks to study.)

As a generally conservative investor, I like to have some return from dividends. Companies with long records of increasing or maintaining dividends work hard to keep those records. Growing dividends are a sign of management's confidence in its ability to achieve future earnings. Dividends also provide some downside price protection and provide some return when the markets are unfavorable.

Since NAIC investors focus on growth companies, most return will derive from stock price appreciation. A stock's price is a function of its earnings and how much the market is willing to pay for those earnings. Stock prices will increase if either one of those factors increase. According to Section 5 of my ABM SSG, 14.2 percent of my return will come from appreciation.

Click to enlarge.

Diane Graese's Visual Analysis of ABM Industries (STB Stock Analyst PLUS! software).

Let's look at the two components of that appreciation calculation. SSG side 1 (see chart above) displays my earnings growth assumptions. From $1.65 to $2.67 is a 10.1 percent rate of growth. This is also reflected on side 2 of my SSG (see chart below). Earnings of $1.65 listed in Section 3C5 are expected to grow to $2.67 as listed in Section 4A.

Click to enlarge.

Sections 2 - 5 of Diane Graese's Stock Selection Guide on ABM Industries (STB Stock Analyst PLUS! software).

I-Club-List participant Faith Fessenden has a mantra: "Sales drive earnings. Earnings drive stock price." My expected earnings growth should drive future price appreciation as reflected in Section 5. It does. 10.1 percent of my 14.2 percent appreciation comes from earnings growth. Where does the other 4.1 percent come from? The answer lies in SSG Section 4A.

A price/earnings (P/E) ratio is calculated by dividing price by earnings. Restating this formula and using numbers from my SSG: Current P/E (15) times current earnings ($1.65) equal current price (24.75). Future P/E (18) times future earnings ($2.67) equal forecast future price (48.09. This is the Section 4A calculation.

Total appreciation of 14.2 percent is the result of future price growth from the current price. I have identified the 10.1 percent component of that return which is the result of growing current earnings into future earnings. By default, the 4.1 percent difference is a function of the change in P/E ratios.

My future P/E ratio of 18 exceeds the current ratio of 15. I am expecting the market to pay more in the future. This P/E expansion will provide the extra return above the earnings growth rate. To the extent this component is positive, I am paying less than has been historically paid for the company's earnings. I have a bargain and like to consider this the "value" component to my estimated return.

Now that I've explained where the numbers come from, let's look at some typical returns. In the table below I have listed a variety of possible return scenarios. In each example the expected total return is 15 percent. However, the routes and risks to achieving these rewards vary.

Click to enlarge.

Example A reflects all return coming from future earnings growth. No dividend is paid and we are purchasing the stock at what can be called a fair price, i.e. current P/E is the same as the forecast average high P/E.

Example B reflects moderate earnings growth with the expectations for a slight increase in the future P/E. To put it another way, the stock's current P/E is at a discount to its future expected P/E. No cash dividend is paid.

Example C reflects moderate earnings growth at a mature company that pays a dividend. To achieve this return, we would be purchasing the stock at a current P/E that is at a slight discount to its future expected P/E.

Example D shows a slow grower with a modest dividend. Most of the return is expected to come from P/E expansion. While unusual, it is not impossible. This might be the case when a solid performer is in a currently out-of-market-favor industry.

Example E shows a company that pays a hefty dividend. It is a slow grower as the majority of earnings are likely being paid out to shareholders. This might be a typical return scenario for a utility or real estate investment trust (REIT).

Example F shows a company that has good earnings growth prospects. The current P/E is higher than our expected future P/E. This is an example of P/E deflation. Despite solid earnings expectations, we anticipate people might pay less for those earnings in the future. Our expected future growth rate is likely lower that the historical growth rate.

My ABM SSG most closely approximates Example C.

Assessing Risk and Return

In the next section I show how you can use this information to improve your confidence with your SSGs and to monitor future performance.

Having identified the sources of investment return, you should review the judgments that impact the largest return component. It's one last test of reasonableness and a way to examine the strength of your convictions in a critical judgment area.

When return is tied to earnings growth, you are relying on management to deliver. According to Peter Lynch, there are "five basic ways a company can increase earnings: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close or otherwise dispose of a losing operation." Since the SSG uses EPS, we must add one other management tool. Management can increase EPS through stock buybacks.

To access risk, ask yourself: Are you comfortable with management's plan and ability to deliver this growth? What exactly are you expecting to happen? Has performance been reasonably consistent in the past?

If there are bumps along the future road, management may still be able to deliver over the long term but the P/E will likely fall in the short term as investors register their disappointment. We have all seen what can happen when management misses expectations by as little as a penny. These investments can have wide price swings. Can you stand the potential volatility of price movements?

From a performance standpoint, you need to know the way(s) you are expecting management to grow earnings. This knowledge will help you evaluate company performance when reading each quarterly earnings release. Depending on your expected source of earnings growth, revenue growth may not be as critical as seeing increasing pre-tax margins. Alternatively, margin improvement may not be necessary if revenue growth is the key component driving earnings growth. You must keep your PERT schedules updated to monitor progress and know which are the most important factors to showing you management is on track.

Sources of Return

When return is tied to P/E, you are relying on the market to change its opinion. For some stocks, people are paying less for earnings today (lower P/Es) than they did in the past or less than you expect them to pay in the future. Do you know why? If you don't have any idea, I suggest you do more homework. Look for news releases, call a full service broker, read Internet message boards, call the company. The market has some reason. It is your job to decide if people are being logical. Contrarians can make very good returns by going against the crowd. But you need to understand the negative market pressures and make sure you are making an informed decision.

To help assess P/E risk, you should ask: What news or events must happen to change the market's opinion? When might this happen? Can I be patient and wait? It often takes longer than one might expect, especially if management is trying to regain the investing community's confidence.

From a performance standpoint, you need to monitor market sentiment as closely as earnings growth. You should focus on the Portfolio Management Guide (PMG) report. When the market returns to paying a fair price, you are left with only the components of return from earnings and dividends. These rates may not be sufficient to achieve your overall return goals. At this point, you could challenge this investment with a replacement.

When return is tied to dividends, you are relying not only on continued earnings but also on the continuing financial wherewithal to pay dividends. When lenders are concerned about debt repayment, they can restrict a company's ability to pay dividends. Earnings must be supported by cash flow . . . it's hard to pay dividends when you don't have cash. For REITs, you want to be sure the company is retaining occupants for its properties and can increase rents to cover operating costs.

From a performance perspective, you want to see dividends increasing. You also want to see the financial strength of the company's balance sheet being maintained. If there is any risk to the ability to pay dividends, you must avoid potential future losses. When dividends diminish or disappear, there is no reason to hold this type of investment. You need to be prepared to be the first to flee if trouble begins to appear.

Diversifying Return Sources in Your Portfolio

You can also use this analysis of return to create diversity in your portfolio. People generally select mutual funds based on investing styles: growth, value, income or some combination thereof. You can select stocks the same way. There are always economic periods where some investing styles perform better than others.

In the last few years, value investing styles have generally underperformed long-term benchmarks. Some pundits suggest the favored style of the times may be changing.

If diversity in size of companies or industries is an important consideration in your portfolio management philosophy, you might consider having some diversity of investing return components in your portfolio as well. Income styles will reward you during slow economic periods, but you must also have growth investments for the periods of economic boom.

Use this knowledge to help balance risk and reward within your portfolio.

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.