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NOVEMBER 2003Printer Friendly VersionQuality: A Measure Of ExcellenceStock and Portfolio Analysisby Mark Robertson, Senior Contributing Editor
Good companies at good prices. Our quest is timeless and fairly well-defined. I submit that our search is actually for excellent companies at sufficient expected rates of return. There's a connection between quality and return expectations in the influence of quality on long-term P/E ratios. The discussion that follows is my interpretation of NAIC equity analysis and portfolio management methods, based on nearly ten years of study and work with NAIC investors. The NAIC was formed in 1951 to share lessons learned after the first ten years of operation for the Mutual Investment Club of Detroit. If I could share the most important lesson that I've learned after ten years with investment clubs, it'd be that QUALITY MATTERS. Quality is also measurable and it can play a significant role in helping investors to avoid trouble. The time-honored path to success with strategic long-term investing is paved by understanding and respecting quality.
NAIC Historical Perspective on Quality Quality. We all know it when we see it. What's it worth? Investorwords.com has a powerful definition for "quality." Quality is, quite simply, a measure of excellence. With excellence comes respect and consistent, credible growth will deliver better results. NAIC investors know that quality is an important attribute as we build our sleep-at-night portfolios. Discovering good companies at good prices necessarily means that we seek the best companies within their industries and we accumulate them only when they go on sale. Implementation of strategic long-term investing over a lifetime means that we take advantage of opportunities to acquire the best of the best when it makes sense to do so. It must be important. NAIC co-founder George Nicholson based much of our portfolio management challenge process on quality. Challenge portfolio management is a process for challenging your holdings. The premise is that the holding with the lowest expected returns is deemed a candidate for potential replacement. The process became an expected total return approach to portfolio management. The main guidelines for challenge portfolio management are (1) to discover higher expected return candidates, and (2) examine the effects of switching. Most importantly, the effort should Improve Quality. The most important consideration is to require that the CHALLENGING STOCK BE OF EQUAL OR HIGHER QUALITY. Nicholson defined quality as having seven major attributes:
Benjamin Graham's Outlook on Quality It's almost the same list and it's focused on the same major drivers.
In the book, Security Analysis by Benjamin Graham and David Dodd, the authors dedicate a fair amount of attention to the subject and influence of quality on investments. Benjamin Graham is widely regarded as the father of value investing and the text is universally used to teach fundamental analysis of common stocks. Graham is also known as Warren Buffett's mentor and most significant influence. Graham said, "For the vast majority of common stocks, the average relationship between price and earnings will reflect the quality and growth of the issue." I found it intriguing that Graham called out this relationship and sought a means to define it. Graham believed that there is a direct relationship between price, earnings (P/E ratios) and Quality. He noted, "a strong, successful, and promising company usually sells at a higher multiple than one that is less strong, less successful, and less promising..." Graham delineated the key influences on P/Es into two groups: Tangible Factors
Intangible Factors
I believe that NAIC investors handle all of the tangible factors with Stock Selection Guides. We build expectations for sales growth and profitability trends in sections 1 and 2 of our guides. When using the Value Line Investment Survey, we're given a rating for EPS Predictability and Financial Strength. I further believe that the intangible factors are covered when we perform an industry study and/or Stock Comparison Guide. Why? Because industry studies generate some guidance with respect to relative sales growth rates and profitability for the companies by making comparisons among peers. Graham and Nicholson both highlighted dividends as part of their equation. But this was during a time when 6-8 percent dividend yields were the norm. With today's declining payout ratios, dividends are still important, but a less significant factor -- and the influence of dividends has not been included in the quality rating calculation. George Nicholson told us quality was important. Ben Graham spent an investment analysis lifetime seeking a reliable means of gauging it. If relative quality is important, and necessary for our challenge process, then we ought to seek means of measuring it. Using A Peer Group Study to Set Up Quality Ratings The following table presents a profile of the Food Retail (Grocery Stores) peer group. The average expected P/E ratio, expected percent net margins, and calculated 3-5 year sales growth expectations are provided for the food retailers from the Value Line Investment Survey. The date of the company reports is November 7, 2003. Although the data is taken from Value Line company reports, the peer group is defined by the Standard & Poor's Global Industry Classification System. These are the peer groups detailed in the S&P 5-page version of their "tear sheets."
(1) Expected Sales Growth Rates The larger companies in the group are Kroger, Safeway and Albertson's. As the group averages are developed, a weighted average is used which is based on the annual revenues of the companies. The larger companies will have the greatest influence on the averages. The average expected sales growth rate for the food retail peer group is 4.4 percent. Note that the highest growth rate is 17.1 percent for Whole Foods Market. This is credible. Whole Foods is a niche supplier, fairly small, and still capable of geographic expansion. (2) Expected Net Margins The average profitability for the group is 2.3 percent, expressed in net margin. The profitability leader, with a net margin of 3.9 percent, is Whole Foods Market. (3) Average P/E Forecast, 3-5 Years The average P/E ratio for the group is 15.6x. The companies in the table are ranked by descending quality rating. Although a little hard to detect with this example, the higher expected average P/E ratios will generally occupy the top of the chart and will generally diminish towards the bottom. This is typical and generally reflects the respect shown, and exhibited by P/E ratios, for industry leaders. The best of the best will generally merit P/E ratios at a premium to industry averages. Calculating A Challenge Quality Rating for Kroger The Challenge Quality Rating (QR) for any company ranges from 0-to-100. Based on the works of Nicholson and Graham, the 100-point scale includes four factors: Relative Expected Sales Growth, Relative Profitability, EPS Predictability and Financial Strength. In the table that follows, the four individual scores are compiled for Kroger:
Sales Growth Rating. The expectations for sales growth for Kroger (5.2%) are compared against the group average (4.4%). Studies of industries revealed some exceptions (e.g. Gentex, Clayton Homes) with growth rates or net margins that far exceeded their industry average. Depending on the peer group chosen, some 50-60 companies within the Value Line universe of 1700 companies will fit this description. Gentex, when classified as an Auto Parts company, has a sales growth rate 3.5 times the industry average and a net margin that is nearly seven times more profitable. The intent is to limit the contribution of any single factor to 25 points. A company operating at the industry average for sales growth would net 12.5 points. The calculation for Kroger is (5.2/4.4)(12.5) = 14.8. Relative Profitability. The calculation for relative profitability is similar to the sales growth comparison. In this case, Kroger is expected to have a 2.6% net margin. The calculation for this category is (2.6/2.3)(12.5)= 14.1.
Financial Strength. What goes into the Financial Strength rating for each individual company? Value Line defines Financial Strength as taking into account a lot of the same information used by the major credit rating agencies. The Value Line analysis focuses on net income, cash flow, the amount of debt outstanding, and the outlook for profits. Other factors are also considered. For example, a company that faces the loss of patent protection on a key product might face a downgrade. The ratings range from A++ (Highest) to C (Lowest) in nine steps, based on the judgment of Value Line senior staff members. To perform the calculation, the "academic grade" rating must be converted to a percentage. In the case of Kroger, their rating of B+ is converted to 50% (per the accompanying table) and this component of the Kroger QR becomes (0.50)(25.0) = 12.5.
EPS Predictability. This factor is actually a numerical score that reflects the straightness of the EPS historical trend in our Visual Analysis. Value Line suggests that it becomes a measure of the reliability of an earnings forecast. I agree. EPS Predictability is based upon the stability of year-to-year comparisons, with recent years weighted more heavily than earlier years. The most reliable forecasts tend to be those with the highest rating (100); and the least reliable, the lowest (5). The earnings stability is statistically derived from the amount of fluctuations, or variations from a straight line. A straight line would generate an EPS Predictability of 100. For Kroger, the EPS Predictability is 100 (nearly a straight line) and the QR calculation becomes (1.00)(25) = 25.0. The Overall Quality Rating. The four components are added to form the overall Challenge QR for Kroger, 14.8 + 14.1 + 12.5 + 25.0 = 66.4. Putting the Quality Rating in Context Any index or ratio or rate is somewhat meaningless without a reference point. To establish reference points, nearly all of the companies within the Value Line standard edition were scored with the QR system. The companies were ranked from highest to lowest quality ratings. The top twenty percent had a QR greater than 65.0. The next group, or 2nd twenty percent, had QRs between 55 and 65. The third quintile fell between 45 and 55. The bottom twenty percent (lowest quality ratings) were less than 35. The median, smack dab in the middle of the list, was 50.0. But does it make sense? Does the Quality Rating reliably identify companies that would be likely to attract the attention of NAIC investors? The companies were profiled by peer group and the following companies had the highest ratings within their groups:
The average Quality Rating for the Better Investing TOP 100 is currently 72.8 (Excellent.) This collection of the most widely held companies by NAIC investment clubs averages an "Excellent" QR. Both the widely held companies and the preceding list of group quality leaders suggests that the metric at least passes a test of common sense. Most NAIC investors would agree that this list of companies would be among those that they regard with the highest perceptions of quality. Summary and Conclusions Quality matters. This method may seem a little complex, but try it. Attention is quickly drawn to the considerations of relative sales growth, profitability comparisons, financial strength and earnings forecast confidence. The calculations are quick and with practice, can be done in a minute or two. The quality rating does provide a frame of reference for comparing companies and challenging holdings, while striving for a sufficiently high level of overall quality for any portfolio -- in concert with the encouragement of George Nicholson. Better companies at Better prices. Our stock analysis framework centers on two questions: (1) Is it a quality company? and (2) Is the expected return high enough? If this definition of quality makes sense to you, you have a means of comparison and a logical reference point based on NAIC principles. If our notion of quality for a purchase candidate isn't high enough, then we don't care how big the answer to the second question is. Quality. A measure of excellence. How much can be gained by seeking "Excellent companies at Better prices?"
References and Reading Materials 60 Second Equity Analysis This reference provides an overview of calculating a quality rating and projected average return (PAR) for Home Depot. The article includes an Excel spreadsheet that can be used to calculate the quality rating and expected return (PAR) for any company. Peer Group Forecasts This reference provides a listing of peer groups and aggregate sales growth and profitability forecasts. Detail listings, providing the group constituents and individual company forecasts, are provided for some peer groups. Improving Company and Industry Comparisons Effective comparisons can be a meaningful part of our stock studies. Maintaining an awareness of industry averages and trends can provide support for judgments about growth and profitability expectations. This article examines the use of peer groups with SSGs and Stock Comparison Guides. Graham and Dodd's Security Analysis; Fifth Edition. Sidney Cottle, Roger F. Murray and Frank E. Block; McGraw-Hill, 1934, 1940, 1951, 1962 & 1988. What is "Investment Quality?". NAIC Investment Club Lessons. Qualifying and Quantifying Company Quality. Mark Robertson. NAIC Investor's School Transcript, December 11, 2000. A 'Sweet Sixteen' for 2001 and Beyond? - Better Investing, March 2001. Mark Robertson. 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. |
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