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Throughout this forum on FDS, I have applied conservative judgments because I fear an economic slowdown is approaching, and I want to avoid paying too much for the stock shares. In this final session, I will look back at some of those judgments and provide an updated SSG (they reported earnings since I did the original guide) with more optimistic judgments.
Past growth is easily studied with the SSG and TakeStock. The big decision is whether growth in the past has been consistent, reliable and strong. Looking at the R^2 values from SA and ITK we get a good sense of that. If these growth numbers are not strong with low R^2 values, the margin of error is higher in the shares. TakeStock is unique in that it provides “normalized” data with the removal of outliers. I find this data very helpful. In TakeStock,if growth of Co. sales and earnings is initially viewed, we see historic (the past 7 years) and recent growth trends. Notice that the historic growth of sales was 18.9% with a predictability of 9.8. Looking at the TSSW front page, the growth stat % box, with outliers removed by the program, the reliable future growth rates are 18.5%. By eliminating the outliers and reducing the future growth rates, the computer is reducing the margin of error for the stock and giving more reliable data. (Had the predictability been 10 on the growth page, the future growth rate would have most likely been 18.9%) 18.5% is a reliable finger print for the growth of this Co. and can be used for future growth rates. (See slide 1)Past growth rates do not guarantee future rates, but stocks with a solid trend have a better chance of producing those results going forward.
Future growth is offered by VL as well as the Co. management. As we saw from the past sales reported in VL, if there are deviations from the trends, it is advisable to find out why. This data, plus your own judgment, should help forecast growth with a higher degree of reliability.
Earnings growth predictions are available from many online sources, mainly from investment managers and investment bankers. I find these predictions quite optimistic in most cases. I try to avoid forecasts that are too optimistic and often do not look at future consensus growth predictions. (Earnings forecasts are not guarantees.)
For future earnings growth, I will use sales growth if the 2 are comparable over a few years. It has been stated many times, that earnings growth can not exceed sales growth for long periods, and therefore should not be a higher number than sales. Comparing the front of the SSG graph shows the relation of growth of the 2. Trend graphs can also show these relationships (See slide 2) as can the PERT graph.
On all SSGs I also do the preferred procedure to compare the growth of the 2 methods. This is valuable if VL future data is also incorporated into the preferred procedure. You end with 3 opinions; earnings growth based on: future sales, preferred procedure with SSG data, and preferred procedure with VL future data. TakeStock also provides data using the business model (preferred procedure). The program provides sales and earnings growth figures based on the predictable growth of the past as well as with the business model. This provides the investor with 2 more opinions regarding the future. (See slide #3)
Before assigning a final earnings growth rate, I look at the most recent 10Q for changes in the business model. For FDS I found that the Co. is rewarding it’s employees with a bonus based on performance. They have stated that this will alter the future Pre tax margins as well as shares outstanding. They also expect a higher tax rate going forward due to the loss of tax exemptions from R&D costs. This can be valuable information when calculating future earnings with the preferred procedure.
My future earnings growth judgment never exceeds the sales growth for the Co. I also do not exceed the past growth rate with high outliers removed (TakeStock), and I look at the implied growth figure and stay at or below that number. I check my growth judgments with club members, StockCentral forums and/or other sources. I try to stay below the average growth rates.
Management judgment is straight forward on the SSG. If PTM and ROE are decreasing, be cautious. Try to find where and why the numbers are going down. I look at the Income statement, Balance sheet and Statement of cash flow. That data is easily accessed at Rueters.com. I find the Ratio Analyzer at Stock Central very useful in evaluating management also. During this forum, I compared FDS with the average of the information services industry. I found FDS to be a leader in this area with Operating and Net profit margins and ROE higher than the average. Comparing FDS with other Co.s in this industry is available at Better Investing. They offer an Online SSG tool that compares companies in the same industry. (See slide 4) Notice that FDS, the nearly straight line at the top of the graph, leads all other Co.s listed.
Experience has shown me that low expectations (low PE) have made the best stock picks. On the flip side of the coin, stocks with high expectations can make some very poor and painful picks. From my past experiences, I have come to the conclusion that stocks with high PEs can maintain or disappoint, but rarely reward. For the best returns, both earnings and PE expansion must occur. Purchasing a stock with a high PE does not leave much room for appreciation, and if the PE is 150% of the average, may signal a time to sell some or all shares.
The stock of a Co. with a low PE may not be a bargain either. If earnings are reported and are lower than expected, the PE will likely continue to fall due to investor sentiment. It takes sales and earnings growth toe push up the PE.
FDS had a PE of 22.9 when the data was entered into the program. Notice that at this PE, the relative value is 109. That is based on my projected PE high and low averages. Notice also that the average PE without judgment is 25.4, making the relative value of the current PE 90. (See slide 5) Each individual who completes an SSG on FDS will add their own judgments and will have differing PE and RV values. I made these values lower due to the slowing of the U.S. economy, where the Co. makes 69% of it’s sales and earnings, the dropping trend of 5 year average high PEs (seen in PERT B) and VL’s forecast PE.
Another exercise I like to do before buying shares of stock is to double the share price at the time of purchase. That is the price we would like to see in 5 years. Compare that 5 year price with the future EPS to find the PE in 5 years. If that PE is close to the 5 year average, the share price is attractive. If the PE is much higher than the average, your returns may suffer from a PE contraction, even if earnings are growing.
Recall from the PERT report that the earnings for the Co. increased 26.9%. That is an interesting number to look at because we know that earnings generally drive the price of the stock. With greater earnings growth comes greater investor sentiment and higher PEs. To demonstrate the power of PE expansion, consider what would have happened if you had been able to purchase shares of FDS at the average future PE (21) 1 year ago, and the PE had expanded to the same level as the earnings growth (26.9). In that case, earnings growth would be 26.9% and PE expansion would be 28%. (Those are the kind of returns that will allow one to buy time shares in Hilton Head!)
A final Summary of my judgments:
Sales growth options:
1. SSG: 10 year, 5 year, 3 year and most recent QTR average.
2. Take Stock: Check the growth stat % box on the front page of the TSSW
3. VL report: annual rates or Revenue calculation from forecast sales to current sales. Look for deviations from the trends.
4. Implied growth: ROE minus POR
5. Management discussion in Co. reports
Earnings growth options:
1. Make Sales and Earnings growth equal
2. Preferred procedure with average (minus outliers) program numbers
3. Preferred procedure with VL future data
4. TakeStock-Trend graph or the business model
Management: (compare to other Co.s in the same industry)
1. Part 2 SSG-remove outliers
2. VL Industry average
3. Ratio Analyzer
4. Rueters financial statements
PE Ratio:
1. Pert B-look for outliers as well as trends and find out why
2. VL future PE
3. Take Stock-Excellent because it removes high outliers
Those are the main decisions involved in completing an SSG. Other tools and guidelines:
PE RV and PEG
1. Double the purchase price of the stock. Divide that by the future EPS to see what the PE will need to be in 5 years to double your investment.
Compound Return
1. SSG with high and average PE
2. Cash Flow future price
PMG graph and data
Use for buy and sell signals
Because each of these steps involves judgment, It is highly recommended that anyone doing the stock study get input from other club members, or the Co. forum at StockCentral. Dialog and disagreement is good. This is pointed out by a recent article in Better Investing:
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“It’s Nothing Personal — Just Business”
"Investment club members would do well to remember this idea during meetings. When a fellow club member has spent hours researching a company and preparing a Stock Selection Guide, you might find it difficult to express disagreement and even harder to vote against acquiring the stock. And if your club votes through a show of hands or voice vote, the pressure can be even greater.
According to observations of several investment clubs recorded by Brooke Harrington in her new book “Pop Finance,” clubs with fewer unanimous votes outperformed ones with more agreement. In examining the voting records of six clubs, Harrington found that “high-performing clubs sustain a great deal more dissent than low-performing clubs.” Turns out, the vast majority of buy/sell votes in low-performing clubs are unanimous. In contrast, members of high-performing clubs are much more likely to debate each others’ opinions. “Far fewer of their votes pass without dissent,” notes Harrington.
Failed buy/sell proposals accounted for 20 percent, 25 percent and 42 percent of three clubs’ total votes, compared with 6 percent for one club and none for two clubs. The clubs with the higher percentage of failed votes also had fewer unanimous votes: 13 percent, 40 percent and 75 percent respectively.
How your club formed might affect the level of debate in your club. Of the three clubs with the lowest percentages of unanimous votes, two were formed mainly through professional ties, and members of the third club met through a broker. Friendship was the main tie for members in the other three clubs. The three clubs with an emphasis on professional or financial ties spent more of their time during meetings discussing stocks and had less cash in their portfolios.
Harrington extends this idea to club performance. “The larger the proportion of friendship and other socio-emotional ties within a group, the worse its portfolio performs,” she writes. “The larger the proportion of relationships based on professional, financial or academic ties, the better the group performs.”
So, do friendship or family ties doom a club to substandard performance? Not necessarily. The lesson here is to make sure that dissent is encouraged and voting is anonymous, not public."
As a final exercise in this forum, I have updated the SSG with more current data and a more optimistic outlook. (See slide 6) With the greater sales and earnings growth numbers, and a higher PE outlook, the stock becomes a stronger buy with a greater forecasted price and compounded return. Because I own shares of the Co. now, I will continue to watch the stock price. If the economy continues to contract and the share price drops, I may add shares. If the PE approaches the level of 21 to 23 (the average PE levels in my study), I will likely be an aggressive buyer.
Because I own shares of FDS, and watch the stock for my club, I will update the Co. with future company reports.
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