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Fundamentals of Investing

Explaining the BetterInvesting Philosophy

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Our February issue traditionally includes an invitation for you to bring a visitor to your investment club meeting so that they can discover how clubs can help them build wealth and can learn about BetterInvesting’s philosophy. Two years ago we published an article explaining our approach to investing that proved popular with readers. This month we’ll tackle the subject again. If you’re bringing a guest to a meeting or want to introduce someone to the BetterInvesting approach, you might consider giving them this issue.

Brad Perry, in his classic book Winning the Investment Marathon, wrote that investing “is pursued most successfully in a simple, straightforward way.” This is the Golden Rule for most investors who employ fundamental analysis and have a long-term perspective. Buy stocks of high-quality companies at good prices and continue holding them as long as the companies’ performance merits doing so.

Sales drives earnings; earnings drives the stock price. That’s what it comes down to for fundamental investors. You might hear of different ways to buy and sell stocks, and countless books have touted systems that promise great returns. But over the long term fundamental analysis is what works in building wealth.
Fundamental analysis comes down to studying a company’s financial performance. Broadly, there are those who look for growth stocks and those who look for value equities, but the line between value and growth investing is gray: As Warren Buffett says, value and growth “are joined at the hip.”
Value investing, as practiced by Buffett and his mentor Benjamin Graham, is a time-tested method involving fundamental analysis that has served many investors well. But for the typical person who has a job and family and who is managing his own portfolio while following Perry’s admonition to keep it simple, fundamental analysis focused on growth stocks might be more appropriate.
This is because individual investors can spot a good growth company quickly. BetterInvesting’s Stock Selection Guide arranges the fundamental data in a way that allows users to see a company’s growth and management performance as well as the stock’s investment possibilities in just a few minutes; see the Stock to Study SSG on pages 29 and 30 for an example. Meanwhile, the work required to spot a good value stock is a little more complex. But as we’ll discuss later, value should be a vital consideration as well.

The Three Most Important Ideas:

Management, Management, Management
The individual investors who belong to BetterInvesting ask two questions when studying a stock:

•  Is this a well-managed company?
•  Is its stock reasonably priced?
We seek great management because talented, capable executives know how to ensure their company thrives over the long term amid competitive battles and periodic downturns. These are the people, in other words, who are responsible for driving the sales and growth increases that fuel stock prices.
In assessing management, we don’t know everything about a company’s day-to-day operations and boardroom discussions. But as laid out in a methodology promoted by association co-founder George Nicholson, we do have a lot of the information we need. A first step in finding a well-managed company is to look at the history of sales and earnings growth. An important indicator of strong management is its ability to grow the business in good times and bad.
We also seek companies that are growing sales and earnings over the long term at a rate that’s high relative to their size. Smaller companies generally should be growing earnings by at least 15 percent a year; mid-size companies, by 10 percent to 15 percent a year; and large companies, by at least 7 percent annually.
We want smaller companies to have higher growth rates partly because they generally are riskier investments than large companies. The higher growth rate compensates us for this additional risk, and if we do a good job of assessing these companies, we’ll see handsome returns. As you’ll see in this issue in “Repair Shop” and “Watch List,” finding small companies can be challenging but also quite rewarding.
Finally, we favor consistent growth over the long term. In the graph on this page, for example, note the railroad-track-like growth of the company’s sales and earnings. Consistent performance reassures us about the capability of management. And although the past is no guarantee of future performance (as they say in the mutual fund world), history informs our decisions regarding future growth.
Two other tests help us assess the company’s management. First, we check the company’s profitability before taxes and other charges outside of management’s control. We like to see stable or growing profit margins. The other ratio is return on equity — how well management is using the equity invested in the company. Again, stable or growing ROE is preferred. Comparing the company’s growth rates, profitability and ROE with those of its peers helps determine whether this is a company built for a long voyage or is simply benefiting from the rising tide for its industry.

Evaluating the Investment Potential

Once we’ve determined the company in question is likely a high-quality one worth studying further, we next project sales and earnings growth. As fundamental investors, we know that in the short term, the market may not reward the company for its excellence. But over the long term, we trust that it will. So it’s the long-term projections — five years, very roughly enough for the company to go through a business cycle — we care about.
We start by forecasting sales growth because we need this for building our earnings projection. With the caveat that making long-term predictions can be a humbling experience, we have a number of data points at our disposal, including:

•  The company’s historical growth rate.
•  Company statements regarding growth goals.
•  Wall Street estimates of both short- and long-term growth. Long-term sales growth estimates can be difficult to find but are sometimes buried in analyst reports.
•  The industry’s historical growth rate and estimates of future expansion.
More experienced investors might consider such factors as the percentage of recurring revenues, the value of projects under contract but not yet completed and historical organic growth and growth by acquisition. For retailers, they might look at projections for store and square footage expansion as well as same-store sales growth. But history is a powerful teacher for beginning and experienced investors alike.
We then estimate earnings growth in light of the sales projection. We’ll consider the company’s history of earnings growth and any goals it has stated. We can also access analyst reports and analysts’ consensus estimates, but these forecasts are usually overly optimistic.
Studying past and potential future profit margins and tax rates can help us understand the path revenues will take to earnings. We also want to think about what will happen to the firm’s number of common shares outstanding. For example, if a company regularly buys back shares to reduce the number of shares outstanding and is expected to continue this practice, we would expect future earnings to be spread among fewer shares.
When we’re finished, we use the earnings growth rate to arrive at an estimate of earnings per share five years from now. If we have forecast growth of 15 percent a year, and the EPS at our starting point is $1, five years from now EPS will be $2. Two things to keep in mind regarding projections:

•  It’s prudent to be conservative.
A firm might have increased earnings 25 percent annually over the past 10 years, but such performance is extremely difficult to maintain. Gravity will eventually take hold as a company moves from small to mid-size to large.
•  Earnings advances can outpace sales growth for only so long. Over the long term, they usually settle in at the rate of revenue growth. If you’re going to project EPS increases that are higher than sales growth, understand where the additional percentage points are coming from: Increased margins? Lower taxes? Fewer shares outstanding?

Checking Valuation

Once we’ve predicted the EPS five years from now, we’re ready to answer our second question: whether the stock is reasonably priced. Investors are good at discovering high-quality stocks but experience more challenges in determining the proper price to pay for the stock. Our first step is to study the stock’s price-earnings ratios over the past several years and forecast the likely high and low P/Es over the next five years. The P/E, the stock’s current price divided by a company’s EPS, is how much the market is willing to pay for $1 of a firm’s earnings; it’s the most common way to measure how expensive a company’s stock is.
Historical valuations can help us in this process, but P/Es often go through unpredictable periods of expansion and contraction as industries go in and out of favor on Wall Street. Another idea to keep in mind is that a stock can trade at extremely high P/Es for a while but eventually will drop — severely so when a high-growth company stumbles. P/Es also tend to contract in times of inflation.
After we have predicted what the high P/E for a stock will be, we’re ready to estimate a potential high price for our stock. It’s a matter of simple math: The high point of EPS — what we forecast the EPS to be five years from now — is multiplied by the high P/E to come up with a potential high price. For example, if we predict EPS will be $2 in five years and the high P/E will be 30, our predicted high price will be $60.
After projecting the low P/E, we can multiply it by the expected low EPS to come up with a potential low price. Since we’ve determined this is a growth company, we usually can use the most recent 12 months’ EPS as the low point for earnings. I can use other criteria for projecting a low, but this is a common method for determining this figure.

Return Expectations

Now that we have the stock’s potential range from low to high, we’re ready to see whether this stock will provide a suitable return. Our SSG divides the range into three zones: Buy, Maybe (or Hold) and Sell. The lowest 25 percent of the range is the Buy zone, and the upper-most 25 percent is the Sell zone.
We include the stock’s dividends — the cash payments of earnings to shareholders — in our return calculations. This gives us three ways to achieve a return on a stock: through dividends, through the market increasing the stock’s price in concert with the earnings growth and through the stock’s price rising because the market believes the P/E should be higher.
We aim for our stock holdings to return 15 percent annually on average over the next five years, or a doubling of return. That’s an aggressive target, but the idea isn’t to be disappointed if we fail to meet it. It’s to maintain our focus on seeking high-quality growth stocks. Achieving returns of, say, 10 percent yearly is pretty commendable.

Managing Risk

Investors can manage their risk in picking individual stocks by following some simple rules:

•  Require that the company have at least five years of financial history. Younger firms haven’t developed enough of a track record for assessing management performance.
•  Study only companies that have proven they can make money. Someone who invests in a company that has never reported earnings is speculating, not investing.
•  Understand the possible risk and reward of owning a stock.
•  Diversify your portfolio. Even if you’ve done your homework on every holding using all the information you need to make an informed decision, you’ll still make mistakes. If you have a good-size basket of stocks, however, you’ll also have some stocks that perform much better than expected.
Besides investing in high-quality growth stocks and diversifying your portfolio, two other simple principles can help you build wealth over the long term. First, reinvest all your dividends and earnings. Second, invest regularly in both good markets and bad; this is often called dollar-cost averaging.
The type of analysis I’ve outlined provides a lot of the information fundamental investors need to determine whether a stock is a suitable investment. But not everything. Reading annual reports, listening to conference calls and viewing company presentations will help you form a fuller picture of the company.
In today’s unpredictable, volatile market, fundamental analysis is even more important than usual. But for an investor using a simple, straightforward methodology that focuses on the long term, these are also times of great opportunity.

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