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Dollars from Sense Demystifying the Stock Market the NAIC Way by Hugh McManus © 2000 Hugh McManus
BetterInvestingPrinciples 1. Invest regularly 2. Reinvest all your earnings 3. Choose growing companies 4. Diversify to reduce (optimize) your risk Preface This text was written to support the six week NAIC tools class. It’s currently in draft mode: you’ll find it’s littered with spelling, grammar and other errors. Some sections (and diagrams) have yet to be added. So I ask you to be patient as improvements are made. This text is actually part of the Crawl, Stand, Walk, Run, Sprint, Series. Crawl is on the better-investing Web Site—see the New Jersey page. This text is the next three parts of the series and part of the fourth. Hugh McManus July 2000 Table of Contents NAIC Principles................................................................................................... iii Preface................................................................................................................... v Table of Contents............................................................................................... vii List of Figures...................................................................................................... xi List of Tables...................................................................................................... xiii Introduction........................................................................................................... 1 Chapter I................................................................................................................ 3 An introduction to the stock market............................................................... 3 What we’re going to cover.......................................................................... 3 The National Association of Investors Corporation............................... 3 Invest regularly......................................................................................... 3 Reinvest all your earnings..................................................................... 4 Choose from among growing companies............................................ 4 Diversify to reduce (optimize) your risk................................................ 5 What is a stock and what is a company?................................................. 6 Sole Proprietorship.................................................................................. 6 Partnership................................................................................................ 6 Corporation............................................................................................... 7 Shareholders............................................................................................ 7 Bonds and Liabilities............................................................................... 8 Other means of financing....................................................................... 9 Going public.............................................................................................. 9 Brokers and Exchanges........................................................................... 11 Brokers..................................................................................................... 11 Stock Exchanges and Markets: an overview.................................... 11 What happens when I place a trade?.................................................... 13 What’s a spread?................................................................................... 16 What’s a stock split?.............................................................................. 16 Some other definitions.............................................................................. 17 Fiscal Year versus Calendar Year...................................................... 17 What’s the business cycle?................................................................. 17 What’s a growth company.................................................................... 18 What’s the business life cycle?........................................................... 18 What’s a mutual fund?......................................................................... 19 What’s the deal with professional money mangers?...................... 19 Reading a Stock Table.............................................................................. 20 The Wall Street Journal........................................................................ 20 Investors Business Daily...................................................................... 22 USA Today.............................................................................................. 22 What are the S&P500 and the Dow all about?..................................... 23 How do I find a good company?.............................................................. 24 How do I research a company?............................................................... 25 Sources of Information......................................................................... 26 What’s Fundamental versus Technical Analysis?.......................... 26 A word or two about accounting.............................................................. 26 Depreciation and amortization............................................................ 27 Revenues and expenses..................................................................... 28 Depreciation and financial reporting.................................................. 30 Inventory.................................................................................................. 31 Company Financial Information—the Annual Report........................ 32 Letter to the Shareholders.................................................................... 32 The Balance Sheet................................................................................ 33 The Income Statement.......................................................................... 36 The Statement of Cash Flows............................................................. 40 The Statement of Shareholders Equity.............................................. 44 Some Other Items...................................................................................... 47 Why do stock prices plummet if earnings dip slightly?................... 47 The Efficient Market Theory (EMT)..................................................... 49 The Capital Asset Pricing Model......................................................... 49 Is gold a good investment?.................................................................. 51 Review......................................................................................................... 51 Chapter II............................................................................................................ 55 The Stock Selection Guide—the First Page............................................. 55 What we’re going to cover........................................................................ 55 General Information Section................................................................ 56 Plotting numbers on the graph............................................................ 57 Determining the rate of growth of sales and EPS............................ 61 Handling Outliers................................................................................... 64 Projecting into the future...................................................................... 69 Recent quarterly figures........................................................................... 74 Review......................................................................................................... 75 Chapter III........................................................................................................... 79 The Stock Selection Guide—Parts 2 and 3............................................... 79 What we’re going to cover........................................................................ 79 The Pretax Profit Margin....................................................................... 79 Why pretax profit?.................................................................................. 81 Let’s talk about taxes and deferred taxes.......................................... 82 Return on Equity—a discussion......................................................... 84 ROE for Clayton Homes....................................................................... 85 Interpreting Section 2 of the SSG....................................................... 86 Section 1 and 2 of the SSG together.................................................. 86 Preferred Procedure for Calculating EPS............................................. 87 Breaking up the ROE................................................................................ 89 ROE and R&D............................................................................................ 94 Section 3 of the Stock Selection Guide................................................. 96 The PE Ratio and Growth.................................................................... 97 Finishing off Section 3......................................................................... 98 Trends in the PE Ratio....................................................................... 101 Projected and current PE ratio.......................................................... 102 Review....................................................................................................... 103 Chapter IV........................................................................................................ 107 The Stock Selection and Comparison Guides....................................... 107 What we’re going to cover...................................................................... 107 Section 4 of the Stock Selection Guide............................................... 107 A. Determining a five-year high price.............................................. 107 B. Determining a five-year low price................................................ 112 A word on rapid growth companies.................................................. 116 C. Zoning.............................................................................................. 117 D. Upside/Downside Ratio................................................................. 120 E. Price Target...................................................................................... 121 Relative Value...................................................................................... 121 Section 5 of the Stock Selection Guide............................................... 123 A. The dividend yield.......................................................................... 123 B. Average yield expected over the next five years....................... 123 C. Estimated compound annual return........................................... 126 A word on simple versus compound rates...................................... 126 How does one apply the results of the SSG analysis?..................... 128 I am making a one-time purchase.................................................... 129 I make regular purchases of this company..................................... 130 I want to buy cheap and make a quick buck................................... 132 The Stock Comparison Guide............................................................... 132 Growth Comparisons.......................................................................... 133 Management Comparisons............................................................... 134 Price Comparisons.............................................................................. 135 Other comparisons.............................................................................. 137 Selecting a company using the SCG............................................... 138 Review....................................................................................................... 139 Chapter V......................................................................................................... 143 Portfolio Management Tools...................................................................... 143 What we’re going to cover...................................................................... 143 What’s a portfolio?............................................................................... 144 The Portfolio Management Guide (PMG)............................................ 144 1. Price Earnings Zones..................................................................... 145 2. Price Zones...................................................................................... 147 3. Cumulative earnings and current PE ratio................................. 148 4. Chart of prices and PE ratio.......................................................... 150 Discussion on the PMG..................................................................... 155 The PMG and when to sell................................................................ 158 The Portfolio Evaluation and Review Technique (PERT)............... 158 PERT-B................................................................................................. 160 PERT-A................................................................................................. 161 PERT Report........................................................................................ 164 Portfolio and Diversification Issues.................................................. 168 Portfolio Trend Report............................................................................. 170 Portfolio Summary............................................................................... 172 Summary................................................................................................... 172 Chapter VI........................................................................................................ 175 Putting it all together................................................................................... 175 What we’re going to cover...................................................................... 175 Selling....................................................................................................... 175 Investment Clubs..................................................................................... 178 Other Issues............................................................................................. 178 Appendix 1........................................................................................................ 179 On-line Resources...................................................................................... 179 Appendix 2........................................................................................................ 181 Completed SSG for Clayton Homes......................................................... 181 Appendix 3........................................................................................................ 185 The Value Line Investment Survey.............................................................. 185 What exactly is Value Line?.............................................................. 185 Running through the Value Line..................................................... 186 Safety and Timeliness........................................................................ 187 Value Line Projections....................................................................... 188 Insider Decisions................................................................................. 189 Institutional Decisions........................................................................ 189 Capital Structure.................................................................................. 189 Current Position................................................................................... 190 Annual Rates....................................................................................... 191 Quarterly Revenues, Earnings and Dividends.............................. 191 Value Line Graph................................................................................ 192 Business Summary............................................................................. 193 Table of Financial Information.......................................................... 194 Index.................................................................................................................. 201 List of Figures Figure 1 Blank SSG for Company Information 56 Figure 2 SSG Company Information completed for CMH 56 Figure 3 SSG Graph: Plot of Clayton Homes Revenues 59 Figure 6 Part 2 of the SSG 86 List of Tables Table 1 Calculation of pretax profit on sales.......................................... 79 Table 2 Calculating Return on Equity........................................................... 84 Introduction “Demystifying the Stock Market the NAIC Way” is a six-week program designed to guide people through the investment process. The course focuses on tools offered by NAIC—the National Association of Investors Corporation—a non-profit organization dedicated to investor education. The program is divided into six sections. The first chapter is an introduction to the stock market and includes some definitions of commonly used terms. Chapter 2 delves into the Stock Selection Guide (SSG)—a tool for doing a simple fundamental analysis of a publicly traded company. The SSG is a two-page summary of financial information. The first page is a graphical analysis of the company. Chapter 3 of this program looks at page two of the SSG. In this part, the user will examine management and try to determine the likely high and low stock price for the next five years. Using parts 1 to 5 in concert will allow the user to determine if a particular company is a good investment. Chapter 4 of this program completes the SSG and starts on the Stock Comparison Guide (SCG). Here the user will get to compare a series of companies all in the same industry. Chapter 5 of this program looks at two tools useful when one has a portfolio of companies to examine. The Portfolio Management Guide (PMG) is an examination of price behavior of the stock without regard to the fundamentals that drive this price. If the market appears to overvalue a company, then the user may benefit from this behavior. The Portfolio Evaluation and Review Technique (PERT) looks at the fundamentals of a company; determines if the company behaves as planned; looks for “bad news”; and shows which companies in a portfolio appear to be undervalued. Capter 6 brings it all together with some examples. I am going to talk about the NAIC principles of investing a lot! So get ready. Here they are again: 1. Invest regularly 2. Reinvest all your earnings 3. Choose from among growing companies 4. Diversify to reduce (optimize) your risk. That’s it! There is a lot of work involved in mastering these tools and applying the principles. Don’t expect to become an expert after just six weeks. Most people who apply these lessons become comfortable after a year or so, often augmenting what they’ve learned in this program with classes offered by a local chapter of the NAIC. What these tools do teach is a systematic way to examine companies. The goal is to allow people to judge with their mind and not with emotion. As an investor with only ten years of experience, the best lesson that I have learned is that “patience is genius in disguise.” The one thing I would urge you to do is to work on the assignments at the end of each chapter—particularly chapters two through five. These assignments are designed to reinforce the material covered in the classes. This text is divided into two sections enclosed in a ring binder. The general information is on white paper; company specific material is on colored paper. The instructor will choose a company and industry to study in this program; you’ll find that either on colored paper in this binder or in a separate handout. This company and industry will be used to apply the general principles covered in this text. Clayton Homes and the Manufactured Housing/Recreational Vehicle Industry will be used as an example. I am very much indebted to Christine Burney of Sydney, Australia, who read through the draft and diligently corrected many errors. NAIC is really IAIC! I hope you enjoy this program and find it enriching on a multitude of levels!
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