Chapter V

Portfolio Management Tools 

What we’re going to cover

In this chapter, we’re going to look at managing a portfolio—a collection of companies.  We’ll look at the thorny issue of selling.  There are two tools that focus on portfolio management: the Portfolio Management Guide (PMG) and “the PERT”: the Portfolio Evaluation and Review Technique.  You will discover that most of the work required has already been completed when you filled in the SSG—it is the cornerstone of the NAIC approach to analysis.

The PMG and PERT are complementary tools.  They are complementary in the sense that the PMG focuses more on what the world thinks of companies, while the PERT is concerned with the mechanics of the companies themselves.  In that respect, the PERT is probably a more important tool than the PMG; however, each will be covered in detail.

Well, the PERT is similar to a conductor turning to the orchestra—let’s say an orchestra on auto-pilot!—disciplined, in sync, but independent.  The PMG is when you turn to the crowd—a rabble, that doesn’t give a tinker’s cuss what you think!  The PERT examines the mechanics of the company, the PMG looks at public’s opinion on how the company is doing.  Sometimes you’ll wonder if you and the investing public at large are looking at the same company J.  I mean it!

What’s a portfolio?

People think of a portfolio as a collection of things—so it is.  If you own five different companies: that’s a portfolio.  A portfolio is a collection of investments.  One person could have cash, bonds and a few stocks in his portfolio, another may just have common stocks in hers.  A fund—a mutual fund—is like a big portfolio that can contain millions of shares of hundreds of different companies.

The Portfolio Management Guide (PMG)

If you keep the following in mind, it will help you appreciate the PMG.  The PMG is a public opinion poll on a company J.  Well, it’s more that just an opinion poll, but this interpretation of the role of the PMG is a reasonable guiding principle to what it’s all about.

Right at the outset, it needs to be said that the Portfolio Management Guide is a guide!  Although it is a portfolio guide, the actual mechanics focuses on a single company—a single stock.  In this analysis, Clayton Homes will be examined again.

The mechanics for completing the PMG are quite straightforward.  The PMG will be completed first, then discussed.  The PMG information was taken directly from Toolkit.

The PMG is a single sheet of paper, with information on both sides—like the SSG.  Unlike the SSG, the quantitative information is on the front page, while the graphs are on the back.  Both the front and the back present the same information in different forms.  The PMG focuses on the monthly price and PE.

The PMG has its origins in the days when the SSG was completed by hand.  Although, now that the tools are computerized, the PMG is coming into its own.  The PMG uses information that was entered when completing the SSG.

Completing the SSG manually is an arduous task.  Investment clubs meet monthly and often review their portfolio at that time.  Most clubs preferred to do an SSG annually, in which case, the PMG can act as a monthly review.  As you will see, the PMG allows the user to enter price information monthly and EPS data quarterly.  In this way a PE ratio can be calculated for each month.  The PMG turned out to be a quick method for figuring out if everything is on track.

The banner above was taken from the PMG for Clayton Homes.  It contains only two pieces of information—the company under investigation and the analyst.  It’s always a good idea to jot down more information—a ticker symbol, some Value Line date (the date of publication)

1. Price Earnings Zones

The concept of a “zone” was discussed earlier, but the concept of a PE zone is novel.  In reality, the idea is very similar to the concept discussed in section 4 of the SSG.

The information required for part 1 of the PMG comes from section 3 of the respective SSG—the SSG for Clayton Homes in this case.  In the figure above, the relevant part of the SSG is described in the banner just above the grid of numbers.

There are five rows and six columns of information.  The first column contains the year.  Interestingly, we’re mixing and matching here.  Since the information comes from Value Line, the share price information is based on a calendar year, while the earnings are fiscal year based.  If the fiscal and calendar years differ, I always write the month of the fiscal year end in bold capitals on the top of the PMG.

In the example above, we are going to look at the information for five calendar years.  The last year in this example is 2000.  As I write, 2000 is not yet over—it’s August.  My preference is to move to the next calendar year after June 30.

The next two columns contain the average high and low PE ratios for the past five years.  This information comes directly from the Stock Selection Guide.  It implies that you have been completing SSG’s on this company for a long time!  The appropriate section is referenced at the top of section 1 of the SSG.

The fourth column is simply the sum of columns 2 and 3.  It’s the sum of the 5-year average high and low PE.

Column five is column four divided by two—half the sum; while column six is column five multiplied by one and a half.

PE guides have just been created.  The value of these guides is based upon experience.  PE ratios tend to move in cycles—as explained earlier—a quick review.

The PE ratio is a measure of how much an investor is prepared to pay for earnings.  Really, the investing community is viewing a company as an earnings (or cash flow) machine.  If the earnings growth rate is large, it’s worth paying more per dollar of earnings today, because earnings (and consequently cash flow) should be higher tomorrow.  Hence, rapid growth companies command higher PE’s.

There’s also a demand/supply phenomenon at work.  This phenomenon was very apparent during the Internet craze!  There is a limited number of shares outstanding.  Say, on day one, a thousand people are interested in investing.  If there are a thousand sellers, everyone is happy.  Let’s say that magazines and TV shows are talking up the company like crazy.  People who own the shares want to keep them, people who don’t want to buy them.  Let’s say it’s now day four—everyone’s heard great news about the company—now 10,000 people want to buy, but only 500 want to sell!  Guess what happens to the price.  Yep, just like on eBay—it goes up J.

Actually, the number of people interested in buying stock generally increases when interest rates drop.  The reasoning is that bonds and similar securities tend to follow the overall trend in interest rates.  As returns on CD’s and treasury bills drop, stocks appear more alluring.  More people chasing a fixed number of shares drives the average price up.

These drivers aren’t completely independent—one from the other—but they each affect the PE.  Aside from an interest rate jolt, PE’s tend to move in trends—driven by the factors discussed above.  The idea of the PE guides is to bracket the areas where the PE tends to roam most frequently.  So last year’s 5-year average PE is used as a guide for the behavior this year.

The PE range is really quite narrow—it’s one quarter of the 5-year average PE ratio.  So if a share price fluctuates a lot, the PE range tends to widen slightly in the succeeding year.  If the price is stable, the PE band in the following year narrows.

We’ll see these guides in action later on in this chapter.  You will actually be able to track the PE behavior from year to year.  A number of different companies will be looked at.  Each has quite distinctive PE behavior—quite different audiences looking the company.

2. Price Zones

There’s really nothing new here—price zones have been discussed.  The price zone is taken directly from section 4C of the SSG.

Actually, when you look at the top and bottom, you may wonder to which of the three zones does the figure above refer.  It’s actually the “hold” zone—the middle zone.  Look at the diagram that follows, taken from the previous chapter.

The three zones are marked.  Now, the top of the buy zone (the low zone) is also the bottom of the hold zone.  Similarly, the top of the middle or hold zone is the bottom of the sell zone.  In other words, if you know where the top and bottom of the hold zone are, you know where both the other two zones are.  Section 2 of the SSG shows the hold zone—the top of the buy and the bottom of the sell.

So we’ve done two things in part 2 of the PMG.  For five years, we’ve marked out a “buy below” and “sell above” line.  We’ve also created guides for the PE ratio—PE zones where an analyst would expect the PE to spend a fair amount of time.

What we don’t know yet is what the price has done from month to month—remember, we discussed the fact that the PMG is designed as a tool to monitor the components of a portfolio month-by-month.  We have no idea what the PE actually did month after month—we have created PE guides, but don’t know what the PE did in relation to these guides.  Meet section 3.

3. Cumulative earnings and current PE ratio

This section is a numbers-fest!  Here’s part 3 of the PMG.

Let me run through section 3.  There are twelve columns and many rows.  The columns can be grouped—four groups in total.  Columns 1-3 are related, as are 4-6, 7-9, and 10-12.  The last three groups are similar one to the other.

The first group of columns (1-3) contains the month and year when the EPS for a given quarter was reported.  The second column contains the value of the EPS; the third column contains the EPS in the adjacent row added to the three EPS values right above it.  In other words, the third column is the sum of the trailing earnings for the past four quarters—it’s a rolling annual earnings per share number.

Look at March 1999 above, when the EPS value is $0.24.  The EPS value for the three quarters immediately before March of 1999 (that’s December 1998, September 1998 and June 1998) are $0.24, $0.22 and 0.30, respectively.  The rolling EPS listed in a box in the next column, a box located beside the March 99 EPS of $0.24 is

The rolling annual EPS value for March of 1999 is $1.00.  Scanning down column 2 also serves to illustrate the cyclic nature of EPS for this company.  The EPS value tends to surge in the fourth quarter of each fiscal year (maybe there’s hope for fiscal 2000!)  The earnings tend to be pretty flat for the rest of the year—the other three quarters.

A new quarterly value of the EPS is reported once every three months.  The next three groups of columns contain information on stock price and PE for each of the three months in a given quarter.

Starting with column 4, a date is written.  It’s better if the analyst (that’s you) selects the same day each month.  Perhaps the last trading-day of the month.  If a person worries about possible end-of-month effects, you could consider choosing some time a few days before the end of the month.  The key is to be consistent—selecting a similar point each month.  For clubs, the date is some day prior to the club meeting.

Column 5 contains the price on that day—the closing price to be consistent.  Nowadays, the number of different sources of pricing information has proliferated.  With after-hours trading, prices can fluctuate from the official close.  Consistency is the key.  Select a time and source and stick with it.  The issues surrounding a price are not as critical as selecting the same day each month.  However, it is a useful discipline to select a date and time and stick with it.

The PE ratio listed in column 6 is calculated by dividing the price in the proceeding column by the rolling annual EPS value calculated in column 3.

Column 7 is the same date one month after the date in column 4—column 10 is two months following the date in column 4.  Columns 8 and 11 contain the stock price for the date in columns 7 and 10, respectively.  Column 9 and 12 contain the PE ratio using the rolling EPS number in column 3.  Remember, the rolling EPS value changes every quarter—when a new quarterly result is announced.

So, we now have four different things.  For a given year, there’s a price guide, a PE guide, 12 actual PE values reported each month, 12 stock price levels taken at the same point each month.  All this information may now be drawn on a graph—the next part of the PMG.

4. Chart of prices and PE ratio

The following is a chart of the monthly results for Clayton Homes.

Let’s start by explaining exactly what you’re looking at.  Across the bottom of the graph, you see the years 1996-2000.  These were the years used when determining price and PE guides.  If you notice, there are vertical lines, every fourth one of which is thicker than the rest (if you’ve printed this document in color, it’s the thick blue lines).  These thick vertical lines are the end of the calendar year; the three vertical lines to the left of each of the blue lines represent the end of a calendar quarter for each year.  The year in question is given at the bottom of the graph.  If this documented printed cleanly, you will see tiny letters across the bottom of the graph for each month in a year.

There are two vertical axes—one on the left-hand side, the other on the right.  The axis on the left refers to the market price—the price at which the company is trading.  The axis on the right refers to the PE ratio at each monthly price.  The price and PE information for each month were both entered when section 3 of the PMG was completed.  The price axis on the left ranges from $2 to $32 per share; the PE ranges from 17 to 32.  Appropriate scales must be chosen to plot the price and PE.

If you look at the graph, you will see a series of eight solid lines and eight dashed lines; these lines stretch across four quarters.  The solid line references the axis on the left; the upper line is the high price guide (bottom of the sell zone); the lower line is low price guide (top of the buy zone).  The dashed line is the PE guide.  The lower dashed line is the low guide; the upper guide is drawn above it.  Note that these guides are drawn for a fiscal not a calendar year.  (Again, if you printed the document in color, the price information is in green, while things related to the PE are in red.)

Finally, towards the bottom of the graph two lines—one dashed the other firm—track their way from left to right.  These lines represent the monthly pricing and PE information entered into section 3.

Looking at the graph, a number of things jump out.  First of all, the price (the solid line) has always been in the buy zone.  In this example, the graph of stock price is always below the lower price guideline.  This guideline is the top of the buy zone.  Likewise, the PE has always been under the low guide.  Since the price has been slowly declining, so too has the PE ratio.  So, the average PE in each successive year is lower than the previous one.  Consequently, the PE graph always lies below the low guideline.  This behavior is a little unusual.  Since the fundamentals of the company appear sound, there must be something going on the industry.

Finally, across the bottom of the graph is a series of bars.  These bars represent “relative value.”  The concept of relative value has been discussed previously.  There are PE guides on the chart—high and low.  The PE bars across the bottom of the graph are nothing more than the PE ratio for a given month divided by the appropriate 5-year average.  If you refer back to section1 of the PMG, the five year average is found in column 5.  If the relative value goes above the upper guide, it’s greater than 150%.  If it drops below the lower guide, it’s less than 50%.  The relative value bars give the analyst a quick method of summarizing the PE behavior for the past five years.

Let’s take a look at a few more PMG charts to get a feel for how these things look.

The PMG chart above was taken from a Toolkit of AFLAC.  AFLAC (AFL) is in the insurance industry and is popular among NAIC clubs and individual investors.

Based on this analysis, the price has pretty much stayed in the hold zone for the entire five years.  This behavior is not a problem for those who contributed to a DRIP.  The relative value has never dropped below 100%—sometimes exceeding 200%!  Note that a high relative value is not always predictive of a future fall in price.  The price has, however, always recovered when the relative value falls—this behavior is not observed in all companies.

McDonald’s (MCD), shown above, is also a popular company.  McDonald’s is the leading purveyor of fast food.  Again, the stock price stayed within the hold zone for most years; however, in 1999, the price extended into the sell zone.  This movement was followed by a decline all the way into the buy zone.  Later the issue of price movements and selling will be discussed—for a fundamental investor, price movements aren’t a relevant indicator.  The relative value has been on a bit of a roller-coaster, hovering in the low 100 percent and exceeding 150% for about 12 months.  Recently, the relative value—driven by the stock price—has dropped below the 100% mark.  This company will be discussed in a moment.

The final company for examination is Amgen (AMGN).  Amgen is a leading biotechnology company.  Amgen serves the pharmaceutical market with two highly successful drugs.  It is interesting to study the SSG for Amgen—it has sales growth that is typical of a company in an early growth phase.  Amgen also has huge pretax profit margins, indicative of a company with few serious competitors.

The PMG is really quite dramatic.  The stock and PE level lay under the lower guidelines for 1997 and most of 1998.  Recently, the company stock has seen explosive growth.  The stock price has moved well into the sell zone, while the PE has move outside the upper guide level.  This analysis would suggest that Amgen is fully valued.

Discussion on the PMG

First of all, it is always important to emphasize—first and foremost—that the PMG is a guide.  The PMG requires information from the SSG.  Assumptions made in the SSG carry over into the PMG.  Reflect on the following:

1.    The buy and sell zones depend on the projected high and low prices;

2.    The projected high price depends on a projected growth rate in either sales or earnings;

3.    The projected low price uses your judgement;

4.    The projected growth rate depends on your judgement of what will occur in the future.

So, it is clear that the results of the SSG are laden with assumptions and that these assumptions carry across into the PMG.  This fact is alarming for new investors—in fact, it’s often frightening.

New investors sometimes worry that something devastating could happen in the future. It’s hard to know for sure what the source of the fear is, but I have my suspicions. Well, let me digress for a moment.  When news programs cover airlines, they don’t head off to the airport to cover the hundreds of planes parked safely at the gates.  The NTSB didn’t order a two year intensive investigation into why there wasn’t a single, fatal airliner crash in the US in 1998.  If they did, the news media wouldn’t have covered the investigation each week.  The fact is that weather it’s airlines or NASCAR, the media reports the extremes and that distorts reality.  The only way that a novice investor can convince him or herself that the stock market is “safe”—whatever safe means—is to plunge in.  I suggest plunging in at the shallow end—get a DRIP J.  Keep in mind too that the PMG is not printed on log paper, so the price movements seem exaggerated when compared to those on the SSG.

Sorry for that aside, back to my original distraction!  The PMG is laden with assumptions and the conclusions you will reach are dependent upon them.  However, when an investor looks at the PMG chart, the things that jump out are those that don’t really depend on the SSG.  Most observers notice the behavior of the line representing the price and the PE.  In reality, what you’re looking at is the audience I described earlier—that audience at the 4^th of July concert—undisciplined—a rabbleJ.

If you reflect on it, it should be a source of great comfort that the price and PE jump all over the place.  For many companies, if you also plotted EPS on this graph and extended it for 20 years, you’d be amazed at what you would see.  The only conclusion you would reach is that the market likes to overpay sometimes and underpay at many other times.  There’s a lot of volatility out there—ups and downs—and, like a surfer, an astute investor can take advantage of this behavior (and look good in the process!)

Getting back to this audience concept, this PMG chart is really telling you what everyone else in the universe thinks of the company.  It’s like a public opinion poll taken monthly for five years!  When that red, dashed PE line jumps high, people are excited about the future prospects of the company; when the line drops low, the public is expressing concerns.  There is a big question that has to be answered: is the company doing anything different to deserve these “votes” from the public?  On many occasions it is not; PERT—discussed later—is when you open the hood of the company to examine the EPS engine!  If it’s working fine, many of your concerns should be alleviated.  You begin to feel a lot more secure about simply ignoring what the public has to say.

Harping on this audience analogy some more, the relative value is telling you what the public’s opinion is today compared to what they thought in the past five years.  When the relative value is 100%, there is no change in opinion; when it drops below 100%, people are more pessimistic about future prospects—above 100% and they’re more buoyant than in the past.

If you review the four PMG charts, volatility stands out—a given.  Companies plummet below the hold zone into the buy, relative values sometimes fall below 100%.  The PMG can signal some great buying opportunities—selling opportunities will be discussed in a moment.  One thing that the PMG helps to support is that if the relative value is high—much greater than 100%—it’s probably an indication that the company is, for the moment, fully valued.  If the investor is making a one-time purchase , chances are that, when the relative value is high and nothing fundamental has changed with the company, it’s time to steer clear.  In the next half of this chapter, we’ll meet the PERT.  You’ll see that it’s important to complement the PMG with a PERT analysis to get the best handle on what’s happening with your company.

It’s very tempting to think about selling a company when the PE and price shoot way up.  Many NAIC investors come to terms with the fact that high prices and relative values are not stable—prices tend to drop.  They also profit from the fact that—all things being equal—low prices and relative values are also not stable; prices tend to climb.  Looking at the chart for McDonald’s many people might ask “why not sell the company when the PE ratio spikes way above the guide, then wait for the price to plummet to buy it back?”  Some people work that way; however, it doesn’t always make sense to me.  In some respects, you can view it as punishing the company for the very thing that you wanted it to do: gain in value.  There’s also no guarantee that the price will “plummet.”  As Wall Street people sometimes say “the stock is getting ahead of itself.”  There are occasions when sharp price movements are followed by relatively little movement until earnings “catch up.”  Companies like Wal-Mart and Home Depot had a few years of flat stock prices (and great buying opportunities for patient investors).  Market timing—let’s be honest, that’s what we’re discussing here—is an approach that studies have shown doesn’t work.

The PMG and when to sell

If you ever go to an NAIC event and ask an instructor about selling, you’ll see squirming like you’ve never seen before!  The dreaded ‘s’ word!  The best response I have every heard came from Gordon Hakes.  Gordon served on the National Board for many years and is a popular teacher all around the US.  His response was succinct and powerful:

“I have made all my mistakes selling.”

If you’ve been an investor for a while, you’re now smiling!

The glib answer to the question about selling is “never”; however, we all know it has to happen—and there are reasons to sell!  They’re are now discussed.

The issue of selling will be discussed in even more detail later when the PERT is introduced.  Before one considers selling, at a minimum a completed and current SSG and PMG are required.

1.    First of all, the company should be in the sell range.  What this tells you is that the world at large—that drunken rabble I talked about earlier J—is paying way too much for this company based upon the earnings you think the business will generate.  Others should be willing to pay too much;

2.    The second reason is really a corollary—a cousin!  The relative value should be greater than 150%.  Each of these criteria is illustrated on page 2 of the PMG for the company.

3.    PERT A backs up what you’ve learned from the PMG!

All these reasons—as with most things—hinge around earnings.  If people are overpaying for them and they’re overpaying like they’ve never overpaid before (someone put music to that!), it’s time to get under the hood and check out that company.  If you don’t like what you see, it might well be time to park your money elsewhere.  Not too long ago, Motorola was a great example of strange behavior: the fundamentals appeared to be deteriorating, but the stock price kept on climbing up and up!

The Portfolio Evaluation and Review Technique (PERT)

While the PMG focuses on the audience, PERT looks at the orchestra.  It examines each section individually and helps you—the conductor—to get a better blend.  PMG looks at price and PE; the PERT looks at the company as an earnings machine: many more things are examined.

Ideally, when you do an analysis of a company you should do the following:

1.    Prepare a stock selection guide

2.    Prepare a stock selection guide for the main competitors in the industry

3.    Prepare a stock comparison guide and select the “best” company

4.    Complete a PMG on the company that looks “best” in the SCG analysis—get to know what the public thinks!

5.    Finally, complete a PERT-A—what?

Well, a company can look attractive on the SSG, but it’s good to find out if it’s really pertee L sorry!  Just a cowboy lingo joke there.  Pert A is an examination of a single company—it looks at the drivers of earnings and makes sure the company is kicking on all cylinders.  In the diagrams that follow, for what I am about to do to you, I am truly sorry!  I am going to ask you to flip back and forth.  All the images are at the very end of this chapter.  The print is small.  Let me run through the various parts to this tool one-by-one.

PERT-B contains annual pricing, PE and dividend information.  Much of what’s in PERT-B is actually germane to the PMG.

PERT-A has two parts: a huge number grid and a graph.  The first page contains seven or so years of EPS, pretax profit, sales and income tax information on a quarter-by-quarter basis.  The information is also presented on a rolling annual basis with year ago percentage changes.  The graph can be used for a number of things, but most people plot EPS and revenues quarter by quarter.  Trends often emerge.

The PERT itself contains lots of information.  It’s a listing of all holdings in a portfolio—a listing of different companies.  The report consists of a series of columns each of which contains either fundamental information about the company or pricing data.  The fundamental information is basically the drivers for success discussed earlier—sales and EPS growth, and PTP information.  The program Investors Toolkit contains an additional report—a Trend Report.  This report is very useful as it compares one quarter with that immediately preceding it.  In this way, you can get a heads up if things aren’t looking too hot.

The final report provided by the Toolkit program is the Portfolio Summary.  This report lists holdings in a portfolio together with information on the PE, relative value, zones, and the percentage of the portfolio.  In the next edition of Toolkit, I am going to ask Ellis Traub to color code the companies (three colors) to represent large, medium or small cap!

Let’s take a peak at the reports in a little more detail.

PERT-B

PERT-B is a worksheet you won’t see much anymore!  If done at all, PERT-B should be completed first!  In fact, it might even be useful to complete PERT-B before you even get to the PMG.  I’ll illustrate PERT-B below, but keep in might that almost everything that goes into PERT-B is done in other places.  Hence, PERT-B doesn’t appear much any more L.

There’s not a lot by the way of comment that needs to be made about this table.  For one thing, all of the information tabulated above appears in the SSG or PMG.  In this regard, PERT-B can be viewed in the same light as the PMG—the results of a public opinion poll!  As mentioned earlier, it is sometimes instructive to augment the PMG with some fundamental information—the rolling EPS value.  Although the PMG is not designed to do this step, it is not difficult to plot the figures, quarter-by-quarter for five years.  Guess where the numbers come from?  It’s PERT-A—the next component in our unraveling of the portfolio.

PERT-A

PERT-A is a two page document containing seven years of fundamental information and a graph.  The numbers grid is on the first page and divides into two halves.  The first half contains quarterly information, the second half focuses on annual results.  In both cases, three of the four “legs” that support a good company are reviewed: earnings, pretax profit and revenues.  If each of these is well behaved, chances are you’ve found a company that will grow over time.

The left side of the table lists the quarterly results for EPS, pretax profit and revenues.  The percentage change from the quarter twelve months prior is also calculated.  The income tax rate for the quarter is listed too.  This information can be obtained from Value Line; however, the quarterly tax information must come from the company or some other data reporting source.  The right hand side of the table contains annual information updated quarterly.  The annual information is based on the rolling four quarter sum.  In both tables the pretax profit margin is also calculated.

The final three columns of the table summarize the annual data.  These columns give the percentage change in EPS, pretax profit and revenues.  Again, this percentage change is based comparing a given quarter with the same quarter twelve months ago.  This method shows changes clearly.  If the number is positive (greater than zero), the item has increased; conversely, if the number is negative (less than zero), you’re witnessing a decrease.

In reviewing PERT-A it probably makes the most sense to examine the change in EPS, pretax profit and revenues.  Ideally, if a company shows no change from quarter to quarter in these values, it adds confidence that the future will unfurl no different from the past.  The results for Clayton Homes are a little disconcerting.

When examining trends, consistency is the key.  Increases in sales and EPS grow is ultimately not sustainable.  If a company is realizing a phenomenal response in the market, eventually that market will begin to saturate and sales will slow—sales will still increase, but not at an increasing rate.  As sales slow, so too will EPS growth rates.

If sales are slowing, it is important to probe the reason.  If both sales and EPS slow, consider it a red flag.  Something is happening to the company or the industry—you need to probe further.  Sustained falling sales will ultimately fell a company!

might actually be stagnant.

Quarterly changes are often more erratic than annual movements.  Quarterly results also act as an indicator of what’s to come.  If you look at quarterly changes in revenues for Clayton Homes, they are negative.  Growth has not only slowed, but is now reversing.  Revenue and EPS information causes great concern.  However, the industry is undergoing a shake out and Clayton Homes appears to be better positioned than its competitors (see the SCG discussion).  It is important to realize that you don’t have to be good to win in business, you just have to be the best!  A “bad” company will do fine if its competitors are worse!

I am getting a little frustrated here.  The computer has crashed three times!  So I am “retyping mode.  Let’s keep going.  Keep in mind that sometimes, a little variation in sales could be a good thing.  Sometimes, particularly in technology driven companies, innovation comes in waves.  Companies have a sudden whoosh of revenues followed by a return to the “normal” growth rate.  Typically such a company will have a large R&D budget—a large R&D spend as a percentage of revenues.  The company might also have a very large pretax profit margin—large compared with its competitors.  Innovation often happens in cycles—a new chip, drug or killer application—so when it is launched, revenues might spike for a time.

Another issue that could occur is associated with foreign currencies.  Imagine a company with a pretax profit margin of 10% and an after tax margin of 6%.  Let’s say that 40% of the revenues of this company come from overseas.  We’ll use the widget example again.  So, 40% of sales are in Europe say, the rest are domestic.  In 19X1, total sales were $100 million.  One million widgets were sold.  A total of 400,000 in Europe, 600,000 in the US.  In 19X2 sales increased by 20% (as measured by number of widgets sold) and the price remained the same.  Let’s run through the calculations:

One little complication, in 19X2, the Euro declines 10% with respect to the dollar, so the actual revenues—as recorded in this US based company—are given in the third line in the table above.  Note the same number of widgets were sold, but because of the unfavorable exchange rate, the actual revenues declined from what they would have been ($120 MM) to $113.1 million.  (MM represents millions—don’t ask me why, I think it’s dumb too!)

How do you know this situation has happened?  You’ll hear all about it in annual reports, press releases and from analysts (whom the company will definitely reach).  The reason is clear; operationally the company is sound—it has increased revenues (and the resulting earnings) by only 13%, but the unit volume in widgets has gone up 20%.

If the exchange rate happens the other way, do companies comment?  I haven’t noticed much comment.  If companies realize a windfall thanks to an exchange rate boost, it is mentioned in footnotes, but not much else!  So, when looking at what a company is up to, if it has substantial foreign holdings, check out the exchange rates.  It is mentioned somewhere in the report.  What is often important is that revenues are increasing in the local currency thanks to increased business.

When a number of leading companies in different industries have been chosen, it’s time to examine the resulting portfolio.  So far we’ve looked at each company in turn.  Now we see how they look together.  It’s time for the Portfolio Evaluation and Review Technique

PERT Report

Although the PERT concentrates on the portfolio, it is a tool that more closely examines the constituents of  the portfolio—the individual companies.  What it does is to place each company in a context—in relation to the others.  The fundamental drivers of profitability are illustrated together with pricing information—fundamentals and the opinion of the masses.  For the sake of this program, I have put together an example portfolio.  This portfolio has been assembled for teaching purposes only.  It is not an example of a well-balanced portfolio, nor are any of the stocks included as a recommendation or solicitation to purchase securities.

The portfolio in the example at the end of the chapter is made up of 50 shares of nine companies.  The companies are

AFLAC, Amgen, Clayton Homes, Disney, Home Depot, Intel Corporation, McDonald’s, Southwest Airlines, Staples.  Again, let me stress that this list should definitely not be taken as a recommendation to purchase stock.  Let’s get going.

The PERT Report allows you to list each company in your portfolio.  Then gives you the opportunity to provide key pieces of fundamental information together with some pricing and value information about the stock.  In the example at the end of this chapter, the companies are listed in order of increasing relative value.  But I am getting ahead of myself.  Here is what you find in the PERT.

Dividend:  The dividend is listed first.  This is the dollar amount paid to shareholders each fiscal year.  The dividend in itself isn’t that informative, but put together with a stock price and now some information is obtained.

Dividend Yield: The dividend yield is the dollar amount of the dividend divided by a share price.  The dividend is in column B and the share price is found in column Q (together with the date on which the price was obtained).  The dividend yield is an indication of the return you get on dividends alone.  Higher yields (say greater than 1% nowadays!) might suggest that the company is no longer in the growth phase and may be moving into a mature phase.  If you recall from the business life cycle, in the mature phase the company generates a lot of cash, but is no longer in a growing market, so it pays a large portion of that cash to shareholders in the form of a dividend.  You normally expect a low dividend yield (or a zero yield!) for a growing company.  The reason is that the company wants to retain all earnings to exploit the great market it finds itself in!

Estimated EPS: The estimated EPS is really the projected EPS.  In this column, earnings for the past four quarters are added together to give an annual EPS.  This number is then projected by the growth rate determined for EPS in either section 1 or 2 of the SSG.  The growth rate for Clayton Homes was estimated to be 15% in section 1 and calculated as 17.4% using the preferred procedure.  Since the value of 17.4% was selected in the SSG, it is also used here.  The last four quarters of earnings for Clayton (or any company) should be in PERT-A.  The value is $1.12, when projected by 17.4%, a value of $1.32 is obtained.  Projected EPS is the value you expect 12 months from now based on the assumptions used in the SSG.

EPS: EPS is determined for the most recently reported quarter and the year ago quarter (3/00 and 3/99 in this example).  The percentage change from year to year is calculated.  If you recall, this growth rate was calculated in section 1 of the SSG.  Refer to the “recent quarterly figures” section on the upper left-hand side of the graph.  This growth rate provides you with a sanity check on the assumptions you made in calculating the projected EPS in the last column.

Now, our goal is to have each company (and the portfolio) double in value in five years.  So we require a growth rate of 14.9% per year.  If stock prices follow the EPS value, we then require EPS to grow at 14.9% each year.  The PERT chart shows that, based on recent quarterly behavior, Clayton is growing at 8.3%.  Scanning down the row, you see that in this portfolio at least, six of the companies (roughly) hit the target.  No need to panic just yet.

Quarterly information can be deceptive.  A quarter is only 13 weeks—actually some years it might be 12 weeks while in others it could be 14!  In other words, there are reasons why numbers could be down in a quarter.  Annual changes are a little more informative, although it is interesting to see what is happening quarter by quarter.

Sales: Revenues are found in the next column (I J).  Just like for EPS, we record the recent quarterly revenues, the year ago quarterly revenues and the percent increase (or decrease for the case of Clayton Homes!).  EPS tells you about growth on the bottom line, now we look at the top line.  The same concerns expressed above for quarterly EPS are relevant here too.  Ideally, a 15% year over year top line growth is required.  However, funny things can happen in a quarter.  A few quarters in a row of bad EPS and revenue growth would be of concern.

Pretax Profit: The next entries are pretax profit—an important indicator of good management.  The pretax profit is calculated for the current and year ago quarter, the profit margin is calculated by dividing the value of quarterly sales, and the percentage change between the two quarters is calculated.  Ideally, revenues, pretax profit and EPS should all track.  The same caveats apply to analyzing pretax profits as was discussed for EPS.  Pretax profit has one more issue—the tax rate issue.  If earnings are increasing but the pretax profit margin is falling, it could be that profits are being realized thanks to a more favorable tax environment.  This situation is not sustainable, so if it occurs monitor it closely.

Trailing EPS:  This column provides the classic way to look at EPS—based on the past four quarters.  The most recent four quarters is compared to the year ago four quarters and the growth rate is calculated.  If you projected future EPS from past performance, they should likely be equal or not much larger than this number—unless something weird happened in the most recent year.  Often times, the preferred procedure can have EPS growing faster than sales—this phenomenon seems to occur more frequently for growth rather than cyclical companies.

PE ratio: The PE is actually the projected PE ratio, calculated by dividing the current price (column Q) by the projected earnings in column E.  The projected PE is a way of trying to estimate what today’s PE ratio would be if you looked at it form one year in the future.  If Peter Lynch’s rule of thumb is applied, then this company is ‘on sale’ if the projected PE ratio is smaller than the growth rate in column H (recent quarterly EPS growth) or column O (recent four quarters EPS growth).

Price: is listed in this column.  It is useful (but not essential) to take prices from a single source.  This price is used to calculate the PE ratio in column P.

Relative Value: Relative value or RV is calculated by dividing the current PE ratio by the five-year average PE.  The number is reported in column R.  Relative values between, say, 75 and 115% are considered ‘good’: that is, the company is temporarily ‘on sale.’  If you recall, PE is the price you pay per dollar of earnings—earnings propel stock price appreciation.  So, if the RV is less than 100%, you are being asked to pay less today for a company than you were in the past.  Assuming nothing else changes, a low RV suggests value.  However, companies have very low RV’s for a reason.  Clayton Homes is at 44%; it’s a very low number indeed.  Often, if the RV is below 70%, it is wise to investigate the reasons in detail.  If a company is in trouble (and I am not suggesting that Clayton Homes is in any kind of peril) and the fundamentals deteriorate, the RV can fall, making the company appear as if it’s a good buy.  Conservative investors find it best to avoid extremes of relative value.

Historical PE ratios: The five year high, low and average PE ratios are listed next.  If the current (projected) PE ratio calculated in column P lies at either end of this range, it might suggest at which end of the PE ratio the company currently lies.  Of course, if the company is outside of the range, you should expect to see and extraordinary high or low relative value—depending on whether the projected PE is above or below the historical price earnings ratio range.  Conservative investors tend to hesitate when the PE ratio is too high or low.

Estimated EPS growth rate: This number comes straight from the value calculated in section 1 or 2 of the SSG.  You can compare your EPS growth estimate with the revenue, EPS and pretax profit rates reported earlier.  If your growth rates are consistently higher (or at the high range) of historical numbers, maybe you are being too aggressive.  Similarly, if you are consistently much lower, it could be time to rethink.  One thing you could do—what follows is a very quick and dirty guideline—is to add up the growth rates in this column—column W X—and get the average.  Compare this average with the average value for the sales and EPS growth rates in columns J and H, respectively.  Again, keep in mind that comparing these averages should be use judiciously.  It just gives you a feel if the estimated growth rates you use bare any semblance to reality.

The PE as a % of Growth Rate: this ratio is nothing more than the PEG ratio discussed earlier.  To get the PEG ratio you divide the projected PE ratio in column P into the growth rate reported in column V.  If you recall, Peter Lynch proposed a one to one relationship between PE and growth rate.  If this ratio gives 100%, great.  A PEG greater than 100%, certainly greater than 150% might suggest you’re paying too much for growth.  If the PEG is less than, say, 75% the price for growth might be just too good.  You might want to examine your proposed growth rate in EPS; it could be too high.

Upside/Downside Ratio: This ratio was discussed in detail elsewhere.  The number is taken directly from section 4 of the SSG for each company.  The normal guidelines apply.  The ratio should be 3-to-1 or better.  A value greater than 8-to-1 could be too good; if the ratio falls below 3-to-1, you are buying risk.  If you scan down the ratios in column Y, some companies have ratios much greater than 3-1.  It might be time to re-examine the low price selected.  This statement is certainly true for Intel, where the upside/downside of 99.9+ suggests that the actual price is lower than the selected low price.  If you notice a consistent trend in your portfolio towards ‘wacky’ ratios, it might show a systematic error in judgement.  That’s one great thing about the PERT report, if you are doing something that’s either consistently right or perhaps questionable, you may well see evidence for this behavior in your report.

Compound annual rate of return: Here you see if you expect at least a 15% annual rate based on dividends and capital gains.  The portfolio overall shows a solid return.  If you are in a DRIP, you know that stock prices fluctuate a lot.  Companies that today show a return of less than 15% (Home Depot, AFLAC, Southwest Airlines and Amgen in our example) are likely to have a downward price adjustment that could make the return more favorable.  Price declines are often associated with stocks that are selling at a historically high PE ratio.  Similarly, if a company continues to prosper and pump out those earnings, the stock price will almost always bounce back.  If Intel continues to be the leader in innovation for microprocessors and related hardware, you would expect the stock price to climb.

Stock price range: Finally, you get the chance to see your high/low projections and compare the value with the current price.  You have already seen this information in another guise when the upside/downside ratio was discussed.

The PERT report allows you to review your portfolio.  To examine each company in the context of all the others and to determine if the goals you set in the SSG are being met.

Portfolio and Diversification Issues

The very last of the four NAIC principles suggests that the wise investor diversify to reduce risk.  If you diligently carry out the SSG/SCG combination described here, you are almost forced to diversify.  The SSG/SCG combination makes you chose the leading company in a given industry.  Once you have the winner, why buy an also-ran?  Most investors move to another industry and repeat the process of finding the leading company.

NAIC suggests diversifying on two bases: company size and industry.  Industries tend to be distinct bits of the economy.  If a surge in oil prices hits the airlines, it might benefit oil supply companies.  A recession seems to affect every part of the economy, but other events tend to be selective.  Diversifying over a number of different industries allows you to balance out any bad events in a given sector.

Diversifying by size is relatively straightforward.  Value Line provides information about the capitalization of a company: large, medium or small.  It might be better to make the division by sales, but for now we’ll choose market capitalization.  People have differing opinions about what constitutes large and small; for this example the following breakdown will be used.

Using this definition for capitalization, it is interesting to see how the portfolio in the example breaks down.  To calculate the market cap of each company, you take the number of shares outstanding (published in Value Line) and multiply it by the share price.  The results are given in a table below.

Five of the companies turn out to be large cap, and only one is small cap.  It is sometimes better to use revenues rather than market cap, as market cap changes as PE’s expand and contract.

Generally speaking, mid cap or medium sized companies (as measured by sales) is where most NAIC people find themselves investing.  Medium sized companies often have a lot of growth left.  They tend to have risk characteristics reminiscent of large companies—that is, low—and growth similar to small companies (but without the risk that small companies have.)  However, when you find a company with a dominant position in an industry—practically a monopoly—it can grow quickly, become large and continue to grow!

Portfolio Trend Report

The Portfolio Trend Report is available on Toolkit and shows the change in PERT from quarter to quarter.  The Trend Report is similar to the PERT in that it is a listing of many of the fundamental markers of a good company: sales, pretax profit, EPS, and so on.  I’ll run through the report next, column by column.  Let’s keep a focus on what we’re doing here: we’re looking for changes in the portfolio from quarter to quarter.  If you identify a change you don’t like, and it persists, it may be time for action.  Keep in mind, however, that if the fundamentals of the company are good and the market does not recognize this fact, you mat be onto a real winner.  Let’s get to work.

Quarterly sales: This entry corresponds to the quarterly sales in the Report.  There is an obvious decline in sales—something worse than a slowdown.  However, the decline is improving.  It’s –0.4% this quarter (a comparison of this quarter with the year ago quarter); that’s an improvement from the –3.1% in the previous quarter.  Investors often look for consistency first and improvement second.  It seems like a strange order; however, improvements are never sustainable for the long term.  If a company is in the early stages of growth, you will probably notice improvements in revenue and EPS growth quarter over quarter.  In fact, EPS will probably grow faster that revenues since the company probably has some fixed costs that don’t scale with sales.  Eventually, the revenue and EPS growth slows: from 40% to 35% to 30% settling ultimately at 20% with a gradual decline to 15%.  Realize that what I have just described is a good thing!  It’s a company—it likely has a new product or service—and it enjoys years of minimal competition as it opens up new markets.  The 15% growth rate it ultimately enjoys is excellent; however, it used to have much better times.  The stock price can often be a lot more volatile when the growth rate is strong.  So, if you have a fast growing company, it’s good to monitor it with PERT-A and the PMG.  It’s also good to remember that volatility (risk) is your friend—as is patience.

Quarterly pretax profit: This information is taken from columns K, L and M in the report.  Notice, we’re moving down the income statement, from revenues through pretax profit and up to earnings!  PTP and earnings should scale; however, you can always check to see if changes in earnings are due to a tax effect rather than something related to the operations of the company.  The PTP in Clayton Home is increasing too—just like revenues; however, the growth in each quarter is positive, suggesting that the company is cutting expenses.

Quarterly EPS: For the case of Clayton Homes, EPS tracks PTP almost exactly.  If the company isn’t benefiting (or suffering) from some short time issue, or isn’t engaged in an extensive buy-back program, they should track.  Revenues, pretax profit and EPS changes should be viewed together

The main objective is to make sure that stock price appreciation will be sustained.  Earnings drive stock price appreciation, so anything that threatens earnings is of concern.  Earlier, the four “legs of supporting a good company”  were discussed.

1.    Steady growth in sales—and the best in the industry

2.    Steady growth in EPS—and the best in the industry

3.    Stable pretax profit margins and the highest in the industry

4.    Stable ROE and the highest in the industry

We also determined that the primary driver for ROE is actually pretax profit on sales.  So actually, the PERT and the Trend Report examine, directly and indirectly, the four legs that support a good company.  If the first three items above are stable and exceptional, you could well be onto an excellent company.  The PERT Report and Trend Report allow you to examine these three, important items; each of which are primary drivers for and likely predictors of earnings.  If you’ve got earnings under control, the stock price should follow.

The next few columns duplicate or augment information in the PERT report.  The estimated EPS growth rate comes directly from section 1 or 2 of the SSG; note, this number is also found in column V of the PERT report.

The projected average return (PAR) is the return you expect if a series of things happen.  First off, it is based on the current stock price—the price in column Q of the PERT report.  The PAR is a combination of the dividend yield and appreciation of the stock price to the projected high.

The Total Return is something slightly different.  The Total Return was calculated for each company in section 5 of the SSG.  The return is a combination of the expected return from dividends plus the price appreciation based on the growth expectations of the company. These last two items can be compared with the change in growth in earnings, PTP and revenues.

The next few items center on the portfolio itself; the number of shares and the dollar value based on the current price (found in column Q of the PERT report).

If you have already identified the market cap of each company, you can then use the percentage information to find an accurate distribution of the various components of your portfolio.  For an aggressively conservative investor—aggressive because he or she selects growing (and somewhat more volatile) and conservative as the investor throttles back every time judgment is required—the portfolio might be heavy in mid and large cap companies with a sprinkling of small cap.  If the small cap have been carefully chosen (like selecting Cisco Systems in 1990), over time these companies will ultimately dominate the portfolio!

Portfolio Summary

This final report is a listing of the companies and some pricing information.  Again, the percent of each company in the portfolio is provided as is the recommendation to ‘Buy’ from the PMG—it’s really more an opinion than a recommendation!  This summary can be particularly useful for those individuals or clubs who make regular DRIP (or equivalent) purchases.  Finding which company or companies are trading at a price lower than one would expect based on earnings growth often signals a buy.  Some people take advantage of this information and make additional purchases for their portfolio—buying cheap.

Summary

In this chapter we have examined the components of a portfolio.  We have looked at two tools: the first focuses on what the ‘market’ thinks of the company, the PERT focuses on fundamental information and shows the drivers of value.

Doing a little extra work can show if the portfolio is diversified.  Diversification by size is probably the only thing a diligent investor will need to investigate.  If the investor has carefully used the SCG to pick out the strongest company in an industry, this process will lead to diversification.