Selecting Shares That Perform 3 – Earnings acceleration (Growth), Outsider info & Good Companies (Buffett)

Today’s post is our third visit to a book recommended by a reader – Selecting Shares That Perform, by Richard Kock and Leo Gough.

Valuation (PE)

The fourth of the ten ways of selecting shares that perform is to detect earnings acceleration.

• But the authors begin by looking at valuation.

The value of the company is its earnings multiplied by its PE ratio:

Value (Market cap) = earnings * PE, or

PE = share price / earnings per share, or

Market cap = share price * PE * number of shares

Looking at last year’s earnings gives the trailing PE, whereas looking a next year’s earnings gives the future or prospective PE.

• Future PE has been shown to be a bad predictor of company prospects since earnings forecasts are rarely delivered.

PE is usually judged relative to the market as a whole or to similar companies (the sector).

• The likely growth rate of the company is used to justify a higher or lower than average PE (by reference to potential future earnings).

The authors define the “normal” range for PE as 5 to 25:

• a PE below 5 means that earnings are expected to decline and / or the company may go bust
• a PE of 5 to 10 indicates that earnings growth below inflation is expected
• a PE of 10 to 12 implies earnings growth in line with inflation
• a PE of 12 to 15 implies that earnings growth will modestly exceed inflation
• a PE of 15 to 20 indicates that earnings growth well ahead of inflation is expected
• a PE over 20 indicates rapid earnings growth is forecast

This is all quite sensible, but can be a bit of a circular argument:

• the PE is the  market’s “rating” of a company’s growth prospects
• shares go up in price because the company’s earnings increase, or because the PE increases (which means that investors think that earnings will increase in the future)

Because new earnings data affects both actual earnings and investor expectations of earnings in the future, price changes in reaction to surprise earnings (up or down) can be dramatic (since two factors are multiplied together).

Way Four – Earnings acceleration

So earnings acceleration can dramatically increase the value of a share.

• Even better, investors take some time to trust the increased earnings as sustainable or “quality” earnings.

The process may take a few months or even a year or two after the change in trend first becomes noticeable.

• This means that you can buy shares after the earnings announcement and still make money.
• This is particularly the case with small, poorly covered stocks that are below the institutional radar.
• The peak PE of a small growth stock will usually be after the peak growth rate in earnings has passed.

Note of course that the same thing happens in reverse, and when a highly-rated (high PE) company’s earnings disappoint, the fall in share price can be equally dramatic.

• Even worse, the fall in price will happen much more quickly than the previous rise.

What kind of growth?

The authors suggest that 30% annual growth is a minimum level to look for.

• The increase from the previous year’s growth rate (the acceleration) should be 50%.
• So the minimum threshold is an increase from 20% growth to 30% growth.

These changes in growth rate can be found in the Investors Chronicle results pages.

The authors suggest verifying these numbers from the results by hand:

• use operating profit (profit before interest and tax) or profit before tax
• cross-check with earnings per share (EPS), to rule out acquisition-led growth, where the number of shares in issue has increased rapidly – EPS must be growing too
• look at the last six to ten half-year results for a period of flattish profits before “take-off”
• avoid companies where profits move up and down, even if they are up recently
• correct for seasonality (compare relevant half-years)
• remove exceptional items (if they really are exceptional)

The goal is to identify the reason for the earnings growth, and to be confident that growth is likely to continue.

Growth checklist

The authors provide a rather fussy seven-point checklist to work out how attractive a growth stock is:

1. What is the rate of growth in operating profit over the last two half-years (P1 and P2)?
   • < 20% = 0 points, 21% to 30% = 10, 31% to 40% = 15, > 40% = 20
   • < 20% for P1, but 21% to 30% in P2 = 5 points
   • 21% to 30% in P1 but 31% to 40% in P2 = 15 points
   • 31% to 40% in P1 but > 40% in P2 = 20 points
   • < 20% in P1, but > 30% in P2 = 10 points
2. What is the pattern of operating profits over the last 6 to 10 periods?
   • no pattern = 0
   • growth but with volatility and reversals = 5
   • growth but not currently accelerating = 15
   • consistent and accelerating growth = 25
3. Is the EPS history similar to the operating profit history?
   • yes = 0
   • no, but only because of tax rate changes = 0
   • no, because of more shares being issued = mark down the Q1 score according to the EPS numbers
4. What rate of earnings growth do you expect in the next 2 to 3 years?
   • < 20% = 0, 20-29% = 10, 30-39% = 15, 40-49% = 20, 50-75% = 30, > 75% = 50
5. Repeat Q4 but with analysts estimates rather than your own
   • < 20% = 0, 20-29% = 10, 30-39% = 15, 40-49% = 20, 50-75% = 30, > 75% = 50
6. Repeat Q4 using the chairman’s statements (the “director speak”)
   • < 20% = 0, 20-39% = 10, 40-75% = 20, > 75% = 30
7. Is the real world reason for the profits surge sustainable for 2-3 years?
   • Yes = 30, No = 0

If the total score is less that 50, the company is rejected.

• If the score is above 59, the score is divided by the historic PE.
• For example, score of 75 divided by PE of 15 = attractiveness of 5.

A score below 3 means do not invest.

• 3 to 4 is moderately attractive
• 4 to 5 is attractive
• 5 to 6 is very attractive
• 6 to 10 is exceptionally attractive
• above 10 means that you probably need to check your calculations

This all seems overly complicated (( For example, why not just use EPS in Q1 and omit Q3; why not combine Q5 and Q6 into Q4 ? )) but could be turned into a spreadsheet that does most of the work for you.

• You might also use a linear (proportional)  scale for some of the questions, rather than the steps and adjectives used by the authors.

Anticipation

Earnings growth can be anticipated by looking for:

1. an increase in turnover
2. extension of a proven product to a new region (a rollout or a riskier overseas expansion)
3. a new and superior product proving successful in tests or gaining market share
4. ability to increase prices
5. reduction in the cost base

Who is this for?

The method requires time and some numeracy, so it is not for everyone.

• Analysis and judgment are preferred over hope and emotion.
• It works best for smaller companies, so a fair degree of risk tolerance is required.
• Patience is a virtue, since most companies will take two or three years to rise fully in price.

Way Five – Outsider information

Outsider information is the opposite of insider information:

• It is research prepared by people not directly connected to the company.
• It is not short-term, price-sensitive information.
• It is not illegal.

Apart from reports by industry analysts, it is basically your own leg work.

• This can be paper-based (eg. competitive analysis of a sector
• But is more likely to involve talking to suppliers, competitors and employees

The authors argue that an outsider can form a better view of a competitive industry than an interested insider.

Key things to look for are:

• customers that are very happy about a particular company or product
• enthusiastic employees
• change in long-term market share trends

Smaller companies are the best place to look.

When you do find such a share, the authors recommend going heavily overweight in it.

• As usual, I prefer to use a variety of approaches simultaneously so that no one stock takes up too much of my portfolio.
• Which doesn’t mean that the outsider information section of my portfolio (if I had one) might not be dominated by two or three stocks.

This Way is only suited to those with a particularly personality type – you need to be both extrovert and somewhat analytical.

• You also need to be patient, as it can take years for the market to appreciate stocks that are popular with their customers and have growing market share.

I’m definitely not this type of personality.

• This Way is also too time-consuming for me, as it requires a lot of travel.

Way Six – Good companies

This Way follows Warren Buffett in dividing companies into good and bad – the sheep and the goats. (( I’ve never understood this phrase – I like goats and sheep seem pretty dumb to me ))

Most people would describe a Buffett stock as a large company that dominates its market and has a defensible competitive advantage (a “wide moat”).

• Coca-Cola and Gillette are probably the two stocks that spring to mind.
• Buffett also made lots of money from newspapers during their heyday, and today owns railways.
• And all of his investments are underpinned by the hugh “float” from his insurance operations.

The authors point out that good businesses can also be new and small, so long as they have a good niche.

• And good businesses can be as cheap as bad ones.
• But you will need to be patient, as it can take years for the market to revalue a firm

Its unfortunate that the authors’ choices of British companies that are good are not convincing:

• KwitFit was in the 4th edition, and Pearson is in the 5th
• RioTinto is also included, but that’s in a cyclical sector where I wouldn’t look for good companies
• Schroders is a merchant bank, which is another cyclical and hard to value sector

The kinds of UK-listed companies that most people would see as Buffett investments include Unilever, Reckitt Benckiser and Diageo.

• These are all customer-facing firms with large market share and strong brands.

What is a good business?

The authors provide a checklist of things to look for:

1. Cash generation
2. High return on capital
3. Stability of profits and cashflow over time
4. A defensible business franchise
   • a brand, location or emotional appeal that will keep customers returning even if prices are high
5. High market share relative to competitors
   • a market niche can be narrowly defined, but must lead to lower costs and / or higher prices
6. Barriers to entry
   • brands, control of distribution channels, low cost of production, technology, customer service reputation, geography, expensive physical assets
7. A winning culture
   • this is harder to define, and harder for the private investor to identify
   • the authors focus on operational factors like supplier management and efficiency, but also the employee attitude mentioned above in “outsider information”
   • unfortunately they use Tesco as an example (albeit alongside Google)
   • they also use M&S as an example of a firm that has a winning culture and lost it (( Many would argue that John Lewis picked up the mantle, but unfortunately they are not listed ))

What is a bad company?

Here’s a checklist of things to avoid:

1. High debt
2. Cyclical earnings
   • construction, property, mining, steel, chemicals
3. High labour costs
4. Vulnerability to environmental standards
   • apart from regulated utilities, which can pass on their costs to customers
5. Bad management
   • incompetent, short-term, unethical or greedy

We’ll leave it there for today.

• We’re now three-quarters of the way through the book, and we should finish with one more article.

Today’s three ways have been on the softer side, and they won’t be for everyone, but some people will find them useful:

• you can definitely make money out of growth stocks, but you need to keep an eye on them as most come a cropper in the end
  • the authors’ process for identifying opportunities is too fussy for me
  • just look for earnings acceleration that hasn’t yet translated into a sky-high PE, and which might be expected to persist
• outsider information is definitely a method that isn’t for everyone
  • few people who have an interest in investing will be drawn to it
  • it requires a strange extrovert yet analytical personality
  • if you are this kind of person, you probably know it already
• the Buffett approach is well-known, but hard to pull off in practice
  • this section reminds me of my old MBA textbooks, with their frequent examples of great companies which fell to earth soon after the book was published
  • it also reminds me of those drawing tutorials which carefully explain how to draw the eye or the ear of an owl, and then conclude with a final instruction to “now draw the rest of the owl”
  • the rest of the owl is the hard bit

I’ll be back in a few weeks with the final four Ways to win.

Until next time.