2 posts tagged “growth”
In our method of stock selection, we first determine which specific stocks warrant investment consideration. Qualification for consideration does not necessarily translate into actual investment. Consideration is only the first step. The actual implementation of purchase and sell decisions depends on a number of other factors which will be described after we have determined the general group of stocks we want to utilize. The qualification process is a filtering technique, through which thousands of different stocks are condensed down to a manageable number. This is not a hypothetical process. It is the actual method we use, and it is the basis from which our extraordinary high degree of accurate price forecasting was developed.
While very logical, the stock selection procedure is possibly too lengthy for the average investor. Do not be alarmed. After explaining the long method, we will describe a greatly simplified approach that is easy and quick, and that approximates the results of the longer method. The following lengthy explanation, however, is necessary for an understanding of the logic of the selection process.
The Criteria
The following qualifications are considered mandatory for the stock of any corporation to be of sufficient quality to warrant possible inclusion in our market strategy.
1. Earnings Predictability.
If you are involved in a serious hunt for a dangerous prey, your primary concern is the reliability and working condition of your weapon. Our weapon is common stock, and its specific selection is a serious (core) concern. The probability of error must be minimized to help assure survival.
Earnings are generally the most important factor in the value of a corporation. It was also mentioned that earnings generally are not easily predicted. Some corporations, however have demonstrated a consistent record of earnings predictability. Because of the existence of such corporations there is no need to rely on corporations whose earnings are less predictable.
As a rule, we consider the earnings predictability factor acceptable if the corporation has managed to meet earnings projections ±15 percent during each of the previous seven years. Disqualifying corporations that have not demonstrated a satisfactory past predictability as to earnings helps to eliminate fundamental surprises, as well as about 80 percent of all common stocks.
2. Earnings Growth.
Predictable earnings does not mean acceptable earnings. Because of the availability of corporations with demonstrated patterns of earnings growth, it is only logical to direct investment toward these issues.
The reason for this criterion is deeper than psychological reassurance. Corporations with demonstrated earnings growth get wider publicitywithin the investment community, and consequently they are considered for investment by a larger number of investors, both individual and institutional. It is from other investors that profits are taken. The greaterthe number and different types of investors involved, the easier the task of prey identification.
Keep in mind, however, that past earnings growth in itself is not enough. Future earnings projections must also indicate a pattern of growth. Themarket is most influenced by anticipation of the future. Limiting investment to corporations with both earnings predictability and earningsgrowth concentrates attention on quality, which can (but won't necessarily) help in supporting market price.
This earnings growth criterion generally halves the number of issues that were able to survive the test for earnings predictability.
The Right to Earnings
This right is the most important single characteristic of common stock, for it (at least in most theories) is the dominant factor in determining stock price. The corporate earnings (theoretically) belong to the owners (stockholders), who therefore have the potential to realize tremendous profit if the corporation is successful.
One must not blindly assume, however, that if corporate profits rise the stock will also appreciate. The fact is that there is no automatic correlation between corporate profitability and common stock pricing. It often takes more than earnings gains to create an advance in the market price of a stock.
Corporate management has the choice of doing any one (or a combination) of three things with earnings:
- Retain them within the corporation to finance future growth.
- Distribute them to stockholders.
- Steal them.
Most texts on the market ignore theft, considering such nastiness a rare event that it is not important. The general perception of corporate theft is that of a slimy little over-the-counter stock sold to the public at a ridiculous price by management or a seedy embezzler packing misappropriated cash in a suitcase and running to Brazil. Theft at the expense of shareholders can take many forms and can occur in dramatic amounts in the largest corporations. There are two basic types of theft:
- That in direct violation of law. All you need to do is look at the paper to see the Mr. Boesky types being taken away for stealing millions, or the billions in fraud that contributed in making the insurance protection for the entire savings and loan industry of the United States insolvent. Such behavior cannot be shrugged off or considered a laughing matter because of the light penalties; remember whose pockets—stockholders' and taxpayers'—were fleeced.
- That not in direct violation of law. This includes management's paying itself exorbitant salaries, perks, options, and other compensation without merit. It also includes such practices as putting friends and relatives on the payroll at inflated costs or making corporate contracts at a price above real market value because of personal interest. In the most abrasive form, management sells corporate assets (or the entire corporation) to itself or "others," where management has an interest at a significant discount. In effect, any managerial "decision" that unethically takes from the rightful owners (stockholders) is stealing. Such activities are common and easily identified, but, since they fall into the classification of "business judgment," they are beyond statutory prosecution.
The point: There are very nice people and very nasty people involved in both the structure of securities trading and in the corporations represented by that trading.
As we will discuss in Chap. 2, there are methods to significantly reduce the chance of becoming victimized by scoundrels, but the reality of the market must include clear, ongoing recognition that the environment involves some unsavory characters. To repeat, it is not a team sport.
Setting thievery aside for the moment, can concentrate on whether corporate earnings should be retained to fund future growth or distributed to stockholders via dividends.
The generally "taught" academic approach is that the corporation (extrapolated to read "stockholders") is most benefited by applying earnings to future growth; consequently, a low dividend policy expands futurepotential.
From the perspective of professional investing, however, an exceptionally low (or inconsistent) dividend policy is a weak point. There is a real correlation between the degree of potential price decline and the dividend when the stock price descends to the point where the dividend payment is offering an exceptionally high yield in relation to the market price of the stock. In other words, people will buy the stock simply because of the dividend. This buying can help support the market price of the stock and minimize risk. It should be noted that, although the dividend yield may help soften the decline of a stock, there is no significant evidence that a high dividend in itself will help the price of a stock to advance.
We have found the three basic stockholder rights to be shallow at best, with only the right to earnings providing a general benefit. Even this right, stolen or not, provides no guarantee that the market price will appreciate.
As an investor, your primary concern is optimal utilization of common stock in your own capital growth. In this context, stockholder rights in themselves do not warrant any emotional attachment. The advantage of the stock market is liquidity. That is, you can easily move in and out of the stock market as well as within the market. By being long (buying) in anticipation of rising prices, or by going short (selling) in anticipation of lower prices you can benefit either way, as long as you correctly anticipate the direction, with very low transaction costs. It is a function of easy maneuverability to whatever area is providing the most opportunity at any given time.
To identify yourself with an individual stock issue is effectively to identify with the "rights." The rights are often illusion and in any form do not guarantee success. Emotional attachment to the rights only encourages relatively poor performance because it does not allow either objective reasoning or full utilization of the liquidity factor.
Face it. As a holder of common stock from a professional trading perspective, you are involved for the price ride. And, like it or not, to maximize profit, the ride has to be for a limited duration. No matter what the stock, the time will come to get out of the market entirely or obtain a position in another stock for another ride. To function as a professional, you must accept in fact that stock is a piece of paper to be utilized as a medium of exchange in acquiring the monies of others.
