Chapter 10:

 

What the NAIC Stock Selection Guide and Report Tells Us

 

 

Visual Analysis:

Ø      The book chose Motorola to use as an example.

Ø      The Capitalization box at the top of page 1 of the Stock Selection Guide and Report requires us to look at the company’s capital structure. (We should be watching for an unusual amount of debt. One main source for getting the information is by getting the annual report of the company.

Ø      Motorola is a large major company that is expected to have a growth rate of 5 to 7 percent. Companies with sales in the billions have more difficulty producing growth at a rate above that than smaller companies.

Ø      Motorola has grown at a rate of about 17%. This company has a growth rate higher than we would hope to find for a small company.

Ø      To sum it up Motorola has the growth of a small company along with the greater strength and stability of a giant company. Motorola more than meets anybody test for rate of sales growth.

Ø      Next we check the earning-per-share growth rate line. The dotted line on the graph shows earning-per-share growth. Motorola exceeded sales growth for the past five years.

Ø      Note: It is always a good idea to check whether the growth rate in earning per share for the last five years has been the same as or better than the rate in earnings per share for the last five years of our study.

Ø      The book states that a compounded growth rate above 15 percent a year is very difficult for a company to maintain. It is usually advisable not to project growth rate at a higher rate.

Ø      With all that said and done the next thing to do is to get a good idea and try to develop a good understanding of the business.

 

Pre-Tax and Equity Margins:

Ø    The pre-tax margin is the amount of profit that a company makes on each dollar of sales before taxes.

Ø    We take a look at Motorola’s earnings. They have followed the same pattern as its pre-tax profit margin. Earnings have been steadily increasing over the years, but are not at a level that seems impossible to sustain. This tell us that management has been controlling costs and increasing margins.

Ø    Note: Investors usually find the greatest opportunity in companies where the percent earned is above 20 percent. That is a very significant indicator of the rate at which shareowner value is increasing.

 

 

 

 

 

Price/Earnings History:

Ø    Section 3,,a record of the price/earnings history of the stock, is very important.

Ø    NAIC’S experience with thousands of investor’s show that the great majority does a very good job of identifying high-growth companies. The most frequent error they make is paying too high a price for the stock.

Ø    Note: The first thing the investor should ask when studying a P/E is where are we now in the long-term stock market cycle.

Ø    No one ever knows what the market will do, but a good case can be made at this time that we are in a period of market enthusiasm in which average P/E ratios of 15 to 21 may prevail for some time. A number of thoughtful analysts believe that a long-term decline in the market will not occur for a number of years.

Ø    The higher the rate of growth the company has had and the longer it has produced that growth, the higher its P/E is likely to be.

Ø    As we look at the P/E record of Motorola, we conclude that the company’s average high P/E has been well above the market average. This is due because of the high growth rate of sales and earnings produced by the company’s management for at least the past 10 years.

 

Evaluating Risk and Reward:

Ø    There are two estimates of what Motorola will be earning per share five years in the future. One would be obtained by projecting our earnings per share trend line five years into the future at 15 percent, compounded annually.

Ø    Two would be to obtain another estimate using what we call the preferred procedure, which is based on a projection of sales rather than earnings and the application of our estimated tax rates and profits margins.

Ø    Note: Analysts generally believe that sales can be more accurately projected than can earnings per share.

Ø    Based on NAIC investors, when you own a stock with a growth rate as high as Motorola, it is dangerous to sell it.

Ø    Note: You should only consider a sale only if the growth rate comes down and there is no apparent reason to expect it to go back up in the foreseeable future.

Ø    EX. If Motorola’s price suddenly moved up to 225, that would represent a P/E of 70, almost three times its normal high P/E of 25.4. Common sense suggests that price is not likely to be maintained because its so far out of line with earnings.

 

Five-Year Potential:

Ø    Section 5. This section will provide us a further check that the combination of dividend income and appreciation projected for this stock will enable us to achieve our goal of doubling value in the coming five years.

 

Reaching a final decision.

Ø    The final eight questions of the SSG is to help us reach a decision based on the results we have calculated as to whether this company is the kind of investment we are looking for.

 

 

One last word:

Ø    The NAIC SSG focuses on two important areas-management and price. The management tests are sales and earnings per share growth, the percentage of pre-tax profit on sales, and the percent earned on equity. Weighing the record of these investment factors and then adding judgment as to the future potential will give the investor a good feeling for the management of the company.

Ø    Note: The NAIC SSG is not an all-inclusive too, but the factors included in the Guide cover about 80% of what determines the potential of the stock.