“The line between gambling and investing is artificial and thin”
Michael Lewis (The Big Short, 2011)
Situation: This month’s blog is about buying and selling “growth” stocks. Some of the best ones don’t pay a dividend, and most of the rest have a dividend yield lower than the S&P 500’s. Stocks yielding more than the S&P 500, and stocks issued by companies that increase their dividend every year, are “value” stocks, as long as those shares are priced much higher than the Book Value per share. Most retirement portfolios have several such “value” stocks (see Month 119).
To analyze “growth” stocks, we’ll have set aside that idea of picking a stock that reliably pays a “good and growing dividend” and instead pick a stock that is likely to have a high rate of earnings growth over the next 3-5 years. In his 1969 book, Mario Farina (A beginner’s guide to successful investing) explained that growth stocks often have a high P/E ratio because their earnings are expected to grow rapidly. Peter Lynch, in his 1989 book (One up on Wall Street) put a fine point on this idea when he wrote that “The P/E ratio of any company that’s fairly priced will equal its growth rate”. We’ll need to have an estimate of Forward P/E, then divide that by the Forward rate of growth in Earnings Per Share (EPS). Usually that “PEG ratio” will be greater than Peter Lynch’s ideal of 1, but basically he was correct. The idea of examining a company closely enough to arrive at that number has finally become accepted. Yahoo Finance will show you the 3-5 year expected PEG ratio for any public company by clicking on the Statistics link at the top of the company’s entry.
Mission: Screen the list of companies in IWY (the iShares Russell Top 200 Growth ETF for highest quality companies, namely S&P 100 companies that have a) S&P Bond Ratings of A- or higher, b) S&P Stock Ratings of B+/M or higher, c) a 20-year history of the stock being publicly traded on a US exchange, d) a positive Book Value for the most recent quarter (mrq), and e) positive EPS for the Trailing Twelve Months (TTM). Analyze those companies by using our Standard Spreadsheet.
Execution: see the 5 S&P 100 companies in the Table.
Administration: As DIY (Do It Yourself) investors, we need to know where investing stops and gambling begins. Growth companies are usually overpriced by the standards of this blog, which means that the typical price is more than 2.5 times the rational price (Graham Number) and is also more than 30 times the 7-yr P/E (see Columns AI and AK in the Table). You’ll note that 3 of the 5 stocks in this month’s Table are overpriced (see Column AN in the Table). And, at the bottom of this page, you’ll note that I own shares in all three (NKE, UNH, JNJ).
Bottom Line: These 5 companies score well on metrics that Warren Buffett holds in high regard, such as Returns on Net Tangible Capital Employed (see Column U in the Table). To calculate that metric, divide Earnings Before Interest and Taxes (see Income Statement) by Total Assets (see Balance Sheet) that have been reduced by removing Intangible Assets and removing Short-Term Debt and Current Portion of Long-Term Debt (see Liabilities section at bottom of Balance Sheet). In his 2020 Annual Report for Berkshire Hathaway, Mr. Buffett wrote that “we constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.” When evaluating a company that grows earnings rapidly, the only metric that will help you arrive at a “sensible price” is Forward PEG (see Columns O and Q in the Table): All 5 companies have a Forward 1-yr PEG and a Forward 3-5 yr PEG, that is under 2.0.
Risk Rating: 7 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10).
Full Disclosure: I dollar-average into NKE and JNJ, and also own shares in UNH and AMGN. Morningstar considers all 4 of these stocks to be overvalued, rating each a HOLD (see Column AO in the Table).
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