Fundamental Investing Using the Stock Selection Guide (SSG) by armin fields » Preferred Procedure

Mark Robinson, founder and General Manager of Manifest Investing, recently posted his SSG of Patterson Companies (PRCO) at BI’s First Cut page. Mark used several extraordinary SSG methods: he added two years of estimated annual data, source and details unknown, which extended his projection of growth for the next 7 years out to 2015.

Also, Mark’s projected High EPS shows as $2.05 of the SSGs front page, but mysteriously as $2.50 on the back. The additional estimated data changed the 5 year average and trend of PTPM as well as ROE, and also led to a projected Low Price option, Low PE x Low EPS, that was higher than the current price even after he lowered his projected Low EPS by 40%. All of this is seriously strange and decidedly questionable..

In January, I critiqued Mark’s SSG for Stryker (SYK) and his SSG methods, http://arminfields.wordpress.com/2009/01/31/studying-stryker-syk-and-mulling-over-methods/

Here, Mark has some surprises which I discuss after the following comparative table. Armin-1 uses all of Mark’s judgments except it does not add any estimated annual data. Armin-2 is identical except it uses 10.00% estimated EPS instead of Mark’s 7.00%.

Patterson Companies (PDCO)	Mark Robertson	Armin-1	Armin-2	Take Stock
Date	7-10-09	8-7-09	Same	8-11-09
Source of Historical Data	S&P	Same	Same	Hemscott/ Morning- star
Price	$21.01	$25.00	Same	$21.89
52 week High & Low Price	$33.85 & $15.75	Same & Same	Same & Same	N/A
Last Quarter of Hist Data	Q4 ending 4-30-09	Same	Same	Same
Software Used	TK 5	Same	Same	Online TS

Years of Hist Data	2001-2008	1999 -2008	Same	Same
Years of Esti-mated Data	2009 & 2010 ESTIMATED	NONE	NONE	NONE
Source of Est Data	UNKNOWN	None	Same	Same

Project Growth from	UNKNOWN	Last Q of Hist Data	Same	Last FY of Hist Data
Sales Growth	6.00%	Same	Same	2.90%
EPS Growth	7.00%	Same	10.00%	0.30%
High PE	22.0	Same	Same	25.6
High EPS	$2.50	$2.37	$2.72	$1.66
High Price	$55.00	$52.10	$59.80 (9% > VL)	$42.56
*Value Line Estimated High Price =$40-55 as of 5-29-09 and $35-45 as of 8-28-09***
Low PE	14.0	Same	Same	15.4
Low EPS	$1.75(down from $2.90)	$1.70 (TTM)	Same	$1.69
Low PE x Low EPS	$24.50 (> current price)	$23.80 *(< current price)*	Same	$26.03 (> current price)
Final Low Price	$16.00(“other” option)	Same	Same	$26.03 (> current price)
Upside/Down	6.8	3.0	3.9	Impossible to calculate
Total Return	21.2%	15.8%	19.1%	11.3%

SSG Buy Under	N/A	$25.03	$26.95	$21.28
RV/PRV (no outs)	69.9/67.3	60.5/56.6	Same/55.0	N/A
Quality	N/A	B+	Same	1.1 (un-acceptable)

PTPM – 5 yr ave	11.3% (end est 2010, trend even)	11.7% (end 2008, trend down)	Same	11.2% trend N/A
ROE – 5 yr ave End Equity	17.1% *(end est 2010, trend down)*	17.4% *(end 2008, trend even)*	Same	N/A
ROE – 5 yr ave Start Equity	N/A	19.3% (end 2008, trend up)	Same	19.3% trend N/A
Debt to Equity – 5 yr ave	N/A	30.5% (end 2008, trend up)	Same	N/A

Discussion

- Mark added two years of estimated annual data (2009 and 2010, source and details unknown) to his SSG which meant that 1999 and 2000 were eliminated because our Toolkit software only holds 10 years of data. Then, he eliminated three more years (2001, 2002, and 2003) as outliers to arrive at a 6.00% quasi-historical sales growth rate that he used as his projected sales growth for the next seven years to 2015.

- Projected sales growth is important to Mark because it is the first element of the BI/NAIC Preferred Procedure which he uses “almost exclusively” to determine his projected EPS growth. Sadly, he did not set forth the other elements of his PP (Pre-Tax Profit Margin, Tax Rate, and Shares Outstanding) which, in Mark’s case, all had to be projected for the next seven years. A simple command, Alt-R, could have set forth the PP on the SSG’s front page.

- If this scheme wasn’t convoluted enough, Mark’s High EPS shows as $2.05 on the SSG’s front page, but as $2.50 on the back page. It’s supposed to be the same so this is a serious and major discrepancy, there’s no attempt at any explanation, and Mark’s SSG cannot be replicated, at least not without the secret code.

- Mark’s PP resulted in a 7.00% EPS rate ($2.05 or maybe 2.50 estimated High EPS in 2015). Unlike Mark, I no longer use the Preferred Procedure because it involves too many estimates and too much guesswork even under normal circumstances. See: Pondering the Preferred Procedure, http://arminfields.wordpress.com/2009/03/28/pondering-the-preferred-procedure/

- In his First Call write-up, Mark insists:

“It’s not the EPS growth rate that matters. It’s the 5-year estimate for EPS [AF: in dollars] that forms the core calculation on the SSG.” He adds: “(For those of you who teeter on the precipice of a nervous breakdown over the EPS growth rate, it’d be something on the order of 7% — but get over it, it’s the 5-year EPS value that really matters and I derive that almost exclusively using the preferred procedure.)”

** Overlooking this needless hectoring, Mark’s core calculation is seriously scrambled because it shows as $2.05 on his SSG’s front page and $2.50 on the back (it’s intended to be identical);

** Moreover, at four major websites, long-term EPS estimates are expressed only as a percentage rate (and not in dollars): Reuters, CNNMoney, Zacks, and YahooFinance. Two others show an EPS estimate as a percentage rate and as a dollar amount: S&P and Value Line. No website I know of makes a long-term EPS only in dollars. See: Estimating EPS, http://arminfields.wordpress.com/2009/03/05/estimating-eps/

- Perhaps the biggest disappointment is that Mark never even tried to explain why it was necessary to add ANY estimated data since the norm is to project the next 5 years based on actual data. How did he project our current recession? Which web site did he rely on and for what data? Why two years of estimated data and not one or three years?

- Lastly, the default for the projected Low EPS is no growth at all which, for Mark’s SSG, was $2.80 estimated (entered as 2010 actual). Mark lowered this by 40% to $1.75 but, once again, offered no explnation. With 6% growth for his projected High EPS and -40% for his projected Low EPS, Mark’s growth projections seem flaky and foolish, especially adding two years of estimated annual data.

CONCLUSIONS:

(A) It turns out that every one of Mark’s machinations were unnecessary. Armin-1 duplicates all of his judgments with one exception: it does not add those two years of estimated data. We both got a SSG Buy and satisfied the minimum 3.0 Upside/Downside and the 15% Total Return criteria. Armin-1 would look even better if I used the same $21.00 price as Mark did.

(B) Mark’s 7.00% projected EPS, after his many maneuverings, is not even close to what the analysts were estimating. When I did my SSG, the six long-term EPS estimates I always check averaged 12.70% with Value Line low at 10.00% and Reuters high at 14.40%. Thomson/FirstCall via YahooFinance was 11.75%, Zacks.com was 12.67%, FactSet CallStreet via CNN Money was 13.00%, and Reuters.com was 14.40%.

** Armin-2 used 10.00% estimated EPS, the lowest of the six analysts and also satisfied the SSG Buy criteria.

(C) The substantial variation among these six long-term EPS estimates demonstrates, I think, the wisdom of not using any estimated annual data in our SSGs. Unlike actual data, you can never be certain with any estimate and one website’s estimate is no more accurate than another’s. Moreover, our SSG wants six pieces of info for each year of annual data which are tricky to estimate. Note the different trends on PTPM and ROE that Mark got with his estimated data and that I got with actual data.

(D) Whenever we share our SSGs, at a club meeting or with BI’s First Cut or at another web site, all of us should try to make clear what we did and why, especially when we do something out of the ordinary. For example, Mark added two years of estimated annual data (source and details unexplained), used the Preferred Procedure (unexplained), got a High EPS of $2.05 on the front page and $2.50 on the back (unexplained), lowered his Low EPS from $2.90 to $1.75 (unexplained), and got a Low EPS x Low PE that exceeded the current price (unexplained).

(E) I think Mark’s SSG and his unique methods are unreliable, and neither helped me understand PDCO.

What do you think?

[You can leave a comment below and/or rate this post by using the new, mouse-over star system at the top]

Armin

Pondering the Preferred Procedure

arminfields — Sat, 28 Mar 2009 00:48:11 +0000

The SSG’s Preferred Procedure is one method to estimate future EPS growth for the next 5 years. Cy Lynch, a NAIC/BI and Manifest Infesting guru, has written a series of articles in Better Investing magazine that explain the PP using Oracle Corp as an illustration. Since Oracle has no Preferred Dividends, only four estimates are needed to calculate its PP: Sales Growth, (less) Pre-Tax Profit Margin, (less) Tax Rate, (divided by) Shares Outstanding (equals) Earnings Per Share.

I have long held that the Preferred Procedure involves too many estimates and way too much guesswork. My earlier assessment is at: Considering Kohl’s (KSS) and Reconsidering NAIC’s Preferred Procedure, September 14, 2006. Oracle (ORCL) is yet another illustration that the PP is full of weak speculation.

(1) Final PP Result for Oracle: 11.30% Estimated EPS

Cy’s PP resulted in an estimated 11.30% EPS growth rate which, he says in the 3-09 issue of BI magazine, is reasonable compared to Value Line’s 11.60% estimate and the 13.40% estimate from Yahoo Finance.

(A) VL’s EPS estimate was 17.00% (not 11.60%) and is now 15.00% as of 2-20-09, VL’s latest report on ORCL. By comparison, Cy’s 11.30% EPS estimate is way low.

(B) Cy did not compare his 11.30% against other EPS estimates: 15.00% @ FactSet CallStreet via CNNMoney; 15.00% @ S&P via BI.org; 13.82% @ Zacks.com; and 13.73% @ Reuters.com. Again, Cy’s 11.30% estimate is low by comparison.

Note that these EPS estimates are from six different data sources, not just different websites, and I ALWAYS check all six for every SSG I do. Here’s a link to how I estimate EPS; see: Estimating EPS. Checking only two sources, as Cy did, is not sufficient to learn which are in the ball park and which may be out-of-whack.

(C) My method would be to stop here and use one of the following: the lowest of the six EPS estimates (13.43% currently by Thomson Reuters via YahooFinance), or the average of all six (14.33%), or the average less 1 Standard Deviation (13.65% and easily calculated by Excel).

I think these three choices are reasonably conservative and each of them “wrings-out” what many consider to be analyst over-optimism. If you were still worried, the average less 2 Standard Deviations is 12.97% which I consider a useful benchmark as anything less (like Cy’s 11.3% estimate) seems unreasonably conservative to me.

We need some criteria to tell us what’s too high as well as what’s too low!!

(2) The First PP Element: 12.00% Estimated Sales Growth for ORCL

We can see why Cy got such a low EPS estimate by examining the separate parts of his Preferred Procedure. The first element of Cy’s PP began with a 12.00% estimate of Sales growth for the next 5 years.

(A) Cy used Value Line data for his SSG and found that ORCL’s Sales growth was 9.4% over the past 10 years which, he says, was flat for the first five and increased to 22% over the following four years due to mergers.

(B) Using S&P data from BetterInvesting.org, I see that ORCL’s sales have grown 9.2% over the last 10 years, 16.0% during the last 7, 22.2% during the last 5, and 24.9% over the last 3. Mergers in 2005 and 2006 complicate using ORCL’s recent historical record to project future growth.

One approach might be to use its 16.00% sales growth over the last 7 years which is the same with S&P or VL data. Estimating 16.00% instead of Cy’s 12.00% sales growth, with no other changes in the PP, results in an estimated EPS of 15.40% instead of 11.30%. That difference is no “small potatoes.”

(C) Another approach would be to check what sales growth the analysts were estimating. Cy says his 12.00% sales estimate is supported by Morningstar’s 13.00% estimate and Value Line’s 11.5% estimate.

** However, Cy did not check the only other analyst that makes a Sales estimate for the next 5 years, Zacks.com which was estimating 21.92% on 11-1-08. Three months later, on 3-18-09, its Sales estimate was down slightly to 22.19%.

** Morningstar’s Sales estimate for the next 5 years was way down from 13.00% to 8.00% on 3-18.

** Value Line does not make an explicit estimate of Sales growth and Cy implied VL’s 11.5% from its 8-22-08 dollar estimate which has dropped in VL’s next two quarterly reports to, using Cy’s method, 9.9% and 6.9%.

** So, should the Sales estimate for the next 5 years be 22% (from Zacks), 16% (ORCL’s 7 year history), 12% (by Cy), 11.5% or 9.9% or 6.9% (all implied from VL), or 8% (from Morningstar)? As you might guess, there is no “right” or “preferred” answer and your guess is as good as mine.

(3) The Second PP Element: 40.8% estimated PTPM for ORCL

The second element of the Preferred Procedure is estimating the Pre-Tax Profit Margin (PTPM) for the next 5 years. Cy estimated 40.8% PTPM which was ORCL’s average for the past 5 years based on VL data.

However, S&P data shows a much different PTPM: 36.6% average for the last 5 years and 35.2% for the last 3 years. Hemscott data from StockCentral.com shows 36.2% which is similar to S&P but again much different than VL.

Sooooooo, what is the best PTPM to use: a three year (35.2%) or five year average (36.6%) from S&P data, or 36.2% from Hemscott data, or 40.8% from VL data? Again, your guess is as good as mine as there is no “right” or “preferred” answer.

(4) The Third PP Element: 29.00% estimated Tax Rate for Oracle

Here, Cy estimated 29.00% as ORCL’s Tax Rate for the next 5 years which again was based on VL’s estimate. Cy says this seems reasonable, but does not explain that no other data source makes such an estimate and that we are pretty much stuck with relying on VL.

However, Value Line only makes estimates for 1500 stocks while over 7000 are included in the S&P data files and 7700 in the Hemscott data files. Still another problem with the PP is that, for the thousands of companies not covered by VL, there is no reality check to test the reasonableness of our estimates, no benchmarks to compare against.

(5) The Fourth PP Element: 5,230.8 estimated Shares Outstanding

For the fourth and last component of the Preferred Procedure, Cy makes a big deal of not relying on VL’s estimate of 4500 M shares and instead uses 5230.8 M estimated shares outstanding in the next 5 years. VL’s estimate is for basic shares while Cy’s estimate is for diluted shares which, he says, are what we should use for our SSGs.

Cy first converts VL’s basic shares to diluted and finds that to be unreasonable given ORCL’s share history and stated intent. He appears to suggest that VL doesn’t adequately know or appreciate those factors. Cy then decides to rely on 5230.8 M shares, some 18% more than VL, without telling us how he derived his final estimate.

Conclusions:

- By working through Oracle as an example, I’ve tried to demonstrate how the Preferred Procedure involves too many estimates and too much guesswork;

- The PP’s weakest link is its first component, an estimate of Sales growth for the next 5 years. Start low and you are almost certain to wind up low;

- Instead of making separate estimates of the PP’s four components to derive one EPS estimate, I prefer to more directly check long-term EPS estimates from six different data sources.

** I can determine what is out-of-whack and which are in the ball park.

** I don’t have to wonder about which of several possible Sales estimates to use, or weigh how best to estimate future PTPM and Taxes, or wrestle with converting basic shares to diluted shares, or worry about the differences between VL and S&P data.

- Even if you continue to use the Preferred Procedure, it’s still a good idea to make some comparisons to check the reasonableness of your estimates and, most importantly, your final result.

Armin

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Fundamental Investing Using the Stock Selection Guide (SSG) by armin fields » Preferred Procedure

CONTENTS

Projecting Growth at Patterson (PDCO)

Pondering the Preferred Procedure