Smashing BI Myths Cy Lynch Classes-To-Go BETTERINVESTING

Smashing BI Myths Cy Lynch Classes-To-Go

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BETTERINVESTING NATIONAL CONVENTION Overview • Myth: Something widely believed, but false (or at least unsupportable) • Just because something’s oft repeated, doesn’t make it so • Hopefully, this session will unsettle you a bit, shake your assumptions and provoke thought

BETTERINVESTING NATIONAL CONVENTION The Big Three • The “Preferred Procedure is “Too Hard” to mess with • The upside/downside (U/D) ratio properly measures risk in buying a stock • Don’t buy a stock whose P/E ratio is more than one to one and onehalf its growth rate (PEG > 1 - 1. 5)

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • The “Preferred Procedure is “Too Hard” to mess with – Not sacrosanct, some truly disagree, but very widely held – Largely a result of misunderstanding what’s going on with all methods of projecting future EPS

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Remember, our ultimate goal is to project potential high EPS figure in five years, not a growth rate • Three broad ways to do this: – Applying a projected EPS rate of increase to historical results (probably most common) – Preferred Procedure (based on projected sales growth) – Use analyst projections

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Preferred Procedure involves four judgments: – Projected years out – Projected years – Projected out – Projected total sales/revenues five pre-tax profit margin in five income tax rate five years shares in five years

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Preferred Procedure involves four judgments • And results in “Expected Income Statement”

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 Four judgments Expected Income Statement 1 2 3 4

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • “Graphical” Expected Income Statement • Same four judgments 1 16, 300. 0 2 3&4

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Some reasons given not to use the Preferred Procedure: – “Too many ‘guesses’ ” • But all methods require projecting sales growth, profitability, taxes and shares (preceding slide) • Would you rather do it “implicitly” (blindly) or “explicitly” (intentionally)

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Some reasons given not to use the Preferred Procedure: – “It results in projected EPS being too ‘low’ ” • Usually caused simply by using “defaults” – projecting current into future • Could be a good reason to use the Preferred Procedure

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 • Other considerations: – Historical sales often more consistent than EPS • Thus growth rate can be easier to project – Where do you start the EPS future trend line? • Last fiscal year (usual method), last fiscal quarter or end of historical trend line? – It’s really not “harder, ” just a little more detailed

BETTERINVESTING NATIONAL CONVENTION BI Myth #1 And realize… The “Preferred Procedure” really was preferred “Usually it is better to estimate EPS five years in the future by applying profit and tax margins to the projected sales five years in the future rather than by drawing an EPS trend line. ” [emphasis added] – George Nicholson, NAIC Investors Manual, 1 st Edition (1984), page 53.

BETTERINVESTING NATIONAL CONVENTION BI Myth #2 • The upside/downside (U/D) ratio properly measures risk in buying a stock – First, volatility isn’t risk – Second, U/D ratio doesn’t take into account dividend payments • Thus, useless in comparing stocks with different dividend yields

BETTERINVESTING NATIONAL CONVENTION BI Myth #2 • The upside/downside (U/D) ratio properly measures risk in buying a stock – Finally, you can’t rationally quantify market irrationality on either high (exuberant) or low (pessimistic) end • Just how well have your projected low prices held up this past year?

BETTERINVESTING NATIONAL CONVENTION BI Myth #2 A • Corollary: – Zoning based on low price as well – Same problem with rationally projecting irrationality – Omission of dividends can impact as well

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 • Don’t buy a stock whose P/E ratio is more than one to one and onehalf its growth rate (PEG > 1 - 1. 5) – Many examples disprove validity of “one-size fits all” rule – The “one-size fits all” rule fails statistically, too

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 • The reality: – P/Es vary by industry (numerator of PEG ratio) – Growth rates vary by industry (denominator of PEG ratio) – Some stocks never sell for PEG < 1. 5 • 3 M (sells for PEG between 1. 9 and 3+) • Procter & Gamble (PEG between 1. 3 and 2. 5) (even higher before Gillette acquisition accelerated EPS growth) • JNJ came close only once in past 10 yrs. • So you would never buy them

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 • The reality: – Stocks with flat or declining EPS for extended periods still have a positive P/E • General Motors (GM) • Ford (F) • Tootsie Roll (TR) • Liberty Property Trust (LRY) • Plum Creek Timber (PCL) • Embarq Corp. (EQ) • Cincinnati Bell (CBB) – P/E should be zero if one-size really fit all

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 Compare Tootsie Roll’s EPS history…

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 … Its P/E history

BETTERINVESTING NATIONAL CONVENTION BI Myth #3 • For one-size fits all rule to be statistically valid: – The trend line would have a slope of 1 – It would intercept the vertical axis at 0 – Shown by dotted green line • But actual trend line (in red) does neither

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