Smashing BI Myths Cy Lynch Classes-To-Go. BETTERINVESTING NATIONAL CONVENTION Disclaimer The information in this presentation is for educational purposes.

Smashing BI Myths

Cy Lynch

Classes-To-Go

BETTERINVESTING NATIONAL CONVENTION

Disclaimer• The information in this presentation is for educational purposes only and is not

intended to be a recommendation to purchase or sell any of the stocks, mutual funds, or other securities that may be referenced. The securities of companies referenced or featured in the seminar materials are for illustrative purposes only and are not to be considered endorsed or recommended for purchase or sale by BetterInvesting™ National Association of Investors Corporation (“BI”) or the BetterInvesting Volunteer Advisory Board, its volunteer advisory board (“BIVAB”). The views expressed are those of the instructors, commentators, guests and participants, as the case may be, and do not necessarily represent those of BetterInvesting™ or BIVAB. Investors should conduct their own review and analysis of any company of interest before making an investment decision.

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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


The Big Three

• The “Preferred Procedure is “Too The “Preferred Procedure is “Too Hard” to mess withHard” to mess with

• The upside/downside (U/D) ratio The upside/downside (U/D) ratio properly measures risk in buying properly measures risk in buying a stocka stock

• Don’t buy a stock whose P/E ratio Don’t buy a stock whose P/E ratio is more than one to one and one-is more than one to one and one-half its growth rate (PEG > 1 - 1.5)half its growth rate (PEG > 1 - 1.5)


BI Myth #1

• The “Preferred Procedure is “Too The “Preferred Procedure is “Too Hard” to mess withHard” 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


• 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

BI Myth #1


• Preferred Procedure involves four judgments:– Projected total sales/revenues five

years out– Projected pre-tax profit margin in

five years– Projected income tax rate five years

out– Projected shares in five years

BI Myth #1


• Preferred Procedure involves four judgments

• And results in “Expected Income Statement”

BI Myth #1


Four judgments Expected Income Statement

1

2

3

4

BI Myth #1


• “Graphical” Expected Income Statement

• Same four judgments

16,300.0

1

2

3 & 4

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)

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

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

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, 1st Edition (1984), page 53.

BI Myth #1


• The upside/downside (U/D) ratio The upside/downside (U/D) ratio properly measures risk in properly measures risk in buying a stockbuying 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

BI Myth #2


• The upside/downside (U/D) ratio The upside/downside (U/D) ratio properly measures risk in properly measures risk in buying a stockbuying 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?

BI Myth #2


• Corollary:– Zoning based on low price as well– Same problem with rationally

projecting irrationality– Omission of dividends can impact

as well

BI Myth #2A


• Don’t buy a stock whose P/E Don’t buy a stock whose P/E ratio is more than one to one ratio is more than one to one and one-half its growth rate and one-half its growth rate (PEG > 1 - 1.5)(PEG > 1 - 1.5)– Many examples disprove validity of

“one-size fits all” rule– The “one-size fits all” rule fails

statistically, too

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

•3M (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

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

BI Myth #3


Compare Tootsie Roll’s EPS history…

BI Myth #3


… Its P/E history

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

BI Myth #3


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Smashing BI Myths Cy Lynch Classes-To-Go. BETTERINVESTING NATIONAL CONVENTION Disclaimer The information in this presentation is for educational purposes.

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