introduction to the stock selection guide – part 1

Selecting the Best CompaniesIntroduction to the Stock Selection Guide – Part 1

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SELECTING THE BEST COMPANIESIntroduction to the Stock Selection Guide – Part 1Presented by:Ann Cuneaz, Senior Manager of Education Programs, BetterInvestingKen Kavula, Director, Mid-Michigan Chapter, BetterInvesting


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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 BetterInvestingTM National Association of Investors Corporation (“BI”). 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. Investors should conduct their own review and analysis of any company of interest before making an investment decision.

• Securities discussed may be held by the instructors in their own personal portfolios or in those of their clients. BI presenters and volunteers are held to a strict code of conduct that precludes benefiting financially from educational presentations or public activities via any BetterInvesting programs, events and/or educational sessions in which they participate. Any violation is strictly prohibited and should be reported to the CEO of BetterInvesting or the Director of Chapter Relations.

• This presentation may contain images of websites and products or services not endorsed by BetterInvesting. The presenter is not endorsing or promoting the use of these websites, products or services.

This session is being recorded for future use.

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Agenda• Learn how to identify high quality, growth companies

• Review guidelines to determine if growth is sufficiently strong

• Explore the relationship between sales, earnings and the stock price

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BetterInvesting Principles

Invest regularly

Reinvest all earnings

Invest in quality, growth companies

Diversify

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The Stock Selection Guide: Printed Report Section 1 & Section 2

Organizes fundamental information needed to

determine if a company is a quality growth

company. (Page 1)

(Page 2)

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The Stock Selection Guide: CoreSSG Analyze Growth, Evaluate Management Tabs

Organizes fundamental information needed to determine if a company is a quality growth

company.

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The Stock Selection Guide: Printed Report Sections 3, 4, & 5

Helps to determine a fair price to pay for the

stock.

(Page 2)

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The Stock Selection Guide: CoreSSGAssess Risk and Reward, Determine 5 Year Potential Tabs

Helps to determine a fair price to pay for the stock.

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The Stock Selection GuideOnce we determine that we are looking at a

high-quality, growth company,

then we can determine if the stock is selling for a fair price.

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Quality Growth Companies• HAVE STRONG FUNDAMENTALS

• Consistent sales growth• Consistent earnings growth

• HAVE EXCELLENT MANAGEMENT• Consistent profit margins• Consistent return on equity• Manageable debt

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Evaluating Sales Growth

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Sales (Revenue)• The funds received in exchange for the goods and/or services the company provides are called sales.

• If a company cannot sell its goods or services, earnings will not grow.

• If earnings are not growing, people will not buy the stock.

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Sales (Revenue)Quality growth companies have

a consistent sales line which is generally up and straight.

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Growth Rate

Growth rate is the annual rate of growth.

Fastenal has grown sales at an average annual rate of 8.9% over the past ten years.

8.9%

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Acceptable Growth RateBetterInvesting determines the size of the company by the dollar amount of sales.

Diversifying by Company Size & Growth RateSales Size Acceptable Growth

< $1 billion Small At Least 12%$1 B - $10 B Medium 7% - 12%> $10 billion Large 5% - 7%

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FAST Growth Rate

• Fastenal had sales of $5.3 billion in 2019.• Does a growth rate of 8.9% meet our criteria for a growth company of this size?

8.9%

$5.3B

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Sales The most recent 5 years are generally

the most important.

9.1%

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FAST Growth Rate

Has the growth rate for FAST improved, stayed the same or declined in the past five

years?

8.9%

9.1%

10-year growth rate

5-year growth rate

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Check the Most Recent Quarter

Is the quarterly growth rate as

good as or better than the annual

growth rate?

If quarterly data has been reported since the most recent fiscal year, there will be one, two or three dots depending on the quarter.

2.5%

FAST has reported 3 quarters since the last fiscal year.

Quarterly growth, as compared to the same quarter one year ago

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Which of These Companies Would You Continue Studying?

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2

3 4

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Compare with CompetitorsAlways pick one

of the best companies in

the same industry.

8.9%5.7%

Fastenal (FAST) 8.9% growth

Watsco (WSO) 5.7% growth

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Evaluating Earnings per Share (EPS) Growth

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Earnings

• Earnings come from sales.

• To grow earnings a company must grow sales and control expenses.

• Profits and Income are two commonly used terms for Earnings.

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Earnings per Share (EPS)Quality growth companies have a consistent EPS

line which is generally up and

straight.

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Growth Rate

Growth rate is the annual rate of growth.

Fastenal has grown EPS at an average annual rate of 11.3% over the past ten years.

11.3%

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8.9%

Compare EPS Growth to Sales Growth

Earnings should be growing at least as quickly as sales.

Sales Growth

11.3%Earnings Per Share (EPS) Growth

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EPS Growth Rate

If EPS are growing faster than sales, management likely is doing one or more of:

• Cutting costs• Selling products that generate higher profits or raising prices

• Buying back shares of stock

11.3%

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5 Yr. EPS Growth RateHas the

growth rate for earnings

improved, stayed the same or

declined in the last 5 years?

13.9%

13.9%

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Recent Quarter EPS Growth Rate

• Check the most recent quarter• If EPS growth rate is significantly lower than the annual rate, there may be a problem

2.7%

11.3%

10-year growth rate

Quarterly growth rate (year over year or YOY)

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Buy One of the BestWe want

to buy one of the best

in the industry.

12.6%

Fastenal (FAST)

Watsco (WSO)

11.3%

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Which of These Companies Would You Continue Studying?

Look closely at what has happened in the last few quarters.

1 2

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Stock PriceEvery year has a price bar showing:

• Yearly High and Low Prices

• The Last Bar Also Shows Current Price (red tic)

Price Bars

The longer the bars, the more movement in the price. This movement is called volatility.

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Quality Growth Companies

Sales and EPS lines areUP, STRAIGHT and PARALLEL.

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Quality Growth Companies• Have GREAT fundamentals

• Sales• Earnings

• Have good management that will consistently grow sales and earnings

Earnings follow Sales and Stock Price follows

Earnings!

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Evaluating Management

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Evaluating Management

Management has two jobs1. Make a profit

% of Pre-Tax Profit on Sales

2. Use that profit to grow future sales and earnings% Return on Equity

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Management’s First Job• Make a profit• We use % of Pre-tax Profit on Sales

• Sales and expenses are controlled by management• Taxes are not totally under management control

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Sales – Expenses

Pre-tax Profit– Taxes

Net Earnings (or Profit or Income)

Management’s First Job

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Percentage Pre-Tax Profit on Sales

• Also known as Pre-Tax Profit Margin• Calculation

• Pre-Tax Profit divided by sales• Multiply by 100 to change to percentage

• Helps evaluate how management controls expenses

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% Pre-Tax Profit on Sales• Ideally, this number should

be flat or trending up

• The last five years are generally the most important

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% Pre-tax Profit on Sales (Profit Margin)

Think of this number as the number of cents retained on every dollar from sales prior to

paying taxes.

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Compare to CompetitorsYou want to

pick one of the best in the industry.

Fastenal (FAST)

Watsco (WSO)

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Management’s Second Job• Use profits to grow future sales and earnings.

• Evaluate % return on equity (ROE) to see how well the company reinvests profits back into the company to generate future profits.

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EarningsEarnings used to create new assets

New assets generate more sales

Return on Equity (ROE)

Sales

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Percent Return on Equity (ROE)• Like pre-tax profit margins, ROE should be flat or trending up.

• The best managed companies achieve 20% or better ROE.

• 15% ROE is considered a good average amount.

• Companies with single digit ROE may not be as well-managed as those with higher ROE.

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% Return on Equity

Are earnings reinvested in ways that will grow future sales and earnings?

Fastenal (FAST)

Watsco (WSO)

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Sources of CapitalThere are three ways companies can get money to grow

• Retained profits• Borrow money (creates debt)• Sell new, additional shares of stock

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Borrowing Money to Grow• There is a risk when a company borrows money.• Interest must be paid no matter what is happening in the economy.

• On the other hand, borrowing money is not necessarily a bad thing.• Debt helps to fund immediate growth initiatives.

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% Debt to CapitalAs a general guideline debt should be less than 33% of the total capitalization for most companies.

Fastenal (FAST)

Watsco (WSO)

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Guidelines for Good Management• Pre-Tax Profit Margins should be trending up or be stable, and match or exceed competitors in the same industry.

• Return on Equity should be trending up or be stable. Ideally, values should be in the mid-teens or better.

• Debt levels for most industries should not exceed 33% debt to capitalization.

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Let’s Review

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What We Have Learned• Quality companies have

• Consistent growth in sales and earnings.• Stable or increasing profit margins and ROE.• Manageable levels of debt.

• After you have found a quality growth company, you are ready to determine a fair price to pay for the stock.

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Skill CheckHistorical sales may include which of the following? (select all that apply)

1. Goods sold2. Services rendered3. Retained profits4. Debt

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Skill CheckEarnings per share (EPS) is the amount of money the company earns _____(select one)

1. As a percentage of return on equity.2. Before taxes.3. Before expenses.4. For each share of company stock.

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Skill CheckWhen comparing management results for % pre-tax profit on sales it is ________ to compare companies in different industries.(select one)

1. common2. useful3. impossible4. not advisable

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Additional Resources• Quality Worksheet

• Practice evaluating the quality of companies using the SSG

• Quality Worksheet for FAST is included as an example• SSG Guidelines for Beginners

• See page 1 for a quality checklist

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Introduction to the SSG – Part 2Determining a Fair Price

The next class teaches how to read and interpret a completed Stock Selection Guide (SSG) to determine a stock’s potential return and whether the stock is a Buy, Hold or Sell. The historical relationship between price and earnings, how high and low potential prices are derived and the contribution of dividends to potential return are also discussed.

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Questions and Comments?BetterInvesting Member Services

877-275-6242Email: [email protected]

58www.betterinvesting.org

introduction to the stock selection guide – part 1

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