Management, Management, Management, Management

Good management teams are easily spotted in the Wall Street jungle. Well-managed companies maintain the following fundamentals:

1. Excellent sales/share and EPS growth of more than 20 percent over the last three to five years, preferably five years.
2. Independent stock analysts estimate the EPS will grow more than 20 percent annually in the next three to five years.
3. Share price has doubled at least once over the past three to five years.
4. Consistent pre-tax profit margin greater than competitors
5. Consistent Return On Equity ratio (ROE) of 15 percent
6. Insider holdings at least 15 percent
7. Diversified product line

We will discuss each characteristic in detail.

Excellent sales/share and EPS growth of more than 20 percent over the last three to five years, preferably five years.

History tends to repeat itself.

We are what we repeatedly do, excellence, then, is not an act, but a habit.—Aristotle

Invest in teams that have a habit of growing sales/share and EPS (earnings per share). This cannot be overstated enough. We are creatures of habit and winners can be separated from the losers by looking not at empty promises, but on past performance. Look to the past to predict the future.

            Where are we going to find companies with annual sales/share and earnings growth rates of more that 20 percent over the last three to five years? This is not easy for a number of reasons. First, there is no standard method to calculate annual growth rates that span over five years. We can easily estimate the growth rate from one year to the next with the following equation:

If EPS in 1999 was 1.0 (old) and in 2000 it was 1.2 (new), then

If EPS went from 1.2 (old) in 1999 to 1.0 (new) in 2000, then

This equation is widely used to calculate year-to-year or quarter-to-quarter growth of sales/share, and EPS, so there is little variation between sources that report last year’s earnings or sales growth.

Sources tend to vary when they report annual growth rates over several years. If EPS grew predictably, then most sources agree. For example, if the EPS of a company grew at a steady 35 percent annual rate, then the EPS data would have grown in a predictable exponential fashion (start with the number 2 and multiply by 1.35 [35 percent annual growth]). This yields 2.7. Now, multiply 2.7 by 1.35. This results in 3.6. This has been repeated for ten years and the data has been compiled in Table 66. The table also includes an example of nonpredictable exponential growth.

To better understand the trends in the data, analysts plot the data on semi-log graph paper with established growth rates plotted on it, refer to the plot below.

To print out blank 8.5 by 11 inch copies of this graph, please go to www.ayionline.com. Now we plot the data nonpredictable and predictable data on this graph paper (closed circles are unpredictable growth, open circles are predictable growth).

The predictable growth data represented by the open circles maintains a predictable pattern. However, the nonpredictable data represented by the filled circles do not follow a particular pattern. Linear regression was used to draw the lines through the nonpredictable and predictable data. Many people draw the line with a ruler or with their own program, which causes discrepancies between growth rate estimates.

Different line drawing methods will produce different slopes and this will result in different growth estimates. Slope is referred to as the line’s relative steepness. The greater the slope, the steeper the line. For example, the slope of the solid 40 percent growth rate line is greater than 20 percent. To estimate growth rate, the slope of the straight line drawn through the data is compared to the slope of the solid lines that represent various established growth rates (20 to 40 percent). To illustrate this concept, we will estimate the growth rate of the plotted unpredictable data, above graph.

The straight line drawn through the unpredictable data will be used to estimate the growth rate by measuring the distance between line A and B on the left hand y-axis. The distance between lines A and B is measured with a ruler and is represented by the letter X. To estimate the growth rate, measure the distance X above line B2, and draw line A2 on the right hand y-axis with a ruler. Line A2 intersects the right hand y-axis in the middle of two growth rates, 20 percent and 25 percent (circle). One can now estimate the growth rate is approximately 22 to 23 percent.

This rate will vary significantly from analyst to analyst because the straight line they draw through the data will vary with respect to slope (rise over run). What does that mean? That means the line they draw through the data might be steeper (greater estimate) or flatter (lower estimate) than what you have drawn. There are no standard ways to calculate the growth rate over several years.

When growth has been predictable, there is very little difference between analysts estimates of growth. For example, the predictable data has the same slope as the solid 35 percent growth rate line in the above graph.

In the real world few companies report predictable sales/share and EPS data. Therefore, do not accept an analyst’s growth rate estimates for EPS and sales/share. You must calculate the rates yourself using the semi-log graph paper as described above.