That's been the request of many readers of this
Detox column. Instead of wanting to know about stocks that are likely to fall, a good number of you are crying out for undervalued companies that could rise in price. After all, for the average investor, going long is easier than being short.
Sorry, but for the foreseeable future, the tilt of this column will be bearish. How could it not be? By any measure, this market is still wildly overvalued. The economy is weak, overstimulated and deeply distorted, something the
is exacerbating with its easy money policies.
Even so, in all climates, investors need a systematic way to identify value. Here, we look at a nifty stock-screening method that turns up cheap-looking stocks that deserve a closer look. By no means should its results be taken as an unequivocal signal to buy or sell. It's no short cut for knowing a company's business and financials intimately. And it's for longer-term investors whose time horizon is years from now, not weeks or days.
Detox found this method in a book called
How to Pick Stocks Like Warren Buffett
by Timothy Vick, a senior analyst at
Arbor Capital Management
. Stocks in Vick's portfolio are up nearly 40% over the past 12 months, a result he's achieved through the aid of the following stock screen.
Vick has devised something called the "15% Rule," based on remarks that Buffett has made over the years on how he picks stocks. Here's how it works.
Vick says Buffett requires that his stocks return at least 15% a year. Anything less doesn't compensate the investor for equity risk, taxes and inflation.
Of course, over time, underlying earnings decide whether a stock goes up or not. However, upside can be limited if investors have already bid up a stock on the back of bullish earnings growth assumptions. In other words, growth is only worth buying if it comes at a reasonable price. But how to gauge whether growth is cheap?
Step one is to project what a company will be earning, say, in 10 years. To a certain extent, this can be done by looking at average annual profits growth over a long period that includes at least one business cycle. Split adjusted per-share earnings going back 10 years or more can be found, for a reasonable subscription price, at
to calculate an average growth rate. On a split-adjusted basis, Dell made 2 cents a share in 1991 and 84 cents in 2000. Dividing 84 by 2 equals 42. In a spreadsheet, the formula =((42)^(1/9))-1 can then be used to calculate the average 10-year growth rate. (Remember to use 1/9 instead of 1/10 for a 10-year period, as the number of actual year-on-year changes in a given time span is one less than the number of years.)
For Dell, this formula yields a 51% growth rate. Now, as we know, the '90s were an extraordinary era for tech firms and there's little chance that Dell will be able to post 50% over the next 10 years.
Here's where industry knowledge comes in. There's a remote possibility that Dell could ratchet up 25% growth if it gobbles up one of its big competitors, succeeds in its push into the low-end server market and the economy grows like a weed for 10 years. But 25% would be a monumental achievement for a company in a maturing industry, given that the mighty
has increased earnings annually by 13% since 1985.
So, let's opt for a 15% rate for Dell in this example -- and move on to step two. Next we apply that 15% to work out Dell's earnings in 2010. The formula here is =(72)*(1.15)^9, which shows Dell making $2.53 in 2010 (its 2011 fiscal year).
For step three we decide what investors might pay for those earnings 10 years from now. One way to do that is to take the average
price-to-earnings ratio of the past 10 years, which can be calculated from average annual P/Es published by Value Line. For Dell, this is 27 times. It's probably wise to bring that down to, say, 22 times if earnings are going to slow. As a result, Dell's stock in 2010 could trade at $56, compared with $27.50 Friday.
Here's where the 15% rule comes in. If an investor buys Dell at $27.50 and holds it till it reaches the putative $56 in 2010, would he or she make 15% a year in stock price appreciation? Nope. Applying the first formula used above gives an annual return of only 8%, just over half the required 15% return.
So what to do? If you believe the earnings projections are sound, and not overly conservative, you have only one choice: to wait until Dell stock falls to a price where it'd give a 15% annual return over 10 years. That'd be $16, a long way down.
Alternatively, you can double-check the earnings growth and see where you should buy if Dell returned 20% a year and held on to its average P/E of 27. That would give a target price of exactly $100, or 27 times year-10 earnings of $3.72. From Friday's $27.50, that would yield annual appreciation of 15.4%.
Of course, investors pay more for predictability. Assume that Dell's earnings go up steadily by 20% a year. Investors would be willing to pay as much as 35 times those earnings. In that case, Dell could be trading at $130, giving an annual return of 19%, well in excess of Buffett's magic 15%.
Now, there are some flaws in this model. One of the biggest is that the results depend to a great degree on what the starting year earnings are.
However, it's versatile and can easily be tweaked according to one's feelings on P/Es and growth.
Oh yes, it also shows how little value there is in tech even with the
down so much. Let the bearishness continue!
Detox's Eavis will be celebrating the fact that his native England was separated from America until July 5.
Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to
In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.
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