SSG - Sections 1 & 2

Looking for Quality

Two Purposes of the SSG:

#1 Is This a Quality Company?

#2 Can I Buy it at a Good Price?

Today, we will concentrate on the

Quality Issues – Sections 1 & 2

Let’s Start with the Capital Box:

Percentage of Insider Ownership:

Insider Ownership refers to the officers and directors that own shares in the company.

10%-30% is good, but anymore may create a liquidity problem.

Percentage of Institutional Ownership:

Institutional Ownership refers to mutual funds, 401K plan providers, etc.

NAIC prefers 50% or less because high institutional ownership causes volatility in the price, since they all buy and sell in a “herd”.

And, finding a company with less institutional following is a sign of a possible undiscovered bargain.

Debt as a Percentage of Capital:

A company gets its money from the following:

Debt Proceeds – from Lenders Stock Sales or Issuance – to Shareholders Profits – from Retained earnings

NAIC prefers to see 33% or less coming from the accumulation

of debt.

Debt as a Percentage of Capital:

However…Companies that trade on debt have different rules.

They should be compared to the debt of other companies in their

industry.

Financial Institutions Insurance Companies Utility Companies

Potential Dilution:

Dilution is the reduction in value of shares, due to the issuance of more shares.

If you are going to use Value Line as a source of SSG information, they already report common shares as diluted. Therefore, you can disregard the last item on the Data entry page in the Toolkit.

The Quarterly Sales & EPS Box:

How are the most recent sales and earnings doing?

Are they growing in line with previous years?

Are they growing at the rate we are seeking? 15%?

Are they growing in tandem with each other?

Preparing the Graph:

Sales – expenses = Pre-tax profit Pretax profit – taxes = Net Income Net Income div. by Shares Outstanding = EPS.

Therefore, adjust your historical lines so that sales are on top and earnings are on the bottom.

The Visual Graphs-Applying Judgment:

Start by removing Outliers. These are one-time events that will not reoccur.

Eliminate them by clicking on the year in which they occur.

(IVC)

The Visual Graphs-Applying Judgment:

Also remove the past years of companies whose growth is slowing after years of meteoric increases.

Visualize the trend line for the most recent years and eliminate prior years that don’t fit the trend.

(APPB)

The Perfect Situation:

Comparing the slope of thehistorical pretax profit line withthe slopes of the historicalsales and EPS lines gives youan idea of what has driven pastgrowth in profits. If all threelines have roughly the sameslope, then past EPS growthhas come from growth in sales.

(WAG)

The Relationship between Sales & PTP:

If the sales line is flatter

than the pretax profit line,

then pretax profit margins

have been rising in the

past…

(HDI)

The Relationship between Sales & PTP:

…Conversely, if

the sales line is steeper than

the pretax profit line, then

pretax margins have fallen in

the past. You confirm this by

looking at Line 2A on the

backside of the SSG.

(FNM)

The Relationship between PTP & EPS:

If the pretax profit line is flatterthan the EPS line, then thecompany has likely beenbuying back shares, or the tax rate could be falling, which isless positive than managementcontrolling costs. You wouldinvestigate this further in ValueLine, S&P Reports, Form 10K,etc. (SIAL)

Point Being:

It's important to understand HOW management

has achieved growth in the past and what

the drivers will be for the future. Otherwise, we

run the risk of projecting trends without

understanding the Company.

Estimating Sales & Earnings Growth:

1. Look for consistency in historical numbers

2. Inspect the Historical Graph on the second visual screen

3. Compare with Value Line’s various projections

4. Compare with Section 2A, since profits should parallel sales

5. Don’t expect fast growth to continue indefinitely…allow room for slower growth in your projections

6. Do your due diligence!

Section 2 – More on Quality:

This is the most important judgment you will

make. Why? The worse a company performs,

the better a value it will appear to be.

How do the profit margins look to you? Are they fairly stable over the whole 10 years? How about the last 5 years? Are they substantial compared to the industry?

Section 2 – More on Quality:

• The yellow boxes depict the last 5 years. The figures are added, averaged, and compared to the most recent completed year.

• If the last year is higher than the 5-year average, the trend is considered UP.

• If the last year is lower than the 5-year average, the trend is considered DOWN.

• If it is consistent, the trend is considered EVEN.

Section 2A – A Big Red Flag:

In Section 2A, if the last year's profit margin is below the average, it's a sign that the expenses in the most recent year were higher as a percent of sales than they have been generally in the recent past which is a cause for concern.

--Ellis Traub

Section 2B – Return on Equity:

ROE consists of three components--net margin, asset turnover, and leverage—most of which we cannot pass judgment on. Therefore, we should be asking:

a) Is ROE stable or increasing?b) Is ROE equal to or better than the average ROE for its

industry and segment?

It turns out that profitability is the main driver for ROE in most cases, so ROE (2B) and pre-tax profit (2A) should track.

Finally…!

Do not venture past section 2 of the Toolkit if

you have not already decided to purchase the

stock.

Again…The worse a company performs,

the better a value it will appear to be!

Next Lesson…Value IssuesSections 3, 4 & 5

The End!