At the end of October, the Moose Pond Investors portfolio had the following weighted averages: projected total return of 21.4%, projected average return (PAR) of 16.1%, upside / downside ratio of 4.6 to 1 and a relative value of 92.2. These are all very good averages. The portfolio has 8% of its assets in cash, part of which we will deploy this month.
Defense and offense alerts.* Several of our stocks have fallen short of the sales growth targets for the trailing twelve months. (See defense report above.) These stocks include Fannie Mae, Affiliated Computer Services and Harley-Davidson. One other stock in the portfolio to watch closely is UTStarcom.
* A defense alert means that a stock’s current sales or earnings growth has fallen below the growth rates that were projected for that stock. We look at changes in growth rates for the both current quarter and the trailing twelve months. In both cases, we compare current sales and earnings with the corresponding period on year earlier. An offense alert means that a stock’s projected average return has fallen below our desired return for that stock.
“Objective tests of managerial ability are few and rather unscientific. … The most convincing proof of capable management lies in a superior comparative record over a period of time….” – Graham and Dodd, Security Analysis
The attached file (933 kb) contains a presentation on Evaluating Company Managment given to the NAIC DC Chapter on October 30, 2004.
Section 2 of the NAIC stock selection guide (SSG) helps to evaluate how management is performing. It shows the key measures of management quality, pre-tax profits margins and return on equity for the past ten years. It also shows the trends for each of these (up, down or constant). The data in Section 2, when compared to the industry peers for a company, provides a good indicator if management effectiveness.
Pretax Profit Margin. Pre-tax profit margin represents how much of each sales dollar a company keeps before taxes. The SSG focuses on pre-tax profit margin rather than net profit margin because tax rates change from time to time. It is easier to compare pre-tax profit margins over a long period of time.
Look for consistency in pretax earnings, e.g., a consistent (flat) or upward trend that is above average for the industry. Be skeptical of above pre-tax profit margins that make a big jump. Consistent pre-tax profit margins might mean that a company has reached peak efficiency or it might mean that management has stopped improving efficiency. Do some additional research. See how the company’s pretax profit margins compare to its competitors.
Pre-tax profit margins can provide an early warning indicator of trouble. A decline in pre-tax profit margins often shows up in the income statement before earnings growth starts to decline. Both NAIC Investor Toolkit and Stock Analyst contain graphs that plot quarterly pre-tax profit margins and trailing twelve month pre-tax profit margins.
Return on Equity (ROE). ROE is a measure of how well a company has used reinvested earnings to generate additional earnings. ROE is a key financial factor in defining the growth potential of the company from internal sources.
ROE can be used to calculate the the “implied” or “sustainable growth rate” of a company. This is the potential earnings growth rate a company can maintain without borrowing. The calculation is simple, Return on Equity x Earnings Retention Rate. It usually better to a an average ROE (such as the 5-year average). The Earnings Retention Rate is how much the retains after taxes (1 – tax rate).