We invest in quality companies that grow their earnings based on a sound business model. We buy these stocks when they are priced to provide superior long term returns. While many investors and mutual funds invest in either “growth†or “value†stocks, we look for companies that have both attributes. Growth, quality, and value are interrelated.
A company should have a sound business model that has demonstrated consistent growth in revenue and earnings over the past 3 to 5 years. The company also should have the potential to sustain growth in revenue and earnings into the foreseeable future.
The quality of a company, which usually reflects strong management, manifests itself in several ways, including: (1) consistent historical growth in revenue and earnings, (2) steady or increasing pre-tax profit margins, (3) steady or increasing return on equity that is greater than the industry median and is generally greater than 15%, and (4) a strong balance sheet.
Value Line ratings of B++ or better for Financial Strength and 85 or better for Earnings Predictability correlate well with quality and good management. We also compare each company’s prospects for future growth and net profit margins with other companies in the same industry. The Manifest Investing quality rating combines these four factors into a single 100 point rating.
The total return on a stock for a given period only has three components: Â earnings growth, dividend yield, and changes in P/E.
Superior long term returns can be achieved by buying stocks whose earnings growth, dividend yield, and changes in P/E together will provide a better than market return. Â We use the BetterInvesting stock selection guide (SSG) to compare stocks. Â We estimate the earnings per share (EPS) in five years and then apply a projected P/E ratio to estimate the stock price in five years. Â We then calculate the projected average return.
This approach is similar to the discounted cash flow methodology used by analysts. Â Analysts have to estimate future earnings as well. They try to use all available information. However, a guess to seven significant digits is still a guess. Morningstar uses a discounted cash flow to determine the fair market (or intrinsic) value of a stock. Stocks rated 4 and 5 stars currently sell below their intrinsic value. Â
We use analyst projections for future EPS and EPS growth rates. We compare our estimated five year EPS with estimates by Value Line, Morningstar, and other sources.
It is generally easier to compare stocks in a portfolio, especially within the same industry or sector, using  projected average return from the stock selection guide.  It provides a reasonable method to compare or challenge one stock with another.
We use the BetterInvesting stock selection guide and look for projected average returns greater than 12-15%. We also look for quality stocks that are selling below their intrinsic value. We prefer companies that, if purchased, offer the possibility of price earnings (P/E) ratio expansion. We generally avoid companies with high P/Es. High growth stocks with high P/Es are particularly vulnerable to sudden, large downward price adjustments if the growth outlook for the company slows down.
Portfolio management is as important, perhaps more important, as selecting good stocks. Several general principles guide our portfolio management: