Warren Buffett Winning Stock Picks

As a self made billionaire, famed investor Warren Buffett has had his share of stock pick winners.  His investment holding company Berkshire Hathaway has made many millionaires and if you had bought Berkshire in the sixties, you could have been one too a few times over.  However, not many of us could have had the foresight and that’s why many Buffett fans continually track his portfolio movements.  One can gain insight on what Buffett is thinking and how he discerns winning stock picks from losers.

Buffett’s best stock picks are ones in which he picks up shares of a well managed company which is undervalued.  That might be easier said than done but despite any efficient market theory, as Buffett himself said, if the markets were always efficient, he’d be a bum on the street holding a tin cup.  And in spite of Buffett’s continued modest living arrangements, he’s far from a bum on the street.  So what are Buffet’s stock tips on the way to riches?

As he had preached in the past, the first rule of investing is never to lose money.  This is followed closely by rule number 2 which reinforces the first rule not to lose money.  Judging by the war chest of cash that Berkshire Hathaway holds (40 billion), you can tell that the Oracle of Omaha is careful with what goes in his portfolio.  The moral of this story is that despite excess cash don’t feel that you have to invest in it right away.  Look for the proper investment opportunity.

Another tip for picking winning stocks is to understand the business in which you are investing.  Buffett preaches a concentration in holdings.  While this might be against standard investing methods of diversification, it actually lessens the risk if it motivates the investor to dig deeply into the business he/she wants to invest.

As a final bit of stock advice, Buffett picks stocks for the long term.  Again, using some of his folksy common sense, he sums it up by saying “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely”.

Due to the ease of use of stock trading programs, amateur stock traders are increasing and trying their hand in day trading.  However, due to the in and out trading, it is eating up their principal in fees if they don’t make a profit.

Overall, you can see that Buffet’s investment advice is geared towards long term stock picks: he buys good companies in which he understands and ones in which are undervalued.  Buffet waits long term until they are in favour again by the stock market.

These are the guiding factors of Buffet’s best stock picks which are easy to understand but it takes a disciplined person to follow.

http://warrenbuffettstockpicks.com/warren-buffett-winning-stock-picks/

Growth Stock Picks

Everyone wants to make money in the stock market by buying companies on the cheap but have great growth potential.   But how can you tell the best growth stock picks from the losers?

A lot of people who invest in the stock market will buy a stock because they know the name or saw an ad on television. This is a good way to lose all your money in a fast amount of time. Buying winning stock picks requires a great deal of knowledge and homework. There are some basics you should look for. These include a low P/E ratio, good operating margins, a lot of cash on hand, a small amount or no debt, and possibly insider buying. The lack of insider buying is not a bad thing; it’s just a big positive when you see it taking place on a large scale. Don’t be fooled by small purchases. This means nothing. If anything, they’re trying to portray something that is not taking place. Also, when you see insider selling, if it’s automated, it’s okay. It’s when you see selling by the masses all within a short period of time that you should be worried. But let’s focus on cash vs. debt. These two stats alone can make you bundles of money. The only requirement is that you’re patient and willing to wait for your long term stock picks to reach their target price or even blowing expectations.

Why would you want to buy stock in a company that has a lot of cash and very little or no debt? You might think the answer is obvious, but it’s not. Actually, in the short term, these are often bad purchases. This might sound confusing, but there’s a logical reason. When a company has a lot of cash and little to no debt, they don’t have as much room for improvement. Wall Street likes growth and recovery stories. If everything is going well, there is no room for recovery. And growth must be caught very early. Therefore, there is nothing to get excited about. A company that is paying off debt at a rapid pace is a better buy than one that has no debt. However, if you buy stock in a young company with a lot of cash and little to no debt and you’re willing to wait, you could wake up one morning with an enormous gain. These companies are the most attractive for larger companies to scoop up. If they get bought, you will usually make between 15% and 50% in one day.

Here are three easy steps to finding the best stocks with potential for being bought. 

• One, find out how long they have been in business. If it’s less than five years, they have a better chance of being bought. 
• Two, look at their cash and debt. Make sure there is a lot more cash than debt. No debt at all is ideal. 
• Three, buy and wait. It’s that simple.

http://warrenbuffettstockpicks.com/

Warren Buffett - An Outstanding Allocator of Capital

Warren Buffett

Warren Buffett was born in 1930 in Omaha, Nebraska. 

He took his first degree at the University of Nebraska and then completed a Master's degree in economics at Columbia Business School in 1951. He was supervised and mentored at Columbia by stock-investing guru Benjamin Graham, author ofSecurity Analysis. 

Buffett received the only mark of A+ Benjamin Graham ever awarded in his security analysis class. From this it's clear that Buffett had an extraordinary ability in stock analysis from the very beginning of his career. 

Making Money

Warren Buffett grew obsessed with numbers and money from an unusually early age. It wasn't an obsession founded upon the lifestyle or the wordly goods money could buy. It was a collecters' obsession. Some boys in the 1930s and 1940s collected stamps. Some collected bird's eggs. Warren Buffett collected money. 

He started at the age of five, selling gum and lemonade in the street and he later set up a business, renting pinball machines to local barbers. By his mid-teens, he had made enough money from these earlier efforts and paper rounds to buy land - which he rented to farmers. 

Making More Money 

Investing In Stocks

Warren Buffett bought his first shares at the age of eleven - his father was a stockbroker - and stock trading gave the young Buffett a natural outlet for his twin obsessions with numbers and money. 

After completing his master's degree, Buffett worked as a salesman in his father's brokerage. Between 1954 and 1956 Buffett worked for his old mentor, Benjamin Graham, then returned to Omaha, ready to begin his own investing business. 

Making Even More Money 

Investing Other People's Money In Stocks

Warren Buffett's progress towards almost unimaginable wealth accelerated in 1957 when he pursuaded friends and family to invest $105,000 in his limited partnership. Then he began the process he is famous for, the process of annually compounding the money he manages extraordinary rapidly. 




http://www.warren-buffett.net/

Warren Buffett - My Biggest Mistake

Warren Buffett's Financial Rules to Live By

Warren Buffett - There is Only One Type of Investment Risk

Warren Buffett - Best Hedge Against Inflation

There is no power on earth like unconditional love.

WARREN BUFFETT INTERVIEW: THE BEST LIFE ADVICE I’VE EVER RECEIVED

POSTED BY ALEX CARTER ON FRIDAY, DECEMBER 23RD, 2011 AT 10:00 AM. FILED UNDER WELLNESS.

Billionaire Warren Buffett, widely considered the smartest investor on the planet and known for his modest lifestyle despite astronomical wealth, was recently asked the best advice he ever received. Surprisingly, it wasn’t about money, finances or wealth creation. It was about parenting. Here’s what Buffett said about the best advice he’s ever received:

The power of unconditional love. I mean, there is no power on earth like unconditional love. And I think that if you offered that to your child, I mean you’re 90 percent of the way home. There may be days when you don’t feel like it, it’s not uncritical love, that’s a different animal, but to know you can always come back, that is huge in life. That takes you a long, long way. And I would say that every parent out there that can extend that to their child at an early age, it’s going to make for a better human being. – Warren Buffett

 http://pursuitist.com/wellness/warren-buffett-interview-the-best-life-advice-ive-ever-received/

Speculative-Growth Stocks - Are Net Margins on the Rise?

Although Yahoo is profitable, many speculative growth companies - including most Internet companies - lose money.

Of course, that is to be expected from a new venture.  It's investing heavily to exploit profit opportunities, and if those investments pay off, earnings will materialize.

But to curb risk, we want to find companies that are making progress toward profitability.

Even if a company is losing money, net margins should be improving, even if that means becoming less negative.  

Yahoo shows an encouraging trend in 1999.

• After losing money in its first three years, Yahoo made a profit in 1998, with a net margin close to 5%.  
• Furthermore, it had net margins above 20% in the third and fourth quarters of 1998 and the first quarter of 1999.  
• Net margins declined over the next few quarters because of non-cash charges resulting from mergers, but operating margins (which exclude such charges) remained solid.
• Yahoo appears to have left its money-losing phase behind.

(My comment:  A great company can still be a bad investment if you pay too high a price to own it.)

Speculative-Growth Stocks - What's the Growth Trend?

Rapid sales growth won't do us any good if it can't be sustained.

We want staying power, not sales growth of 50% one year and shrinkage the next.

Even though it has only been around for a few years, Yahoo has been one of the most consistent Internet stocks around, growing steadily without a lot of wild swings from quarter to quarter.  

• The pace of that growth has been steadily declining (from 230% in 1997 to 120% in the first quarter of 2000), but that's to be expected as a company gets bigger and grows from a larger base.  
• Yahoo has demonstrated a lot of staying power, at least by the standards of Internet stocks.

Speculative-Growth Stocks - Is Sales Growth Outpacing Asset Growth?

The speculative-growth market is full of companies that are doubling their sales by doubling their assets.

This is a legitimate way to expand.  Investors pour additional capital into the business, which drums up new sales.

Eventually (we hope), the company reaches a critical mass at which it becomes a big moneymaker.

But to limit risk, we can focus on companies that are making more efficient use of their assets as they expand, generating rising sales on each $1 of capital.

Yahoo has done pretty well on this front.

• Between 1997 and 1998, its sales grew 18%, but its assets grew even faster, at 333%.  
• In 1999, though, Yahoo's sales started to grow faster than its assets, indicating that it's starting to squeeze more growth out of its assets.  
• That tells us that Yahoo is growing quickly, but prudently.

Speculative-Growth Stocks - Introduction

Speculative-growth stocks can inspire dreams of wealth - and nightmares of poverty.

These companies are often new ventures selling something people want, generating rapid revenue growth, but incurring high expenses as they strive to become a permanent fixture of the corporate landscape.

One might be the next Microsoft MSFT.  Or the next Atari.

Their defining characteristics are rapid revenue growth but slower or spotty earnings growth - strong sales, in other words, but a lagging bottom line.

In fact, many speculative growth companies lose money - lots of it.  That's not much inducement to invest.

Still, corporate America's future heavyweights and best investments may lurk in this high-risk, high-reward corner of the market.

It's possible to curb some of the risk, too.

For example, Yahoo YHOO, the World Wide Web portal was one of the hottest Internet stocks of the 1990s.

Buffett: My job is to take advantage of the craziness of Mr. Market; whacking him when he gets way out of line

March 31, 2008

Question: What are your thoughts about the Chinese Stock market?



Buffett:


The Chinese stock market? I don’t know what markets are going to do.  When I was over in China they were bombarding me with questions about the market and of course you have these A shares, including Petro China, which was going public in China.  Petro China and others were trading at twice the price within China (at that time Chinese people were not permitted to buy shares in Hong Kong or in the United States) than outside China.  This was really extraordinary.  If you knew these restrictions were going to break down it would have been great to short the stocks in China and buy them elsewhere around the world.


But the Chinese stock market has 1.2 billion people waking up to the stock markets and having an investing or gambling urge.  The stock market was becoming wildly popular as we know in China.  Petro China at one time, based on the Chinese prices, was the most valuable company in the world, and was selling for over 1 trillion dollars, whereas Exxon was only worth 500 billion.  This made Petro China twice as valuable as the largest company in the world. 


I have no idea why and where that many people were relatively new to the market and were very excited about stocks.  You do know in the end you have to buy things on a basis of when you get a value for what you pay.  This seemed to lose relevance in a market like China.  They had a situation like that in Kuwait 20 years ago.  When a whole society, and a rich society, (certainly far richer than 15 years ago), a huge market opened up for them.  I have no idea whether the people get friendlier or crazier.  That is not my game.


My game is simply to buy something worth a dollar for 50 cents.  Then if they go crazy in the right direction it helps me and if they go crazy in the other direction I  just buy more.  


My job is to take advantage of craziness.  And that goes back to Ben Graham’s Intelligent Investor chapter 8.  If you are going to invest based on value with a partner (lets say Mr. Market) - let’s say you each own half of a McDonalds stand.  Every day he quotes a price at which he either wants to buy me out or sell me his interest.  If he hears a bad rumour he low-balls it, so I buy.  Other days he is all excited about some Burger King burning down and seeing some line ups and decides to give a high offer, so I sell.

If I’m going to have a partner like that what kind of partner do I want?  I want a psycho.  The stupider he gets the better I am going to do.  I don’t want some cool, calm rational partner.  I want somebody with huge ups and downs - a manic depressive.  Basically that’s what you get in the stock market some times.  As long as you realize he is there to serve you, and not to instruct you, you can make a lot of money.  You can’t listen to Mr. Market and think he must be right.  Only listen to what he says in the context of: when this guy gets way out of line I am going to whack him.  And basically that’s what you get in the stock market.

In China you can’t tell how far the markets will go to extremes.  You can’t tell that, I have no idea where the markets are going to go tomorrow or the next day or the next month or the next year.  I do know that in the end stocks tend to sell for what they are worth.  At least in the range of what they are worth.   They go all over the place in between - but tend to true value in the end.




A Discussion of Mr. Warren Buffett with Dr. George Athanassakos and
Ivey MBA and HBA students
Omaha, NB, March 31, 2008, 10:00 am - 12:00 pm

http://www.bengrahaminvesting.ca/Resources/Interviews_Notes/Buffett_March_31_2008.pdf

Only One Warren Buffett: Buffett's investing style is to buy great companies at reasonable prices.

Buffett is often thought of as a pure value investor, buying companies and shares only when they are dirt cheap. He does some of that, and his investments in Goldman and GE last year were an example.

But far and away Buffett's investing style is to buy great companies at reasonable prices. His simple definition of a great company is one which has a sustainable competitive advantage, like a railway, for example.

Price wise, he is not getting Burlington on the cheap. The Financial Times calls Burlinton's valuation "generous", but also says "Buffett is not a man to quibble (on price) when he sees something he likes".

Buffett imitators often try to buy shares in a company because they are cheap. Buffett himself concentrates on buying great businesses. The difference is chalk and cheese, and it's the reason why there's only one Warren Buffett.

http://www.fool.co.uk/news/investing/investing-strategy/2009/11/04/theres-only-one-warren-buffett.aspx

Buffett's Ratio Says Stocks Are Getting Interesting

17 August 2011
The art of cheap.

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."

There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."

He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."

Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.

Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.

^{Source: Dow Jones, St. Louis Fed, author's calculations.}

Understand what this does not mean:

• It does not mean stocks are bound to go up in the short run. No metric can predict that.
• It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.

And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.

But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:

U.S. Stocks as % of GNP	Average Subsequent 2-Year Return
< 60%	21%
60%-80%	24%
80%-100%	13%
> 100%	(4%)

^{Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.}

There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favour. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. 

"The lower things go, the more I buy," Buffett said last week. How about you?

http://www.fool.co.uk/news/investing/2011/08/17/buffetts-ratio-says-stocks-are-getting-interesting.aspx

So which Stock Type do you wish to add to your portfolio?

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

1. Speculative Growth
2. Aggressive Growth
3. Classic Growth
4. Slow Growth
5. High Yield
6. Cyclicals
7. Hard Assets
8. Distressed.

These stock types address the question:   What kind of company is this?









Here is a quick overview of these very different companies.


Speculative Growth:  Yahoo YHOO.  The premier Internet portal has become one of the giants of the online world in 1999, with an audience in the tens of millions.  It has become consistently profitable, unlike most of its online brethren, but its track record is still so short that it is definitely risky.


Aggressive Growth:  Starbucks SBUX.   The coffee chain has grown like gangbusters while also showing a healthy profit, the two most important characteristics of an aggressive growth stock.


Classic Growth:  McDonalds MCD.  the fast-food giant is a stereotypical classic growth stock:  A well-known name with an established track record.  It's growing steadily, but not as fast as speculative growth or aggressive growth companies. 


Slow Growth:  Procter & Gamble PG.  The consumer-products giant is a good example of this type; its growth is slower than that of even classic-growth companies, but it makes up for this lack of growth with high profitability.


High Yield:  Philip Morris MO.  The food and tobacco giant's stock was hammered in 1999, but the company still gives back much of its enormous cash flow to shareholders in the form of a hefty dividend.  


Cyclicals:  United Technologies UTX.  This industrial conglomerate is a great example of a cyclical stock.  Its business - aerospace equipment, air conditioners, and elevators - are highly sensitive to the performance of the general economy.


Hard Assets:  Barrick Gold ABX.  This company is one of the most consistently profitable gold-mining stocks, but it also illustrates many of the charcteristics unique to companies that sell hard assets such as minerals or oil.


Distressed:  Silicon Graphics SGI.  This maker of computer workstations and server systems was once a hot technology stock, but it has suffered through a lot of problems since the mid-1990s and has seen its stock price tank.

Using stock types, help you pinpoint where a company is in the corporate life cycle.

Savvy investors know about the corporate life cycle:

• Companies in their startup phase lose money.
• If they're successful, though, they enter a rapid growth period, where sales - and eventually profits - shoot upward. 
• Then, alas, comes the point when the company has exhausted all of the easy growth opportunities.  The low-hanging fruit has been picked.  The company enters a mature phase in which sales maybe growing, but at a much slower rate than before.
• Finally, in a company's dotage, it's all management can do to grow the company at all.  The company's either in stagnation or outright decline.  

Using stock types, help you pinpoint where a company is in the life cycle.




Let's look at semiconductors.
What is the key difference between chipmakers Intel INTC and National Semiconductor NSM?
Or between Broadcom BRCM and Rambus RMBS?


One of the babies of the industry is Rambus, a company that makes devices to speed up computer processing.  The company's sales have grown rapidly, though inconsistently.  Earnings have been spottier.  Rambus has actually lost money over the past 5 years in aggregate.  It is a great example of a speculative - growth company.

Moving up the maturity scale a notch, we find Broadcom, a company about 10 times the size of tiny Rambus.  The company specializes in chips that enable broadband data communication.  Broadcom's sales have grown  rapidly, and although it has had one money-losing year over the past five years ending in 1999, it's generally increased its earnings in line with sales.  That's the sign of an aggressive-growth company:  one that has managed to increase both sales and profits at a rapid clip.

Now we come to companies like industry leader Intel.  Not too long ago, Intel landed in the aggressive-growth group along with firms like Broadcom, but because of slowing growth, Intel has mellowed into a classic-growth company.  Despite the snags of late, Intel has a record of good sales growth and consistently positive earnings.  That's the mark of a classic-growth firm.  Don't expect them to grow sales by double digits every year, but do expect them to generate solid profits - and maybe even pay out a good dividend.  

Even more mature than Intel is Texas Instruments TXN.  The company was busy restructuring itself in the late 1990s and has been shrinking as a result.  The company's trailing three-year sales growth at the end of 1999 was negative, and earnings have bounced all over the place.  Texas Instruments merits a slow-growth tag because of its rather unspectacular record.

The trials at Texas Instruments, however, are nothing like those at chipmaker National Semiconductor.  The company's sales and cash flows have fallen, and the firm has lost money as a result.  The situation is bad enough to land National Semiconductor in the distressed stock type - the nether-zone in which we place firms with a history of serious operating problems.  These are typically companies that have run into growth problems, either because the market is saturated or because competitors have the upper hand.

Stock Types

Microsoft MSFT and Microtest MTST.  They are both technology companies.  Both have "micro" in their names. But that's where the similarities end.

Microsoft is the most successful company of the 1990s with a market value of $450 billion at the end of 1999.

Microtest is a struggling produce of hand-held scanners, is worth a piddling $30 million.

These are two technology companies, two very different stocks.

Inside any sector - whether it is technology or utilities - you will find companies as different as Microsoft and Microtest.

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

1. Speculative Growth
2. Aggressive Growth
3. Classic Growth
4. Slow Growth
5. High Yield
6. Cyclicals
7. Hard Assets
8. Distressed.

These stock types address the question:   What kind of company is this?

What about Microsoft and Microtest?

• Bill Gates' company lands in our aggressive-growth stock type, the home of the fastest-growing companies.
• Microtest doesn't fare so well.  Because of declining cash flows and negative earnings, it is in the distressed group.  Hawking handheld cable scanners hasn't generated much growth.

Keys to Successful Investing

Know Yourself
Know your investing objectives
Know your time horizon
Know your risk tolerance
Know your financial capacity and reserves

Know your investing philosophy and strategy
Keep it simple and safe (relevant, powerful and focussed)
Never lose money (Rule No 1 and Rule No 2 of Warren Buffett )
Develop and stay with your investing philosophy and strategy (value investing, long term)
Know the difference between investing and speculation/gambling (avoid speculation and gambling)
Avoid market timing (a most dangerous game to play, best avoided)
Selective stock picking (earning power, economic moat, durable competitive advantage, franchise value)
Know your rules for buying (circle of competence, margin of safety, buy quality, great companies at wonderful price)
Know your rules for selling (sell the losers- fundamentals deteriorated permanently or underperformers)
Know your rules for portfolio management (concentrated, defensive and offensive strategies)
Keep good records to guide your investing (an essential to your success in your investing journey)
Reinvest your dividends and dollar cost averaging (take advantage of compounding)

Ongoing activities to invest for the future
Continue to learn and explore.
Continue to master the understanding of all types of businesses
Continue to master valuation of business
Continue to master the understanding of market behaviour and Mr. Market
Continue to master behavioural finance to understand herd and individual behaviour.
Continue to learn, develop, refine and explore investing knowledge, concepts and applications.
Continue to research companies and businesses.
Continue to seek opportunities in good and bad markets.

Invest intelligently by following these three principles of value investing

PRINCIPLES OF OPERATION 

Invest INTELLIGENTLY through adhering to the following three principles of value investing.

First, we think of stocks in the same way that a business person would think of a business.

Second, we do not follow, but instead try to take advantage of the manic depressive Mr. Market.

Third, we always look for a margin of safety.

Mr. Market

MR. MARKET

“Common stocks have one important investment characteristic and one important speculative characteristic. 

Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings. 

However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble”.

- Benjamin Graham

What is Value Investing?

The style of investing developed by Benjamin Graham in the early 1930s, referred to as Value Investing.

read more about Benjamin Graham

   

Benjamin Graham

   

            What is Value Investing?

Value Investing - "An approach to investing best summed up by Benjamin Graham, a veteran American investor, who urged others to seek a 'margin of safety'; the opposite of growth investing. Value investors ferret out the stocks of companies (that is value stocks) which have solid businesses and balance sheets but which, for one reason or another, are out of favour with the market. Such investors aim to buy low and sell high. Their techniques vary. Warren Buffett, one of the most successful investors of all time, values companies on the basis of the present value of their future cash flows. Others look for companies whose price/earnings ratios are below the average for the market as a whole. Most take a long-term view of investment."

   from Essential Finance, by Nigel Gibson, p.305.

When choosing a stock to buy, don't overlook the PEG ratio

The figurative earnings can indicate a bargain

Stocks

Dollars & Sense

April 02, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.COM

Bankers are sticklers for the details. It's their business to invest money in loans to individuals and businesses, and they expect to be repaid, on time and in full -- no excuses.

As stockholders, we should think like bankers. When we buy shares in a company, we're making an investment, and we should be paid back, too. The payback for shareholders is figurative, of course, but consider how much a company would have to earn before its cumulative earnings equal its current stock price. That period is called the PEG payback period, and it's based on the PEG ratio: a firm's price/earnings ratio divided by its expected growth rate. The PEG payback period is the time it would take a company to pay back its investors with earnings.

Take Schlumberger, the oil- and gas-services company. It has a PEG payback period of 15.3 years, so at the company's expected growth rate, Schlumberger would have to add up its earnings per share for 15.3 years straight before those earnings would equal its current stock price. (Morningstar includes each stock's PEG payback period in the "stock valuation" portion of its Quicktake report.)

The PEG payback period is good for gauging whether a company's expected earnings justify its current stock price. A high PEG payback period generally means shareholders are paying for a company with relatively low earnings. Stocks with low PEG payback periods aren't risk-free, but they're cheaper based on expected future earnings.

For this week's analyst picks, we stayed with companies that have PEG payback periods of less than 11 years. One company worth noting is Alltel, the nation's fifth-largest wireless telephone carrier. The Little Rock, Ark.-based company has a PEG payback period of 10.6 years -- a figure that has increased recently with Alltel's stock price.

Alltel's appeal comes from its growing wireless network. The company recently inked a deal to buy wireless assets from Bell Atlantic and GTE, two companies that have been forced by regulators to divest some assets in conjunction with their merger this spring.

The deal will give Alltel customers inexpensive access to Bell Atlantic and GTE's wireless networks so Alltel phones may "roam," or operate on the other companies' infrastructures, at a low cost. Alltel's sales growth has been outpacing the telecommunications-industry average. The company has also posted strong profitability ratios, which earns it B-plus grades from Morningstar for profitability.

Another PEG-payback qualifier is Tyco, the conglomerate that fell out of favor last year due to questions about past accounting practices. Those still-unproven accusations tarnished Tyco's reputation, but with a PEG payback period of 8.1 years and an otherwise solid track record, this company may be worth a look.

http://articles.baltimoresun.com/2000-04-02/business/0004080794_1_payback-periods-peg-ratio-alltel

The Longer the Payback Period, the Greater the Risk

The most useful thing about payback periods is that they give a good (albeit rough) idea of how risky an investment is. 

We may feel fairly confident in our assessment of a company's earnings potential over the next year or so, but that confidence usually diminishes as we peer farther into the future. 

Thus, the longer the payback period, the greater risk we run that we won't get the return we expect. 

That is especially true if the company we're looking at is a young firm without an established market position or is dependent on a rapidly changing technology.

Take Qualcomm QCOM, for example. This digital-wireless-communications powerhouse was the hottest stock on Wall Street in 1999 after appreciating 12-fold in 11 months. Its PEG payback is 12.4 years--not too bad considering its $350-plus stock price. But compare that with Allstate ALL, which watched its stock drop about 30% in 1999. Its PEG payback is 6.6 years. 

Qualcomm may be the sexier company and certainly has had upside for its investors, but sometimes the cheaper stock looks like a better deal.

After all, stocks with longer payback periods aren't just riskier, they also have lower rewards. 

Remember that the payback period is the amount of time it takes to double your money. 

If a stock has a payback period of five years, that means it doubles the amount of the original investment in five years. An investment that doubles in five years has an average rate of return of 15% per annum (on a scientific calculator, take the fifth root of 2, subtract 1, and multiply by 100). 

A payback period of 10 years implies a rate of return of a little more than 7%. At 20 years, the rate is less than 4%. And so on. 

The longer the payback period, the lower the rate of return.

Payback Period = Double Your Money

A payback period is the amount of time it takes for a company to accumulate enough in earnings to equal the amount of your original investment. 

That sounds complicated, but in simple terms, it is the time it would take you to double your money based on the profits a company is generating. 

There are a couple of payback periods to consider, and one of the simplest can be determined by looking at the stock's P/E, or the ratio of its price to its earnings per share. 

P/E is one way you can estimate how many years it would take for the company to accumulate earnings equal to its share price. 

• Imagine a $10 stock with $1 per share in earnings. 
• Based on its P/E of 10 ($10/$1), if the company continues to earn $1 per share every year, it would take 10 years for all those dollars to add up to the original $10 stock price. 
• So a stock with a P/E of 10 has a payback period of 10 years, assuming its earnings are the same each year.

But most companies don't make the same earnings year after year. As an investor, you're hoping the earnings will grow. 

To account for growth, there is something called the PEG payback period, which is based on the price/earnings growth (or PEG) ratio. 

The PEG ratio relates a company's price/earnings ratio (P/E) to its earnings growth. 

It is calculated by dividing a stock's forward P/E, or its P/E based on consensus analyst earnings estimates (what Wall Street analysts expect the company to earn over the next 12 months), by its forecasted earnings-growth rate (the rate at which analysts expect the company to grow).

PEG ratio = forward P/E / expected growth rate

Like P/E, the PEG ratio tells you how many years it will take for earnings to equal the stock price. But unlike P/E, it assumes earnings will grow at a certain rate.

Take our $10 stock with $1 per share in earnings. 

• If analysts' consensus estimates say the company will grow at a rate of 10%, we would increase each year's earnings by 10% before adding it up. 
• Therefore, the first year's earnings would be $1.10 (that's $1 times 1.1), the second year's would be $1.21 ($1.10 times 1.1), and so on. 
• Based on a 10% growth rate, it would take seven years before earnings added up to the original stock price. 

As you can see, the PEG payback period for any growing company will be shorter than the P/E payback period.

PEG and Payback Periods

If you own a home or a car, you are probably all too familiar with what happens when you take out a loan.

• A bank lends you a certain amount of money that you must pay back at a specified rate, such as one payment per month for five to 30 years. 
• In exchange for taking a risk that you won't repay the loan, the bank earns some revenue on top of its investment, based on the interest rate it charges.

 As a shareholder in a company, you're a lot like a bank. 

• When you buy stock, you're in essence lending a company your money so it can buy what it needs for its business and (hopefully) grow. 
• You get paid back as the company's earnings grow and its stock appreciates. 

But whereas a bank clearly establishes its profit margin and a timetable for being repaid, shareholders aren't that lucky. (It's a different story for bondholders, who literally loan the company money and do get scheduled interest payments.) 

It is possible, however, to estimate what you may earn on your investment and when you'll earn it by examining a stock's payback period.