When Bertrand Russell wrote about how to find happiness, he first commented on what makes us unhappy. In The Conquest of Happiness, he provided us with a checklist of habits to avoid before he addressed what may make us happy. In that spirit, in this article, I will focus on what to avoid when purchasing stocks.
Checklist #1: paying over the fairly valued price of a stock
If a stock is fairly valued - that is, the value you get equals the cost of the stock -then the stock trades at the average earnings multiple and average earnings per share over the past decade. Let’s look at the following three examples: Campbell Soup Company (CPB), Kellogg Company (K) and Williams-Sonoma (WSM). For Campbell, the 10-year average earnings per share was $2.26 and the average multiple over that period ranged from 21 to 16 times the earnings. The fairly valued range is between $47 and $36. Because Campbell trades at about $48 per share, it followed the definition of a fairly valued stock.
Using the same technique, the fairly valued range for Kellogg was $72 to $58, and again, since the stock trades at $68, it trades at the fairly valued range. For Williams, the range was $50 to $30 and the stock now trades at $52.
While purchasing a stock at its fairly valued range can be reasonable, paying a sum greater than what is fairly valued is a mistake. If you pay $126 Cboe Global Markets (CBOE), or $63 for Activision Blizzard (ATVI), you would pay above the fairly valued price range. For Cboe, the average 10-year earnings per share was $1.74 and the earnings multiple ranged between 27 and 19. That means that the fairly-valued price range is $47 to $33. For activision, the fairly-valued price range was $14 to $12. But the stock traded at $126.
Checklist #2: management that dilutes shareholders by issuing stock excessively.
At times, companies issue stock to raise capital, or to compensate management for their time, effort, or recent success. Whatever the reason may be, this habit often repeats itself in the future. And, as with everything else in life, what in moderation may be an acceptable business practice, at the extreme, it is really an addiction.
HEICO Corp (HEI), an aerospace company, had about 98 million outstanding shares at the end of 2007. Compare that with the current outstanding shares of about 325 million. If management had not diluted shareholders, each share would earn much more than the recent $2.04 per share and a position in the company would be worth more than $92. The story is the same for Hercules Technology Growth Capital (HTGC), a capital market company. Hercules had a mere 28 million shares outstanding as of 2007 and a decade after had over 73 million.
Diluting shareholders is not a business necessity. Look at the multinational conglomerate company Berkshire Hathaway Class B shares (BRK.B). Berkshire had 2.318 billion shares outstanding in 2007. As of its most recent filing, outstanding shares were 2.467 billion, an increase of about 6%.
It is even more impressive when a company reduces the amount of shares outstanding over time, effectively increasing the stock holder’s share in the company. Brinker International (EAT), a restaurant company, had about 105 million shares outstanding in 2007. It now had has 51 million shares outstanding.
Checklist #3: businesses that lose money
Because losses often trigger management to seek capital by issuing additional shares and the net worth of the company declines, I try to avoid companies that lose money, even if I miss out on opportunities. Hamilton Thorne (HTL), a provider of advanced laser systems, has great potential and showed positive earnings over the past three years. But, from 2007 to 2012, the company lost earnings. DDR Corp (DDR), a real estate investment trust, holds an impressive portfolio of real estate. But the company reported losses over the past decade, even if you add back deprecation (as expected - management diluted shareholders and increased by 2.5 times the outstanding shares).
But losses do not always deter me. That is, if I can reasonably estimate earnings in the future. Besides, loss in earnings over the past year or two has typically reduced the stock price, resulting in an attractive in price at the first place. I felt that to be case when I purchased Famous Dave's (DAVE) at about $3 this year. Between 2007 and 2014, Famous Dave’s earned an average of $0.54 per share. But in both 2016 and 2015, loss was reported at $0.49 (in 2017, expected loss will be greater than $0.75). But I felt the decline in stock price did not reflect the economic realty over the next few years.
I was planning to go over the entire what-to-avoid checklist, but I am not even close to its end. (It is also a work in progress, as I often add or broaden certain checklist items.)
I covered three checklist items in this article and I plan to write about 12 more checklist items over the next few weeks. If you would like to be notified when I post articles, leave your contact information in the footbar below.