Rule #1 Finance Blog

With Investor Phil Town

DON’T FORGET THE “MEANING” PART OF 4M

A nice guy named Tim is taking the Success investor education class. He emailed me to ask me about the following. Some of the info I’m using for the analysis is time sensitive, so I’m going to post this as/is and not worry about linking to the numbers online. Everyone should know where to find them on MSN Money and Yahoo Finance by now.

The important thing to look out for here is Meaning. Make sure you understand the business: what it does and what its moat is. Good numbers at a glance aren’t enough.

Hi Phil,

I’ve found a couple of stocks that pass both Phrase 1 and 2 and whose current price is about half of the Target price – OIS and XXIA. Plus both of these stocks had 3 greens as Friday. So, I’m planning to buy both.

My response:

Before you leap, let’s ask a few Rule #1 questions remembering that we are business owners, not speculators:

1). What is the moat for this business? Brand? Secrets?…. I’m not sure I see a moat. Are they number one in their business? It does have nice Big Five numbers: ROIC is 11%. Sales and EPS growing off the chart. Equity growth rate of 15%. Cash bumpy.

2) Who runs this thing? Do you know anything about them? Are they into this for the quick hit?

3) MOS: Choosing the growth rate for a business is critical. It should be obvious. In this case it isn’t at all. They haven’t been public all that long and their EPS and sales are massively outpacing their equity growth rate. If I had to pick a number, it wouldn’t be the 31% estimate put up by one analyst. For all I know he’s owned by them. I’d go with the equity growth rate of 15%. That’s the growth of surplus and that is what they are using to build value for the owner.

And the PE multiple you use is also critical. Note that the historical PE is only 11. For a business with an estimated EPS growth rate of 31%, that is one low PE. Remember that we like to double the growth rate to get a default PE. Something’s up with this thing.

Today’s PE of 21 is the highest it’s ever been. The range is 6 to 17 historically. If we go double the growth rate our default PE is 30, way past reality. Historical is 11. Red flag because with that disparity in PE the market is saying bs to the long term growth numbers. But let’s use 11 and see what happens. I get a Sticker (called Target at Success) of $18 with an MOS of $9. This might have been a solid buy in 2002 but, for me, not now. Not at $33. Missed the boat.

XXIA: These guys measure data communication system performance. Is that an area you know a lot about?

Equity growth is at 18%, EPS at 24% but only because of a big 2004. Analysts put its growth rate at 22% but I’d use 18%. The historical PE is 84 but I’d go with the default of 36. That puts the Sticker at $21 and the MOS at $11. It’s selling for $17. Just out of range for a buy. Maybe if it goes down a bit and if you understand the biz and if you love the management… then when you get three greens you are buying something you understand and is at a wonderful price.

Might be worth watching, but watch out for the volume. This is pretty thin. 200,000 shares a day. Be sure, if you buy it, to limit the amount you put in to no more than about 1% of the day’s volume: In this case, that means 2000 shares – about $40,000 at today’s price. Otherwise YOU are going to be the arrows, my friend, and you don’t want that, trust me.

Tell me what you think.