Forum Archive Index - June 2000

[Phil Eriksen <phil@acepay.co.nz>]

nick wrote:
> 
>               I have come up with a five rule system for
> picking stocks.  I set out to try and look for a system which would
> find stocks which were undervalued.   Here it is, let me know what
> you think.
> 
> Rule 1  p/e must be less than 10
> Rule 2  eps must be expected to grow in next forecast year
> Rule 3   Gross dividend yield of at least 8%
> Rule 4   must be within 20% of 52 week low compared with high
> Rule 5  Sell when p/e over 12

Interesting post Nick.  I somewhat disagree with points 1, 2, 3 and 5
however.  

Rule 1 for example.  If you had a stock that historically traded at a
p/e of 20 because of a track record of strong growth, and had fallen to
a p/e of 15, it could be a much better buy than a stock trading at a p/e
of 9 with a much weaker business.  While i regard myself as a "value"
investor (although i hate the value/growth debate) I am happy to buy a
stock at a P/E much higher than 10 if I believe this is "value", and
will avoid a P/E of 8 if I believe there is less value.  What counts is
quality of earnings, consistency of earnings, and how well management
deploy retained earnings and new equity.  If management does this very
well, a higher P/E is justified and 15 could be value - especially if
historically the stock traded at, and deserves, 20. 

Rule 2 I have a definite problem with.  Some of the best opportunities
come when you have a company which has a solid track record, and the
long term prospects appear sound, but because of a "glitch" or the
sillyness of the market, the expectations are doom and gloom for the
next year.  If you are a "buy and hold" investor, some of the best
investments will be ones you can buy at rock bottom because of very low
expectations, chuck in a drawer for a year, and then just sit back.

Rule 3 Obviously this rule is designed just for the NZ market, as it
would eliminate most overseas shares.  My only point here - what is
better, Telecom giving out 8% , investing nothing in their business and
eventually having major issues, or Telecom using their mass of cash to
improve their business and give consumers little reason to switch to
competitors.  If cash cannot be deployed at a high rate of return, it
should be paid out.  If it can, a high dividend is lunacy.

Rule 5 My only problem here is by trying to sell at a p/e of over 12 you
are shooting yourself in the foot.  As a "value" investor, you are
missing many opportunities - as you have noted, only 3 investments meet
your criteria.  Therefore, to sell as soon as it goes up a little gives
you a "trader-style" profit.  However, if you are in at a low price, and
the business performs, the "value" investor really needs to stick around
for many years reaping the rewards.  There will generally be a time when
the general market is extremely bullish about a stock or the whole
market - thats when you sell.

My problem with the above criteria is probably best explained with the 3
shares that it selects.  First Force, which while unexciting, does
qualify as a "value" share which I have bought and will buy.  

As for Brierley, the dividend must be in question and using a p/e ratio
on a company dependent on "transactional" profits is always risky.  When
I see Brierley, I see a punt, but I don't see a lot of value - at least
by my definition.

Restaurant Brands, frankly, I wouldn't touch with the biggest bargepole
I could find.  Sure, their earnings per share are expected to grow,
presumably because of Starbucks and the acquisition of Eagle Boys.  But
Eagle Boys were kicking Pizza Hutt's ass - from what I gather,
Restaurant Brands are going to rebrand the Eagle Boys stores as Pizza
Hutt.  I've also heard funny things about what is going to happen to
individual stores.  Bottom line is the reason 50 people bought Eagle
Boys franchises is because they wanted to own their own business - not
because they wanted to work for a large listed firm.  The reason Eagle
Boys did so well is because each store was owned by someone with his
money tied up, who cared about the results.  From what I can gather, its
unlikely many of the franchise owners will stick around (many won't be
wanted anyway) so what are you left with? - 50 stores, with much weaker
branding, run by early 20's people put through a head office management
course who don't really care.  Sounds a lot like Pizza Hutt to me. 

While I may look like a complete dork in a year when Restaurant Brands
announce much better earnings due in part to the Eagle Boys acquisition,
long term, if I bought anything, it would be a Pizza Haven franchise.

Cheers,
Phil

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