Ben Graham and the Growth Investor

Presented to Bryant College April 10, 2008

HEWITT HEISERMAN JR. www.EarningsPower.com Hewitt.Heiserman@EarningsPower.com

The Earnings Power Chart and Earnings Power Staircase are property of Hewitt Heiserman Jr. All rights reserved. Copyright 2008

Preface

Why We Have to Be at the Top of Our Game

Which Asset Class Is Better Value Today?

Stocks: S&P 500: 1355 S&P earnings (TTM): $66

Bonds:

10-year Treasury: 3.52%

S&P 500 earnings source is Barrons. Market data as of Apr. 9, 2008

Stocks Better Value Than BondsP/E Basis

Stocks:

Bonds:

21x (1355/$66)

28x (1/3.52)

P/E Misleads If Economy At Inflection Point

Real 10-Year P/E: The Stock-Bond Gap Narrows

S&P 500 Real 10-Year Earnings (avg.) Bond yield (10-year Treasury) P/E

Stocks 1355 $59 23x

Bonds

3.52% 28x

Source: IrrationalExuberancecom, EarningsPower.com

Repetitive Cycles of Enthusiasm and Despair

Will History Repeat?

Peak
Date 6/1901 9/1929 12/1968 10 Yr. P/E 25x 33x 22x S&P 239 383 635

Trough
Date 12/1920 6/1932 7/1982 10 Yr. P/E 5x 6x 7x S&P 74 74 238

Contraction
Years 19.5 3.75 13.6 S&P CAGR -6% -36% -7%

4/10/2008

23x

1355

55-Yr. Avg. 300bps Above Current 3.52% Yield

If 10-Year Reverts, Then Bonds Offer More Value

S&P 500 Real 10-Year Earnings (avg.) Bond Yield (55-year avg.) P/E

Stocks 1355 $59 23x

Bonds

6.44% 16x

As the cost of money rises, corporate earnings and P/E multiples get punished

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We Need to Be at Top of Our Game

If market reverts to generational trough P/Es of 5x7x, expect tremendous loss in wealth or time; either we have i) explicit bear market of 430 today or ii) decade of flattish S&P while earnings catch-up. We do not have benefit of P/E expansion ca. 19821999, when it climbed to 44x from 7x and produced a 13% CAGR. Introduce Earnings Power 1-2-3 Process to help you navigate choppy investment waters

11

Resources:

Prof. Robert Shillers website:

http://www.irrationalexuberance.com/

To view the Real 10-Year PE Data, click here:

One can access an Excel file with the data set (used and described in the book) on stock prices, earnings, dividends and interest rates since 1871, updated.

Section I

The Growth Trap

13

Many Ways to Make Money on Wall Street

Net-net Sum-of-the-parts Risk arbitrage Catalyst Activist Short selling

Technical analysis
Growth

14

Growth Stock: Company with Rising EPS

EPS to $1.42 in 1999 from $0.07 in 1990

15

Benefits of Growth Investing

Defer capital gains taxes, so your principal compounds faster Save money on commissions, bid-ask slippage costs Trade less, which improves investing results No exquisite timing required; you can build a position over many years Asymmetrical risk-reward. Worst-case, investment goes to zero. Best-case, multiply your capital several-fold. $10,000 in Microsoft in 1990 grew to almost $1 million over next ten years.

16

But Beware of the Growth Trap

10-Year Avg. Annual Real Returns for S&P 500, 1926-9/2007 12% 10% 8% 6% 4% 2% 0%
Highest P/E (growth) Lowest P/E (value)

17

Source: Jeremy Grantham, GMO, Oct. 2007

Three (3) Obstacles Confronting Growth Investor

1. Poor earnings quality 2. Competitive advantage wanes 3. Premium to intrinsic value

GAAP income statement has four (4) structural limitations. So just because a company is profitable in the traditional sense of the word does not mean that it has authentic earnings power. Successful companies attract imitators. This is good for consumers, bad for owners. We predict by extrapolation, so growth stocks often get pushed beyond real worth.

18

Section II

Obstacle #1: Poor Earnings Quality

19

The GAAP Income Statement

To create comparability, all companies follow generally accepted accounting principals (GAAP) Roberts Rules of Order for corporate America

When you open an annual report, 10-K or 10-Q and look at financials statements, thats GAAP
Many investors take GAAP at face value; they think EPS is hard number, like

20

height of Fenways Green Monster (37 feet)

But EPS is a Soft Number

GAAP income statement has four (4) structural limitations A dollar of earnings for one companys may not be comparable to a dollar of EPS from another company, or for same company from one year to next

22

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

Investment in fixed capital is ignored, so when capital spending is greater than depreciation the company may be profitable on GAAP basis but short cash. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses the company may be profitable on GAAP basis but short cash. Intangibles like R&D, advertising, employee education are expensed even though the benefits will last more than one accounting period. Stockholders equity is free even though owners have an opportunity cost.

23

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

Investment in fixed capital is ignored, so when capital spending is greater than depreciation the company may be profitable on GAAP basis but short cash. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses the company may be profitable on GAAP basis but short cash. Intangibles like R&D, advertising, employee education are expensed even though the benefits will last more than one accounting period. Stockholders equity is free even though owners have an opportunity cost.

24

Notes on Capital Spending

Fixed capital is buildings, trucks, telephone networks, etc. When a company buys fixed capital, it spends the cash today but for accounting purposes depreciates outlay over assets expected useful life. Depreciation enables companies to match current sales with current expenses, and future sales with future expenses If capex is greater than depreciation, a company makes investment in fixed capital. Investment in fixed capital is a use of cash. This cash outlay has to come from somewhere; e.g. checking account, liquidate other assets, borrowings, or stock sales. Will investment produce higher future sales, cost savings? Beware of capital-intensive companies. The 20% with highest capital spending growth lagged market by 1.5% a year during 1973-1996, while lowest 20% beat market by 1% a year. (Paul Sturm, Smart Money, June 2005)

25

TheStreet.com (TSCM)

Structural Limitation #1: Investment in Fixed Capital

TheStreet.com (TSCM)($mls) Capital spending (real cash they spent in 2007) - Depreciation (a noncash charge in GAAP P&L) = Investment in fixed capital

2007 $5 3 $2

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Expensing Investment in Fixed Capital Usually Reduces GAAP Earnings

TheStreet.com (TSCM)($mls) Net income (inc. $3M of depreciation) - Fixed capital investment = Adjusted net income

GAAP $31 n/a $31

Expense $31 2 $29

28

Sidebar: Are Acquisitions a Capex Equivalent?

TheStreet.com (TSCM)(millions) Net income - Fixed capital investment - 20% of 2007 Acquisition ($30/5 years) = Adjusted net income

GAAP $31 n/a n/a $31

Expense $31 2 6 $23

Acquisitions are 1) a use of cash, 2) a substitute for capital spending, and 3) their payoff is uncertain. Depreciate deals over 5 years.

29

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

Investment in fixed capital is ignored, so when capital spending is greater than depreciation the company may be profitable on GAAP basis but short cash. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses the company may be profitable on GAAP basis but short cash. Intangibles like R&D, advertising, employee education are expensed even though the benefits will last more than one accounting period. Stockholders equity is free even though owners have an opportunity cost.

30

Notes on Working Capital

Working capital assets include receivables, inventory, other current assets (but not cash, marketable securities); working capital liabilities are payables, accrued expenses. Working capital is WCA - WCL While it is good to have more assets than liabilities, when working capital increases from one year to next, this is an investment in working capital Investment in working capital is use of cash that does not appear in GAAP income statement. Still, like fixed capital investment, it has to be financed somehow A profitable company can suffer liquidity squeeze if it cant collect receivables and/or sell inventory in timely manner

31

Crocs (CROX)

Structural Limitation #2: Investment in Working Capital

Crocs Inc. (CROX)($mils) Working capital assets: Receivables Inventory Total WC assets Working capital liabilities: Payables Accrued Expenses Total WC liabilities Net working capital Investment in net working capital

12/31/06 $66 86 $152

12/31/07 $153 248 $401

$44 31 $75
$77

$83 57 $140
$261 $184

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Expensing Investment in Working Capital Usually Reduces GAAP Earnings

Crocs Inc. ($mils) Net income - Investment in working capital = Adjusted net income

2007 $168 184 $(16)

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Sometimes WC is a Source of Cash

Blue Nile (NILE) ($mils) Net income - Investment in working capital = Adjusted net income

2007 $17 (14) $31

A negative investment in working capital is wonderful; its like having a job that pays you today for work you will do in two weeks.

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Structural Limitation #2: Investment in Working Capital

Blue Nile (NILE)($mils) Working capital assets: Receivables Inventory Total WC assets Working capital liabilities: Payables Accrued Expenses Total WC liabilities Net working capital Investment in net working capital

12/31/06 $2 15 $17

12/31/07 $4 21 $25

$67 7 $74
$(57)

$86 10 $96
$(71) $(14)

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GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

Investment in fixed capital is ignored, so when capital spending is greater than depreciation the company may be profitable on GAAP basis but short cash. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses the company may be profitable on GAAP basis but short cash. Intangibles like R&D, advertising, employee education are expensed even though the benefits will last more than one accounting period. Stockholders equity is free even though owners have an opportunity cost.

37

Notes on Intangibles

Intangible growth-producing initiatives are R&D, advertising, and employee education. We call them intangibles because we cant weigh, touch, or measure these assets, in contrast to fixed capital Companies invest in intangibles to boost revenue, charge higher prices (brand value), cut costs, improve productivity, etc. But GAAP says intangibles are expenses, not assets. Thus, GAAP earnings for brain companies are not comparable to brick companies Increased R&D led to both improved operating performance and superior stock returns, per study of 8,300 companies over 50 years. (Source: Journal of Finance, 2004, Vol. 59) When we capitalize intangibles we are not eliminating the cost. Instead, we are deferring it to a later period. This is the matching principle of accrual accounting: align current sales with current expenses, future sales with future expenses

38

Google (GOOG)

Depreciation Intangibles Over Expected Useful Life Usually Increases GAAP Profits

Google (GOOG)($mls) - 2007 Profit before R&D - R&D = Operating income Increase (%)

GAAP $7,204 2,120 $5,084

Depreciate $7,204 1,316 $5,888 16%

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Structural Limitation #3: Intangibles are Expensed

Google (GOOG)($mls) R&D (GAAP) Depreciation period

2005 $599 3

2006 $1,229 3

2007 $2,120 3

Depreciation
Year 1 Year 2 Year 3 Total

$200
$200 132

$410
$410 200 132

$707
$707 410 200 $1,316

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Depreciation period is the useful life of the asset. If you depreciate over three years, then you need three years worth of R&D.

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

Investment in fixed capital is ignored, so when capital spending is greater than depreciation the company may be profitable on GAAP basis but short cash. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses the company may be profitable on GAAP basis but short cash. Intangibles like R&D, advertising, employee education are expensed even though the benefits will last more than one accounting period. Stockholders equity is free even though owners have an opportunity cost.

42

Notes on Stockholders Equity

All companies financed by combination of debt and equity Debt comes from banks, bondholders; equity from owners via retained earnings (GAAP profits minus dividends) Debt an expense but equity is free. Why? Noncash cost; also, different owners have different required rates of return. But GAAP-profitable company may destroy value if you expense owner opportunity costs.

43

Playboy (PLA)

Playboys Stock is No Miss April

Structural Limitation #4: Stockholders Equity

Playboy (PBA)($mls) - 2007

GAAP (equity free)

Expense Equity

Pre-Interest income (EBIT + investments) - Interest - Debt Only ($115) - Interest Debt & Equity ($283 x 7.1%) = Pre-tax profit

$12 5 n/a $7

$12 n/a 20 $(8)

If the accounting treatment for equity is same as debt, then pre-tax profit turns into a pre-tax loss

46

Estimating Playboys Interest Debt & Equity (1/2)

Avg. 2 Years

1 Capital Weighting

2 1x2 AT Cost Wtd. Avg. of capital* Cost of Capital

Debt* Equity Total

$115 168 $283

41% 59% 100%

2.8% 10.0%

1.2% 5.9% 7.1%

*Pretax cost of debt = $5 million/$115 million = 4.3%; after-tax cost = 4.3% x (1-35%) = 2.8%. Cost of equity = 10-year Treasury + 500 bp, or minimum 10%.

47

Estimating Playboys Interest Debt & Equity (2/2)

Playboy (PLA)($mls) Total Capital X Wtd. Avg. Cost of Capital Interest Debt & Equity

2007 $283 7.1% $20

The more equity a firm employs as a percentage of total capital, the less money it makes if you think equity has a cost

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Summary

Structural limitation

As a result

1. Omits investment in Company may be profitable on a GAAP fixed capital basis but run out of cash if capex is much bigger than depreciation 2. Omits investment in Company may be profitable on a GAAP working capital basis but run out of cash if it cant collect on receivables, or if inventory doesnt sell 3. Intangibles are expensed 4. Equity has a cost Penalizes forward-looking companies investing for higher future sales, earnings The more equity a firm employs as % total capital, the less intrinsically profitable it is

49

How Do We Fix These Structural Limitations?

Do we re-build income statement to 1) expense investment in FC, 2) expense investment in WC, 3) depreciate intangibles, and 4) expenses stockholders equity? We could, but then we create other problems; e.g., we penalize companies that are investing in FC, WC. Also, who is arbiter of cost of equity? (Elvis still alive, some think.) No single income statement is cure-all. Instead, lets add the strengths of two alternate P&Ls that have been devised in recent years to our analysisfree cash flow and Economic Value Added

50

Metric Wars: Which Alternate P&L is Best?

Free Cash Flow

Adjustments 1. Expenses investment in fixed capital. 2. Expenses investment in working capital Self-fund? A company does so when it produces more cash from ongoing operations than it consumes.

Economic Value Added

3. Intangibles depreciated over useful life 4. Stockholders equity is an expense Create value? A company does so when it produces a return on capital that is greater than its cost.

Goal

51

Not this Ben Graham

52

This Ben Graham!

53

Benjamin Graham (1894-1976)

Graduated #2 in class from Columbia in 1914 at age 20, then offered teaching jobs in English, mathematics, and philosophy departments Instead, went to Wall Street. Nearly ruined by speculation before devising margin of safety strategy of buying companies selling at twothirds of net working capital after subtracting all liabilities Then made 20% a year for two decades. Taught popular investing class at Columbia 1928-1956 Warren Buffetts teacher, employer, and friend Turned class notes into Security Analysis (1934). The Intelligent Investor published in 1949. Goal to take advantage of Mr. Markets occasional manic personality Helped found CFA program in 1960s Wanted to do something foolish, something creative and something generous every day. Gave presents to employees on his birthday, figuring that he was the lucky one

54

The Intelligent Investor: Grahams Two Types

The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses Pessimistic commercial banker Expenses investment in fixed and working capital because they are uses of cash; also, who knows if investment will pan out

The determining trait of the enterprising...investor is his willingness to devote time and care to the selection of securities more attractive than average Optimistic venture capitalist Intangibles expensed over useful life because they are key driver of higher future sales, earnings; also, equity is an expense because stockholders have opportunity costs

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Source: The Intelligent Investor (Harper & Row, 1973)

In Honor of Graham

Personality

Income statement To learn more

Pessimistic commercial banker Defensive (free cash flow) Cash Flow and Security Analysis, Hackel and Livnat

Optimistic venture capitalist Enterprising (Economic Value Added) The Quest For Value, Stewart

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Case Study: Enron Corp.

Per-share GAAP earnings up 9 of 10 years ending 2000 During the 90s, total return 1,415% vs. 383% for S&P 500 One of Fortunes 10 Stocks to Last the Decade (August 2000) Board of directors rated among U.S.s five best

57

Step 1a of 3: Three Income Statements

Enron Corp. year ending Dec. 31, 2000 (millions except per-share) Income statement Revenue - COGS, SG&A, other - Investment fixed capital (#1) - Investment working capital (#2) - Intangibles (#3) - Interest expense (#4) - Other - Taxes Total expenses Profit (loss)
Source: Company reports, EarningsPower.com

Defensive $100,789 98,836 3,555 1,071 0 838 (1,093) 684 $103,893 $(3,102)

GAAP $100,789 98,836 n/a n/a 0 838 (215) 434 $99,893 $896

Enterprising $100,789 98,836 n/a n/a 72 2,609 (55) 765 $102,228 $(1,439)

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Step 1b of 3: Quality of Profits

59

Step 1c of 3: Earnings Power Chart

60

Enron: A Second Look

2000 was a record year for revenue, net income; total return +89% vs. -9% for S&P 500 But then management declared bankruptcy in December 2001 after admitting 1997-2001 earnings were overstated; biggest U.S. corporate failure to date Stock falls to pennies from high of $85 21,000 employees lose their jobs, pensions Despite GAAP profits, Enron does not possess authentic earnings power according to the Earnings Power Chart

61

Section III

Just Four Types of Companies

62

Lower-Left Box: Enron

63

Upper-Left Box: HealthSouth (HLSH) (down 83% from $30

peak in mid-1998)

64

Lower-Right Box: Krispy Kreme Donuts (KKD) (down

88% from $50 peak in mid-2003)

65

Coal Mine Canary

Defensive: Autozone (92-99) Centennial Technologies (93-97) CML Group (92-97) EDS (00-02) Fine Host (95-96) Gap, The (96-02) Gateway (97-01) Krispy Kreme Donuts (02-04) Lucent Technologies (97-00) Measurement Specialties (98-01) Tyco (3/00-12/01) United Airlines (94-01)

Enterprising: Bethlehem Steel (96-00) Boston Market (93-97) CKE Restaurants (95-97) Crown Cork & Seal (95-00) HealthSouth (96-01) Ikon Office (93-98) Rite-Aid (95-00) Sherwin-Williams (91-00) WorldCom (97-01)

Both: Allou Health & Beauty (98-02) Bombay Company (91-94) Enron (96-00) Polaroid (95-00) Sunbeam (93-98) Warnaco (94-99) Xerox (96-00)

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Source: EarningsPower.com

Upper-Right Box: Wrigley (WWY) (up 41% 1998-2002 vs. 9%

loss for S&P 500)

67

How to Use the Earnings Power Chart

1. 2.

3.

4. 5.

Source new ideas. Long prospects in upper-right box; short candidates in lower-left box. Monitor current portfolio. Which of 4 boxes is company in? Why? Are gains in GAAP confirmed by higher levels of defensive, enterprising profits? If not, why? Is there a tight or loose fit between GAAP and defensive, enterprising profits? What is long-term trend? Competitors. If your companys competitors are weakening, your company may be next. Customers. See #3. Test management candor, realism. Do they say they had good year but company moved in lower-left direction? (See Enron)

68

Tripe from Enrons Last Annual Report:

Enrons performance in 2000 was a success by any measure.Our talented people, global presence, financial strength and massive market knowledge have created our sustainable and unique business. Ken Lay and Jeff Skilling

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Key Points:

The Earnings Power Chart fixes the four (4) structural limitations of the GAAP income statement Regardless of size, industry, or capital structure, all companies are situated in one of Earnings Power Charts four (4) boxes Which box are the companies you own in? Why? The Earnings Power Chart is like looking both ways before you cross the street; it provides a margin of safety. There are companies in the lower-right, lower left, and upper-left boxes that will be great stocks. But life is short and our capital is limited. So unless you have a compelling reason, stick with upper-right box. These twice-blessed companies have the authentic earnings power that Wall Street prizes.

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Source for an Earnings Power Chart Spreadsheet:

http://www.filespace.org/Sand101/IETC1.2.zip

n.b., I did not make this spreadsheet so user beware. Also, do not ask me questions about this SS as I use my own proprietary version.

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Section IV

Hallmark of Profitable Growth: The Earnings Power Staircase

72

Microsoft ca. 1990s: Authentic Earnings Power + Earnings Power Staircase

$10,000 grows to almost $1 million

73

Apollo Group: $10,000 grows to $78,000

74

Apple: $10,000 grows to $106,000

75

Cisco Systems: $10,000 grows to $631,000

76

Chicos FAS: $10,000 grows to $73,000

77

Dell Computer: $10,000 grows to $1.3 million

78

First Cash Financial: $10,000 grows to $86,000

79

Garmin: $10,000 grows to $44,000

80

Google: $10,000 grows to $51,000

81

Paychex: $10,000 grows to $257,000

82

Quality Systems: $10,000 grows to $70,000

83

Not All Great Stocks Are Staircase: $10K to $200K

85

Section V

Best Stock: 1997-2006

86

The winner is: Hansen Natural

$10,000 grows to $2.6 million

88

Authentic Earnings Power + Earnings Power Staircase

89

Section VI

Putting It Altogether: The Earnings Power 1-2-3 Process

90

Three (3) Obstacles Confronting Growth Investor

1. Poor earnings quality 2. Competitive advantage wanes 3. Premium to intrinsic value

GAAP income statement has four (4) structural limitations. So just because a company is profitable in the traditional sense of the word does not mean that it has authentic earnings power. Successful companies attract imitators. This is good for consumers, bad for owners. We predict by extrapolation, so growth stocks often get pushed beyond real worth.

91

Our Case Study: American Eagle (AEO)

Highlights

Mall-based retailer with 926 stores in U.S., Canada Three concepts: American Eagle, aerie, and Martin + Osa HQd in Pittsburgh Founded 1977 Ranked #2 coolest brand among 12-19 year olds We compete on trend but not ahead of trend. Schottenstein family with AEO since 1980; owns $750 million of stock. One of 10 best stocks for decade ending 2006

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Three (3) Obstacles Confronting Growth Investor

1. Poor earnings quality 2. Competitive advantage wanes 3. Premium to intrinsic value

GAAP income statement has four (4) structural limitations. So just because a company is profitable in the traditional sense of the word does not mean that it has authentic earnings power. Successful companies attract imitators. This is good for consumers, bad for owners. We predict by extrapolation, so growth stocks often get pushed beyond real worth.

94

Step 1b of 3: Earnings Power Staircase

95

Step 1c of 3: Earnings Power Staircase

96

Three (3) Obstacles Confronting Growth Investor

1. Poor earnings quality 2. Competitive advantage wanes 3. Premium to intrinsic value

GAAP income statement has four (4) structural limitations. So just because a company is profitable in the traditional sense of the word does not mean that it has authentic earnings power. Successful companies attract imitators. This is good for consumers, bad for owners. We predict by extrapolation, so growth stocks often get pushed beyond real worth.

97

Step 2 of 3: Competitive Advantage

Strategies, skills, knowledge, or resources that differentiate a business from its competitors If a company has a competitive advantage, it probably has authentic earnings power and may even forge an Earnings Power Staircase Warren Buffett says competitive advantage is moat around the castle. Wider the moat, the more protected the castle Use the Quality of Profits and Earnings Power Charts to gain insights into whether company has competitive advantage The more durable the competitive advantage, the longer we can project above-average growth in Step 3, Valuation

98

Morningstars 4 Types of Competitive Advantage

Types 1. Low-cost provider 2. High-switching costs 3. Intangibles (e.g., patents, mindshare, locations, addictive product, management, employees) 4. Network effect

Examples Wal-Mart, Dell (?) Paychex, Microsoft Pfizer, Starbucks, International Speedway, Berkshire Hathaway, Altria (Philip Morris), Best Buy, Disney eBay, Chicago Merc

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Most Competitive Advantages Wane over Time: Who Is Building the 13-Corkscrew Version?

American Eagle Has Mild Competitive Advantage?

Competitive advantage 1. Low-cost provider 2. High-switching costs 3. Intangibles (e.g., patents, mindshare, locations, addictive product, management, employees) 4. Network effect

Examples no no Jay Schottenstein is long-time board chair; and familys interests are aligned with outside stockholders. But not the most durable competitive advantage. no

10 1

If no competitive advantage, keep your forecast period short

Three (3) Obstacles Confronting Growth Investor

1. Poor earnings quality 2. Competitive advantage wanes 3. Premium to intrinsic value

GAAP income statement has four (4) structural limitations. So just because a company is profitable in the traditional sense of the word does not mean that it has authentic earnings power. Successful companies attract imitators. This is good for consumers, bad for owners. We predict by extrapolation, so growth stocks often get pushed beyond real worth.

10 2

Take Analyst Forecasts With a Grain of Salt

There is no persistence in long-term earnings growth beyond chance.growth forecasts are overly optimistic and add little predictive power. (Source: The Level and Persistence of Growth Rates, Louis K.C. Chan, Jason Karceski and Josef Lakonishok) David Dreman: The average error was 44% annually, based on 500,000 quarterly estimates of more than 1,500 companies between 1973-1996. (Source: Contrarian Investment Strategies, Dreman)

10 3

Step 3 of 3: American Eagles Intrinsic Value

Low This Year Earnings Next Year Earnings Earnings Years 3, 4 & 5 Earnings Years 6-10 Earnings Terminal Period Share Count annual growth Intrinsic value (inc. net cash) Weighting -4% 7% 7% 3% 3% -1% $36 40%

Medium -4% 10% 11% 4% 3% -1% $41 35% $40

High -4% 13% 14.3% 5.6% 3% -1% $47 25%

10 4

Wtd. Avg. Intrinsic Value

Valuation: 5 Margins of Safety

1. 2.

3.
4. 5.

Cost of equity (discount rate) is 10% High growth = consensus; Low, Medium growth is 50%, 75% of High Growth in years 6-10 is 50% of years 1-5 Intrinsic value estimate 40% based on Low Growth, 35% on Medium, and just 25% on consensus. Buy when companies sells at 50%-70% of intrinsic value, depending upon quality of earnings and durability of competitive advantage

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American Eagles Price-Intrinsic Value (PIV)

Stock price Intrinsic Value = PIV

$17 $40 43%

Authentic earnings power on sale: At $17, you get $1 of intrinsic value for $0.43.

10 6

American Eagles Expected Return

Expected Return

= ($40 - $17)/$17 = 134%

The lower your price-intrinsic value (PIV), the higher your

expected return (ER)

Portfolio management: Rank all your companies by ER, from high

to low. Does the company you are thinking of buying offer a higher ER than the lowest-ranked company you own? If not, then why buy it?

10 7

Sell Discipline

Earnings quality: Quality of profits permanently deteriorate Loss of competitive advantage Stock climbs to intrinsic value

10 8

Summary

Why Ben Graham and the Growth Investor?

10 9

Whats Your Process?

It al starts with a well-defined process that is executed with a high degree of discipline. There are a lot of smart people in the investment business, but not very many of them are consistently successful. We think the reason is that not many of them have a truly well-defined process and are truly disciplined in executing it.
Source: He Recruits Managers with Passion and Focus For Stocking-Picking Teams, Wall Street Journal, Nov. 7, 2005

Avoid Growth Trap - Use Multiple Margins of Safety

Next Microsoft wont be cheap on a Ben Graham net-net basis. To protect against miscalculation or bad luck, include multiple margins of safety in your well-defined process: 1) seek out authentic earnings power, 2) look for a durable competitive advantage, and 3) buy at a discount to intrinsic value

11 1

Bonus Material for Bryant College:

- Useful Writing Tips

Useful Writing Tips

1. Its vs. its

Its = possession. Example: its dog Its short for it is. example: Its exciting when my stocks double in an afternoon No: U.S. Global Investors went up a lot in 2006. Yes: U.S. Global Investors went up 338% in 2006 No: Its quite/very hot here in Las Vegas. Yes Its 92 degrees in the shade here in Las Vegas No I honestly believe, or I personally think. No: According to data from TowerGroup, more than half of all U.S. investors make fewer than five trades per year. (TMF, 1/30/07) Yes: More than half of all U.S. investors make fewer than five trades per year, according to data from TowerGroup,. Dont send a cover letter explaining how much you admire Warren Buffet. Buffett has 2 ts

2. Show me, dont tell me 3. No quites or verys 4. No adverbs 5. Key info at beginning of sentence, then cite source

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and please!

Its Earnings That Count (McGraw-Hill, 2004)

Challenges conventional wisdom that company has earnings power just because EPS keeps rising Introduces Earnings Power Chart to find conservative growth stocks for long-term capital gains Foreword by John C. Bogle, founder and former CEO of The Vanguard Group Endorsed by Charles W. Mulford, Tom Jacobs, Thornton Oglove, Morningstars Mark Sellers, Robert L. Rodriguez, Arne Alsin, Jim Rogers, John D. Spooner, Kenneth L. Fisher

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Biography

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Hewitt Heiserman Jr. conceived the Earnings Power Chart and the Earnings Power Staircase, which are featured in his book "It's Earnings That Count" (McGraw-Hill, 2004). He also writes a column on earnings power for RealMoney.com. Heiserman graduated from Kenyon College with Distinction in History, and also received the Faculty Award for Distinguished Achievement. Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. Heiserman's work on earnings quality has appeared in TheStreet.com, BusinessWeek, CBS MarketWatch, Business 2.0, Better Investing, The Motley Fool, Complete Growth Investor, Barron's, and the Haverford Trust Company Adviser. Heiserman has spoken to the New York Society of Security Analysis, the Boston Security Analysts Society, Fidelity Management an Research, the Babson Investment Management Association, the American Association of Individual Investors, and Complete Growth Investors on "Ben Graham and the Growth Investor." Heiserman is a finance instructor for GersonLehrman Group. He is a trustee for a land conservation group. To learn more, visit www.EarningsPower.com

Questions?

Hewitt.Heiserman@EarningsPower.com www.EarningsPower.com

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