HOW TO KNOW IF AN ADVISOR IS SMART

If you've ever gotten a mail or email like this one, it's nice to know how to evaluate not only the stock they are touting, but also the investing wisdom of the touter:

XYZ Profit Picks: XXXX Is A Winner!

"Energy is going to keep rising and we have found the perfect company for our readers. This company is on the move and making money. This company can very easily go over $X.XX fast, so get in early and enjoy another great pick. Good luck and we are glad to bring you great success with our picks."

This is from an unsolicited email I got today.  But most of your financial advisors are doing something more or less similar.  So how do you know if they have a clue?

Here's how you can tell if they've got their head screwed on straight: First thing is to check two of the Big Five - ROIC and Equity growth rate - for the recommended business.  Those two numbers will disqualify 99% of all of these recommendations and recommenders. 

If those are okay, get a quick and dirty Rule of 72 growth rate off the equity numbers.  If they are recommending overvalued businesses, you can tell them to take a hike.

If you haven't been through the Rule of 72 before, here's how: 

1. Just take the oldest equity (or book value per share) number and see how many doubles of that number you can do before you exceed the latest (most recent) number. 


2. Let's say you have ten years of equity numbers and you can double the oldest number three times.  


3. Divide the number of doubles into the number of years minus one (so if you are looking at 10 years, divide 3 into 9).  That gives you the number of years for one double.


4. Divide that number, in this case 3, into 72. You get 24. That's 24% growth rate for equity.


5. Now check the analysts' estimated growth rate and see if it's higher or lower than what you got.  If it's lower use their number.  If it's higher use the equity growth rate you figured out. Always use the lower equity growth rate number.


6. Now get the current earnings per share and grow that at, in this case, 24% for the next  ten years.  In this case that will give us 3 doubles.  If the EPS is $1, the future EPS is $8 (3 doubles is 1 to 2, 2 to 4, 4 to 8).


7. Now get the historical PE and use whichever is less - the historical PE or 2x your  growth rate.  In this case if the historical PE is less than 48 (2 x 24, which is our growth rate) I'll use that.  Let's say it's 30. 30 x 8 (future EPS) is $240.... the future stock price.


8. Divide future stock price ($240) by 4 and you get the Sticker or current value of the business if all goes well.  In this case, $60.


9. That means our margin of safety (MOS) is $30 - half of the Sticker.

This process takes me a few minutes on MSN Money and about 40 seconds on Investools, where a lot of it is automated.

If the ROIC and Equity growth rates are high enough, consistent and holding or growing, and if the stock price is less than the MOS price, I'm (a) impressed at the recommender and (b) interested enought to dig deeper and start looking at the Moat, the Meaning, the Management, all of which take time that I don't want to spend if these people are recommending either unpredictable or overvalued businesses for me to buy.

This is a very quick way to get a reading on the intelligence of the people who are doing the recommending.  The only problem is that after you do this a few times you'll realize that most of the brokers, TV pundits and junk mail soliciters are totally clueless. 

They have about as much business recommending businesses to buy as you or I would have recommending which lottery number is going to come up this week.  That means that you are on your own.  Scary thought.  But better to know what's really going on than to live in a fiscal fantasy and wake up in a financial nightmare, don't you think?

If, on the other hand, you are getting recommendations that turn out to be wonderful businesses at attractive prices, hey, tell me who these guys are, too!

Now go play.

Comments

[Oscar]

"But better to know what's really going on than to live in a fiscal fantasy and wake up in a financial nightmare, don't you think?"

I like the way you put that. It is very clever.

[ray]

Phil,
you said in point 9:

"Divide future stock price ($240) by 4 and you get the Sticker or current value of the business if all goes well. In this case, $60."

I would like to know why "divide by 4", how did the "4" come about ?

thanks for the excellent article.

raytoei
by the way, i have a small position in IED since early last year.

[Jessie Ramsey]

Can anyone tell me how to set up the tools on investools? I want to set the MacD for 8-17-9, stochastic for 14 and 5 and the moving average for 30 days. Thank you!

[Eddie Herring]

Jessie - If you go to the graph view on investools of a stock symbol, on the right hand side of the screen are the fundamental scores. At the top of the fundamentals there are two tabs, one says fundamentals and the other says chart view. Click on chart view and it will give you the area you can then make changes to for MacD, stochastic, etc. If you want to save that view you can then click down at the bottom of the graph where it shows chart style (right below the time frame) and name it. That will then allow you to switch between different views. Hope this helps.

Eddie