Finding Quality: Getting a 2 nd Opinion (or How To Use the S&P Quality Ranking)

1. Finding Quality:Getting a 2nd Opinion (or How To Use the S&P Quality Ranking) By Kevin Gillogly For Happy Destiny Investment Club July 2005

2. Measuring Managerial Ability “A statement of actual earnings, over a period of years, with a reasonable expectation of that these will be approximated in the future. The record must cover a number of years, first because a continued or repeat performance is always more impressive than a single occurrence, and secondly because the average of a fairly long period will tend to absorb and equalize, the distorting influences of the business cycle.” – Benjamin Graham and David Dodd Security Analysis

3. What is Quality? • As long-term investors, we look for quality growth companies • What does quality looks like? • On the SSG it is consistency of Sales, Pre-Tax Profit (PTP) margins, and EPS • Is it well managed? • On the SSG it is the trends on the graph and in Sec. 2 (Evaluating Management) • Want a 2nd opinion? • Where do you turn?

4. Finding Quality Myriad ways to find quality without doing a SSG. Not one is perfect. All have some limitations. • The Stock Check List • SSG on training wheels • Looks at a sample of the past 7 years • Quick cut; “Wrong” years can lead to misinterpretation • Take Stock software • Shows the Better Investing concepts in 4 clicks • Goes through quality points found on the SSG • Can be conservative; Can miss some good choices

5. Other Forms of Quality Non Better Investing forms: • Kausch Meisheri’s Quick Analysis • Looks at the trends of the past 10 years worth of Value Line (VL) data • Quick cut; but can’t tell if the price is right • Mark Robertson’s 60 Second Equity Analysis • Also uses VL data • A Quality Ranking that can be compared across industries and uses projections in the calculations

6. How Strong Are These Companies? Most of the previous metrics look at sales, EPS and margins. • What about financial stability? • How strong is management? • Can a company survive a financial hit? • Where do we turn? metric n., a system of measurement

7. Looking For Independent^ Quality Ratings* Sources: • Morningstar Stock Investor • Newest on block • Uses “Stewardship” grade & Star Rating • Value Line • Peter Lynch “like hiring your own analyst” • Financial Strength & Earnings Predictability • Standard & Poor’s • Used by founders of Better Investing • Quality Ranking ^ = reputable w/ no brokerage business * = no price component

8. S&P Quality Ranking • Formally known as S&P Earnings and Dividend Ranking • Proprietary measure started in 1956 • Attempts to measure Graham & Dodd’s sustainable earnings power • See quote on page 2 • Measures long-term growth and stability of earnings and dividends. • Focus is on the last 10 years worth of data • Covers over 3,500 US based companies

9. Why Use It? According to back-testing by S&P when compared to lower ranked companies, high quality rankings have: • Less risk; • Lower debt levels, higher profit margins and higher return on equity; • Less likely to engage in accounting manipulations; And • Outperformed the S&P 500 index

10. How To Use It • Simple and quick way to determine if company is worth studying • Screening Shorthand • Simple and quick way to determine if company is worth keeping • Portfolio Management Shorthand • Uses letter grades • 8 in total Remember to do your own research!

11. Where To Find It Two places: • S&P Company Report (aka “tearsheet”) • On-line Premium Service (OPS) • Can drop straight into Toolkit (TK5), Stock Analyst (SA 3.1), and Prospector (NSP 2.6) • Not available in Classic (NCP 2.3) • Can also be used in MS Excel

12. S&P “Tearsheet” For Most Companies

13. S&P “Tearsheet” For Smaller Companies

14. S&P Quality in Stock Analyst

15. S&P Quality in Toolkit 5

16. Translating the Grades * • A+ Highest ( 2%; 81 companies) • A High ( 6%; 204) • A- Above Ave. ( 6%; 233) • B+ Average (16%; 576) • B Below Ave. (19%; 702) • B- Lower (26%; 966) • C Lowest (24%; 872) • D In reorg. ( 1%; 36) • LIQ Liquidation • NR Not Ranked (3670 companies) * Source: OPS 3705 cos. w/ Quality Rank Jun 05

17. Translating into NSP * • A+ Highest 8 • A High 7 • A- Above Ave. 6 • B+ Average 5 • B Below Ave. 4 • B- Lower 3 • C Lowest 2 • D In reorg. 1 • NR Not Ranked 0 * NAIC Stock Prospector

18. S&P Quality as a Cross Check Can Be Found • In screening of Prospector

19. S&P Quality as a Cross Check Can Be Found • In the Portfolio Portion of Stock Analyst

20. Benefit of S&P Quality Rating Combines some key aspects of the SSG • Growth and stability of earnings • Growth and stability of dividends

21. Limitations of S&P Quality Rating Misses key aspects of the SSG • No forecast of future Sales & EPS growth rates • Does not help determine future value Misses key aspects of the SCG • Measuring to its peers • Measuring the better return

22. From Quality to Performance • Top Return to Risk Was Not Found in stocks with the highest ranking, “A+” • Two notches below, “A-”, preformed best. • Price Premium of top ranking • That’s still leaves over 200 companies (with a ranking of A-) to examine that could be potential purchases

23. Quality to Performance S&P Quality Ranking will not help finding undiscovered “gems” of the stock market: • Penalizes companies not paying a dividend • Highest they earn is a “A-” • Also favors companies paying a dividend • Lowest they earn is a “B-” • Penalizes young small companies • Good companies > 10 years may not be ranked • No ranking of foreign companies • Used only on US based companies

24. Final Thoughts S&P Quality Ranking has … • No price component • Therefore no “buy” or “sell” aspect as found in other S&P proprietary measures (STAR & Fair Value/Outlook) • No projected return • As in Sec. 5c of the SSG • Which is our reason for studying stocks • Use as your starting point • First cut • Remember it’s limitations

25. Final Thoughts Use the S&P Quality Ranking … • Like a pilot use your instruments • Several different gauges to tell the same thing • Use in conjunction with other metrics • VL Financial Strength • Quick Analysis • 60 Second Equity Analysis • It is ok to have overlap • Cross-check your work on the SSG • The visual analysis • Evaluating Management

26. What We Learned • The Value of a simple quality metric • How To Eliminate Stocks Before Doing a SSG • How To Monitor Existing Stocks • Another use for OPS • Another Benefit of using NAIC Software

27. Questions?

28. Further Reading • Brain Lewis articles • Sept. 04 Better Investing (BI) • Aug. 04 BITS (expanded article) • ICL list (NAIC Chat room – free to anyone) • August 12 to 23, 2004 • www.standardandpoors.com • Equity Research (near top) • Analytical Methodology (left side)