Unlocking The EPS Stability Code

Cover Story, by Mark Robertson, Managing Partner


Posted on June 1st, 2006


In\r\nthis issue, we take a closer look a key component of quality and examine what actually happens during bear markets and recessions.

Have you ever wondered how we might identify a group of companies that have been historically less susceptible to corrections? What makes one group of companies more recession proof while another group is badly damaged when economic conditions worsen? What companies achieved the best results during the last bear market? In this issue, we take a closer look a key component of quality and examine what actually happens during bear markets and recessions. Our EPS Stability ranking now includes all companies covered by MANIFEST. Here’s how it’s measured and why it matters.

In this rare footage, a Guardian of the Lair de Ursa can be seen imitating a replica of Leonardo Da Vinci’s Vitruvian Man. Their claws become quills as they scribe Fibonacci numerical sequences into the ice.

F A C T :

The Lair de Ursa is a secret society founded centuries ago for the purpose of enforcing rational capital markets.

This organization counts a number of prominent and powerful people among its members. It’s possible that your friends and neighbors are secretly affliliated with this conspiracy. Inquire about their participation at your own risk. You have been warned.

Grisly and Grizzly Reminders

The Guardians had been busy during the months of April and May 2006. Despite some compelling evidence that expectations for EPS growth were strong, at least for the next couple of years, overall market prices seemed to be — once again — getting frothy. VLMAP, according to the high priests of the Value Line sect, was bobbing near historical lows and this new symbol, MIPAR, was also approaching relatively low values.

Not yet decided as to whether a “correction” would be sufficient to reign in recent stock market irrationality, the Guardians continued their woeful scratching of numerical series in the ice. 1-1-2-3-5-8-13-21…

We know that mathematician Leonardo Fibonacci created this sequence of numbers in the 13th century. Each number is the sum of the previous two. What comes next depends on what has come before. What are Da Vinci, Fibonacci and the Guardians trying to tell us? How common was the name Leonardo?

The Relevance of Trends to Fundamental Analysis

Pardon the digression but if Dan Brown has sold over 40,000,000 copies of The Da Vinci Code, most of you have either read the book or seen the movie by now. We also know that for many of us, investing is more exciting than we’d like from time to time and sometimes resembles a desperate pursuit of a mythical Grail. We know that examination of the larger (long-term) trends in sales, profitabilityand valuation can be most helpful in our efforts to successfully invest over the long term.

Graph #1: Anatomy of a Recession. As the chart shows, overall earnings actually declined during 2001. The 2004 results probably provide some explanation of why 2003 was such a good year. Current expectations are for “fairly normal” levels for 2006 and 2007.

Corrections and bear markets are always a challenge. It’s in our best interest to understand what happens and why during bear markets and recessions. In the accompanying graph #1, take a look at the sequential year-over-year EPS growth for the core Value Line universe of companies.

During a recession, aggregate demand declines or slows, leading to a reduction of sales forecasts for most companies. This often combines with the effect of reducing prices (hammering margins) in order to preserve market share, maintain minimal progress in total sales or to keep the production facilities running at sufficient capacities. The bottom line is when the deep cyclical companies (low EPS Stability) are forced to operate at reduced levels, annual earnings results approach zero and often go negative.

Since the inception of MANIFEST, we’ve relied on EPS Predictability as our measure of consistency. Effective immediately, we’ll be converting to EPS Stability, a measure of the year-over-year variability in EPS growth. There are several reasons for pursuing this modification, including but not limited to:

(1) It eliminates any reliance on a non-transparent rating by Value Line (EPS Predictability) and provides an opportunity for comparison for VL subscribers.

(2) The coverage extends to all companies covered by MANIFEST, including over 1000 outside the core set of companies and those with no coverage by Value Line.

Graph #2: EPS Stability and Quality – An Antidote for Bear Markets and Corrections? Despite the 2001 bear market, the group of companies with the highest EPS Stability rating still managed an 8.4% EPS growth for 2000-2001. The results for the low-quality and deep cyclical companies exhibiting the lowest EPS Stability ratings provides a sharp contrast.

In Graph #2, we take a look at the best, the most predictable and consistent companies (top 20% of all EPS Stability rankings) versus the worst (bottom 20%) and see how they fared during the 2001 bear market. The bear market of 2001-02, when combined with an economic recession, probably generated one of the deepest EPS “troughs” seen in stock market history. In a sense, this is one way to visualize just how massive the “perfect storm” of 2001-02 was.

Note the year-in and year-out consistency of the highest EPS Stability companies. We also note that EPS growth forecasts for 2006-07 have higher expectations for the lowest Stability Rating companies, reaching levels that exceed the most stable. Might this explain the “sluggishness” of the blue chip larger companies as we wait so patiently for prices to resume their upward march?

A Quick Comparison

The accompanying table displays the EPS predictability rating versus the EPS Stability ranking for the ten most widely held companies by MANIFEST subscribers. Current EPS Stability Leader & The Method

Which company is #1 from the approximately 2600 companies covered by MANIFEST? The answer is Medtronic (MDT) with its EPS Stability of 100.

We examine the annual EPS results from 1998-2005 and include two years of estimated EPS for the determination of the EPS Stability ranking. As shown in the accompanying graphic, Medtronic has averaged 16.1% EPS growth with a high of 19.5% and a low of 14.1%. Although we use statistics (standard deviations) to measure the variations, think of the result as a measure of the plus/minus for annual EPS growth. At 1.5%, Medtronic currently has the lowest variations and hence, the highest EPS Stability ranking when compared versus the other 2500+ companies in the Solomon database. A company with an EPS Stability ranking of 50.0 (e.g. Handleman) has an average variation of 32%. Handleman has averaged 18.6% EPS growth with a high of 100% and a low of (-51%).

Medtronic (MDT) – EPS Growth Trend. The EPS Stability ranking is generated by calculating the average variation in annual EPS growth and then ranking the result versus the other 2500+ companies. In this case, 1.5% is the lowest average variation among all companies at this time. Source: Manifest Investing

Bear Market and Correction-Resistant Stocks

Part of the quest was to seek stocks that weathered the bear market the best. The accompanying table of EPS Stability Leaders was obtained by screening on the following criteria:

  1. EPS Stability greater than 80.
  2. Average EPS Growth (1998-Present) greater than 15%.
  3. Minimum of 10% EPS Growth for the entire period for each individual year. 2001 knocked out a whole bunch of companies with this criterion.

The annualized total return displayed is for the period from 12/31/1998 through 12/31/2005. The average for this group of companies was 20.4% and can be compared with an annualized total return of approximately 2.0% for the Wilshire 5000 over the same time frame.

This collection of companies merits consideration for our pounce piles and watch lists, particularly for investors who prefer to avoid roller coasters. What about that search for the Grail? Could this be it? Probably not, but Leonardo was right, sequences of numbers can tell a powerful story. I doubt that we’ve seen our last bear market or significant correction and I’d like to own a few of these when I need them. I’m pretty sure that Mona Lisa already does.

Mark

Mark Robertson

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.

Expected Returns, Jun 2006

Join Manifest Investing

Manifest is an easy to use resource for your investing.

Create dashboards, research companies, discuss your ideas on the forum, and get insight into long-term investing.