Finding Quality:Finding Quality:Getting a 2Getting a 2ndnd Opinion Opinion

(or (or How To Use the S&P Quality How To Use the S&P Quality Ranking)Ranking)

By Kevin GilloglyBy Kevin Gillogly

For Happy Destiny Investment For Happy Destiny Investment ClubClub

July 2005July 2005

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Measuring Managerial Measuring Managerial AbilityAbility

– – Benjamin Graham and David DoddBenjamin Graham and David DoddSecurity AnalysisSecurity Analysis

“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.”

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What is Quality?What is Quality?

As long-term investors, we look for As long-term investors, we look for quality growth companiesquality growth companies

What does quality looks like?What does quality looks like? On the SSG it is consistency of Sales, On the SSG it is consistency of Sales,

Pre-Tax Profit (PTP) margins, and EPSPre-Tax Profit (PTP) margins, and EPS Is it well managed?Is it well managed?

On the SSG it is the trends on the On the SSG it is the trends on the graph and in Sec. 2 (Evaluating graph and in Sec. 2 (Evaluating Management)Management)

Want a 2Want a 2ndnd opinion? opinion? Where do you turn?Where do you turn?

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Finding QualityFinding QualityMyriad ways to find quality without doing a Myriad ways to find quality without doing a

SSG. Not one is perfect. All have some SSG. Not one is perfect. All have some limitations.limitations.

The Stock Check List The Stock Check List SSG on training wheelsSSG on training wheels Looks at a sample of the past 7 yearsLooks at a sample of the past 7 years Quick cut; “Quick cut; “Wrong” years can lead to Wrong” years can lead to

misinterpretationmisinterpretation Take Stock softwareTake Stock software

Shows the Better Investing concepts in 4 clicksShows the Better Investing concepts in 4 clicks Goes through quality points found on the SSGGoes through quality points found on the SSG Can be conservative; Can miss some good Can be conservative; Can miss some good

choiceschoices

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Other Forms of QualityOther Forms of QualityNon Better Investing forms:Non Better Investing forms: Kausch Meisheri’s Quick AnalysisKausch Meisheri’s Quick Analysis

Looks at the trends of the past 10 years Looks at the trends of the past 10 years worth of Value Line (VL) dataworth of Value Line (VL) data

Quick cut; but can’t tell if the price is rightQuick cut; but can’t tell if the price is right Mark Robertson’s 60 Second Equity Mark Robertson’s 60 Second Equity

AnalysisAnalysis Also uses VL dataAlso uses VL data A Quality Ranking that can be compared A Quality Ranking that can be compared

across industries and uses projections in the across industries and uses projections in the calculationscalculations

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How Strong Are These How Strong Are These Companies?Companies?

Most of the previous metrics look at Most of the previous metrics look at sales, EPS and margins. sales, EPS and margins. What about financial stability? What about financial stability? How strong is management? How strong is management? Can a company survive a financial hit?Can a company survive a financial hit? Where do we turn?Where do we turn?

metric n., a system of measurement

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Looking For Independent^ Looking For Independent^ Quality Ratings*Quality Ratings*Sources:Sources:

Morningstar Stock InvestorMorningstar Stock Investor Newest on blockNewest on block Uses “Stewardship” grade & Star RatingUses “Stewardship” grade & Star Rating

Value LineValue Line Peter Lynch “like hiring your own analyst”Peter Lynch “like hiring your own analyst” Financial Strength & Earnings Financial Strength & Earnings

PredictabilityPredictability Standard & Poor’s Standard & Poor’s

Used by founders of Better Investing Used by founders of Better Investing Quality RankingQuality Ranking

^ = reputable w/ no brokerage business* = no price component

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S&P Quality RankingS&P Quality Ranking Formally known as S&P Earnings and Formally known as S&P Earnings and

Dividend RankingDividend Ranking Proprietary measure started in 1956Proprietary measure started in 1956 Attempts to measure Graham & Attempts to measure Graham &

Dodd’s sustainable earnings powerDodd’s sustainable earnings power See quote on page 2See quote on page 2

Measures long-term growth and Measures long-term growth and stability of earnings and dividends.stability of earnings and dividends. Focus is on the last 10 years worth of Focus is on the last 10 years worth of

datadata Covers over 3,500 US based Covers over 3,500 US based

companiescompanies

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Why Use It?Why Use It?According to back-testing by S&P when According to back-testing by S&P when

compared to lower ranked companies, compared to lower ranked companies, high quality rankings have:high quality rankings have:

Less risk;Less risk; Lower debt levels, higher profit margins Lower debt levels, higher profit margins

and higher return on equity;and higher return on equity; Less likely to engage in accounting Less likely to engage in accounting

manipulations;manipulations;AndAnd Outperformed the S&P 500 indexOutperformed the S&P 500 index

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How To Use ItHow To Use It

Simple and quick way to determine if Simple and quick way to determine if company is worth studyingcompany is worth studying Screening ShorthandScreening Shorthand

Simple and quick way to determine if Simple and quick way to determine if company is worth keepingcompany is worth keeping Portfolio Management ShorthandPortfolio Management Shorthand

Uses letter gradesUses letter grades 8 in total8 in total

Remember to do your own research!

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Where To Find ItWhere To Find It

Two places:Two places: S&P Company Report (aka S&P Company Report (aka

“tearsheet”)“tearsheet”) On-line Premium Service (OPS)On-line Premium Service (OPS)

Can drop straight into Toolkit (TK5), Can drop straight into Toolkit (TK5), Stock Analyst (SA 3.1), and Stock Analyst (SA 3.1), and Prospector (NSP 2.6)Prospector (NSP 2.6)

Not available in Classic (NCP 2.3)Not available in Classic (NCP 2.3) Can also be used in MS ExcelCan also be used in MS Excel

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S&P “Tearsheet” For Most S&P “Tearsheet” For Most CompaniesCompanies

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S&P “Tearsheet” For Smaller S&P “Tearsheet” For Smaller CompaniesCompanies

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S&P Quality in Stock AnalystS&P Quality in Stock Analyst

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S&P Quality in Toolkit 5S&P Quality in Toolkit 5

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Translating the Grades *Translating the Grades * A+A+ Highest Highest ( 2%; 81 ( 2%; 81

companies)companies) AA High High ( 6%; 204)( 6%; 204) A-A- Above Ave. Above Ave. ( 6%; 233)( 6%; 233) B+B+ Average Average (16%; 576)(16%; 576) BB Below Ave. Below Ave. (19%; 702)(19%; 702) B-B- Lower Lower (26%; 966)(26%; 966) CC Lowest Lowest (24%; 872)(24%; 872) DD In reorg. In reorg. ( 1%; 36)( 1%; 36) LIQ LiquidationLIQ Liquidation NRNR Not Ranked Not Ranked (3670 companies)(3670 companies)

* Source: OPS 3705 cos. w/ Quality Rank Jun 05

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Translating into NSP *Translating into NSP * A+A+ Highest Highest 88 AA High High 77 A-A- Above Ave. Above Ave. 66 B+B+ Average Average 55 BB Below Ave. Below Ave. 44 B-B- Lower Lower 33 CC Lowest Lowest 22 DD In reorg. In reorg.

11 NRNR Not Ranked Not Ranked 00

* NAIC Stock Prospector

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S&P Quality as a Cross CheckS&P Quality as a Cross Check

Can Be FoundCan Be Found In screening of In screening of

ProspectorProspector

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S&P Quality as a Cross CheckS&P Quality as a Cross Check

Can Be FoundCan Be Found In the Portfolio In the Portfolio

Portion of Stock Portion of Stock AnalystAnalyst

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Benefit of S&P Quality Benefit of S&P Quality RatingRating

Combines some key Combines some key aspects of the SSGaspects of the SSG

Growth and Growth and stability of stability of earningsearnings

Growth and Growth and stability of stability of dividendsdividends

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Limitations of S&P Quality Limitations of S&P Quality RatingRating

Misses key aspects of the SSGMisses key aspects of the SSG No forecast of future Sales No forecast of future Sales

& EPS growth rates& EPS growth rates Does not help determine Does not help determine

future valuefuture value

Misses key aspects of the SCGMisses key aspects of the SCG Measuring to its peersMeasuring to its peers Measuring the better returnMeasuring the better return

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From Quality to From Quality to PerformancePerformance

Top Return to Risk Was Top Return to Risk Was NotNot Found in Found in stocks with the highest ranking, “A+”stocks with the highest ranking, “A+”

Two notches below, “A-”, preformed best.Two notches below, “A-”, preformed best. Price Premium of top rankingPrice Premium of top ranking

That’s still leaves over That’s still leaves over 200 companies (with 200 companies (with a ranking of A-) to a ranking of A-) to examine that could be examine that could be potential purchasespotential purchases

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Quality to Quality to PerformancePerformance

S&P Quality Ranking will S&P Quality Ranking will notnot help finding help finding undiscovered “gems” of the stock market:undiscovered “gems” of the stock market:

Penalizes companies not paying a dividendPenalizes companies not paying a dividend Highest they earn is a “A-”Highest they earn is a “A-”

Also favors companies paying a dividendAlso favors companies paying a dividend Lowest they earn is a “B-”Lowest they earn is a “B-”

Penalizes young small companiesPenalizes young small companies Good companies > 10 years may Good companies > 10 years may notnot be ranked be ranked

No ranking of foreign companiesNo ranking of foreign companies Used only on US based companiesUsed only on US based companies

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Final ThoughtsFinal ThoughtsS&P Quality Ranking has …S&P Quality Ranking has … No price componentNo price component

Therefore no “buy” or “sell” aspect as Therefore no “buy” or “sell” aspect as found in other S&P proprietary found in other S&P proprietary measures (STAR & Fair Value/Outlook)measures (STAR & Fair Value/Outlook)

No projected return No projected return As in Sec. 5c of the SSGAs in Sec. 5c of the SSG

Which is our reason for studying Which is our reason for studying stocksstocks

Use as your starting pointUse as your starting point First cutFirst cut Remember it’s limitationsRemember it’s limitations

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Final ThoughtsFinal ThoughtsUse the S&P Quality Ranking …Use the S&P Quality Ranking … Like a pilot use your instrumentsLike a pilot use your instruments

Several different gauges to tell the Several different gauges to tell the same thing same thing

Use in conjunction with other metricsUse in conjunction with other metrics VL Financial StrengthVL Financial Strength Quick AnalysisQuick Analysis 60 Second Equity Analysis60 Second Equity Analysis It is ok to have overlapIt is ok to have overlap

Cross-check your work on the SSGCross-check your work on the SSG The visual analysisThe visual analysis Evaluating ManagementEvaluating Management

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What We LearnedWhat We Learned

The Value of a simple The Value of a simple quality metricquality metric

How To Eliminate Stocks How To Eliminate Stocks Before Doing a SSGBefore Doing a SSG

How To Monitor Existing How To Monitor Existing StocksStocks

Another use for OPSAnother use for OPS Another Benefit of using Another Benefit of using

NAIC SoftwareNAIC Software

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Questions?Questions?

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Further ReadingFurther Reading Brain Lewis articlesBrain Lewis articles

Sept. 04 Better Investing (BI)Sept. 04 Better Investing (BI) Aug. 04 BITS (expanded article)Aug. 04 BITS (expanded article)

ICL list (NAIC Chat room – free to ICL list (NAIC Chat room – free to anyone)anyone) August 12 to 23, 2004August 12 to 23, 2004

www.standardandpoors.comwww.standardandpoors.com Equity Research (near top)Equity Research (near top) Analytical Methodology (left side)Analytical Methodology (left side)