theo20185 (40.47)

The Theo Score

January 28, 2011 – Comments (1) | RELATED TICKERS: AFSI , IQNT , VSEC

I like to think of myself as a value investor, even though I don't invest yet. The stock market is a mysterious beast, and I think I've falled in love with it. So much so that I've decided to develop my own stock picking method for fun, just to see if it works over the course of a couple years.

First, some background information. I am an amateur. I've been studying stock valuation methods for about a year. It started after I read "The Snowball: Warren Buffett and the Business of Life". Since, I've read "The Intelligent Investor" and "Security Analysis" by Benjamin Graham and David Dodd, "The Little Book that Beat the Market" by Joel Greenblatt, "The Little Book of Value Investing" by Christopher Browne, and a host of others. I thought it was interesting how these men were able to build fortune by doing nothing more than purchasing equity in businesses. To me, it seemed too good to be true. You do no physical work, and reap the profits of others' work. Sign me up! The following post will detail how I am rating my stocks on the CAPS systems.

That said, I know nothing about business except the basics. You must earn more than you spend to be successful. If you are to buy a business, you want the best relative price compared to how much the business can earn.These two ideas translate directly into my stock-picking method.

Many experts have their own formulas to valuate a business. Some of the calculations I've seen are easy to use, but not to understand. Where did they get some of the constants they use in their formulas? Many don't explain. Benjamin Graham thought a fair P/E for a stock with no growth was 8.5. Is that true? I don't know. And there's no way to prove it. I reject complete formulas, such as Graham's intrinsic value formula and Greenblatt's magic formula. 

Isn't it silly for an amateur to reject proven formulas from the great investing minds of the past and present? Well, we're going to find out!

I started to think, how would I valuate a business?  I took pieces from the great minds, stuff that I did understand, to make my own formula. I call this the Theo score. I start with a couple principles.

1. The market may be more efficient than in the past, but is not perfectly efficient. Therefore, advantages can be obtained, and no business is ever perfectly priced. Business will always be, at least to some small degree, ever overvalued or undervalued.

2. A few people have routinely beaten the market, some of them without formal business education (Walter Schloss is a great example). If they can do it, I can do it, and so can you! Even Warren Buffett believes that to be a great investor, you only need an average IQ.

So, where do I start? Well, first I start by valuating a business assuming it was to be liquidated. This was the method Benjamin Graham used to pick stocks when Warren Buffett worked at his firm. I love the concept of Net-Net Working Capital. Cash and cash-equivalents are taken at book value. Receivables are discounted by 25% (some receivables will not be collected). All other current assets (inventory, etc.) are discounted by 50%. This is a company's NNWC. Divide this amount by the number of shares outstanding, and you get the NNWC per share. 

Benjamin Graham used this later in his career. In his early days, he used NCAV (current assets minus total liabilities) and looked for stocks trading at a 33% discount to this number. I think that any stock today that trades this low is most likely in trouble. Find some using a Ben Graham style screener, and you'll likely find that their balance sheet is terrible. The company is likely not turning a profit, saddled with heavy debt, or in the middle of bankruptcy. Yuck. Ben Graham liked these stocks, buying them at a deep discount and then waiting. He would sell them after a year or if they popped 50%.  It was not pretty, and it was not fun. Many of his stocks failed, but gains were more than enough to offset his losses and provide him with a return that beat the overall market.

Warren Buffett learned a lot from Graham, but does not use Graham's "cigar-butt" method. In "The Snowball", it is said that Buffett criticized Graham's method because he believed it missed some real winners, companies who had huge gains and were also strong money-machines afterwards. Graham believed in selling the stock within a year, Buffett believes you should never sell a good stock. Therefore, I not only want undervalued stocks, but I want them in companies that will stick around for my lifetime and generate healthy profits the entire way.

Enter Joseph Piotroski. He has a simple method for evaluating the strength of a company's balance sheet and income statements. He devised nine simple tests. For each test, the company gets 1 point or none. The companies with the strongest balance sheets get a 9-8 and the weakest get 1-0. To read more on his system, please see: http://www.grahaminvestor.com/articles/quantitative-tools/the-piotroski-score/

So, any stock I pick has the Piotroski score calculated. I use this to develop my sense of margin of safety, another Graham teaching. Whatever Theo Score I arrive at, I multiply this score by the Piotroski score plus 1, then divide by 10 (this way I don't get a zero when the stock scores 0). The weakest stocks need a 90% margin of safety before I consider them, and the strongest need almost none. How do I use margin of safety with my score? We'll get to that. Just remember, for now, that the strongest Piotroski score leaves the Theo score intact, a weak Piotroski score depletes the Theo score.

So, we have the NNWC and the Piotroski score, what next? Earnings history! Get 10 years of diluted normalized EPS for your stock. Go on! Now, calculate the average growth over the past 10 years. I even look at stocks that have less than 10 years of history. I require at least 3 years, but still divide everything by the total ten years to be safe. Now that you have your data and your growth rate, forecast next year's EPS. Analysts do it, so can we! You can use whatever method you want. A linear growth rate is easiest, and since we're projecting only 1 year out, should not be too innaccurate. You can also use a best-fit curve if you have a statistical mathmatics background. Either way, forcast next year's EPS and keep a note of it.

Now, find the dividend the stock is paying! If the stock pays no dividend, well, that was easy! If it does, figure out whether the dividen is quarterly, yearly, etc. Now, put down your safest guess as to what the dividend will be next year for the full year. Write down this number next to your NNWC per share and 1 year forecast EPS.

We're done with research! We got a lot of relevant information about this stock! We have a general sense of how valuable the underlying business is without forecasting future earnings using the NNWC. We have sense of how fast (or slow, or not at all...) the company is growing it's EPS. We have a pretty good guess of what dividend return we can expect in a year's time. And we also have the Piotroski score, telling us relatively how strong (or weak) the actual balance sheet is. Time to calculate the score.

This is the easiest part. The Theo score = 100 / ((Current Stock Price - NNWC Per Share) / (1 Year Forecast EPS + 1 Year Forecast Dividend))

As the great Wall-E said, "Ta-Da!" Let's examine this a bit. Current Stock Price minus NNWC Per Share shows the difference between the current price and the estimated liquidation value of the business. If the NNWC is negative, you end up with a number larger than the share price. Dividing this by the EPS + Div gives you how many years of cashflows it would take to equal the difference in price and liquidation value. Dividing 100 by this number makes the result look more manageable, and makes it so the higher the Theo score, the more undervalued the stock is. If you don't want to divide 100 by timeframe estimate, then don't. Just remember, if you don't, the lower number indicates a stock that is undervalued.

Now, some notes. A stock will get a 0 Theo score (meaning I don't want to touch it no matter how sexy a broker tells me it is) for a couple reasons. First, the forecast EPS is negative. Boom, goodbye. Second, if the dividend payments exceed the forecast EPS, goodbye. I believe this is unsustainable unless the company can boost earnings significantly.

Ok, so we found some stocks with great scores, when do we sell? Ha! We don't. We hold them forever. If the company is a great company and earnings continue to grow for the business, why would you want to sell? The price you paid in the past does not change. The future income adds to your value every year! If the stock pays a dividend, and the dividend grows, the yield compared to your initial purchase price can be ginormous after years! Why reinvest that in another stock that would start you off with a dividend yield that is likely below 5%? 

That's it. I'm trying to stick with stocks that score more than 10 on the Theo score scale. I plan to use this while I'm college to hunt down stocks and see how it performs on the CAPs system. I've had a CAPs account before I developed this and started using it. Therefore, any picks after today will have a commentary that details the Theo Score for each stock on my list. So, if you don't see a commentary on my stock that details the Theo Score, then it was selected before I started using this method to pick stocks.

As of this writing, there are five stocks that meet my threshold on the Theo score that I know of: KLIC, AP, VSEC, TNDM, and AFSI. I will be posting the current scores on these today on my invidiual stock commentary. I do not have any real positions on these stocks, nor do I plan to establish one within the next 72 hours.

Thank you for reading!