Ben Graham and the Growth Investor

Presented to Bryant College

April 10, 2008

HEWITT HEISERMAN JR.

www.EarningsPower.com
Hewitt.Heiserman@EarningsPower.com
The Earnings Power Chart and Earnings Power Staircase are property of Hewitt Heiserman Jr.
All rights reserved. Copyright 2008

Preface

Why We Have to Be at the Top

of Our Game

Which Asset Class Is Better Value Today?

Stocks:

Bonds:

S&P 500: 1355

S&P earnings (TTM): $66

10-year Treasury: 3.52%

S&P 500 earnings source is Barrons. Market data as of Apr. 9, 2008

Stocks Better Value Than BondsP/E Basis

Stocks:

Bonds:

21x (1355/$66)

28x (1/3.52)

P/E Misleads If Economy At Inflection Point

Real 10-Year P/E: The Stock-Bond Gap Narrows

Stocks
S&P 500
Real 10-Year Earnings (avg.)
Bond yield (10-year Treasury)
P/E

Source: IrrationalExuberancecom, EarningsPower.com

Bonds

1355
$59
3.52%
23x

28x

Repetitive Cycles of Enthusiasm and Despair

Will History Repeat?

Peak

Trough

Date

10 Yr.
P/E

S&P

6/1901

25x

9/1929

Contraction

Date

10 Yr.
P/E

S&P

Years

S&P
CAGR

239

12/1920

5x

74

19.5

-6%

33x

383

6/1932

6x

74

3.75

-36%

12/1968

22x

635

7/1982

7x

238

13.6

-7%

4/10/2008

23x

1355

55-Yr. Avg. 300bps Above Current 3.52% Yield

If 10-Year Reverts, Then Bonds Offer More Value

Stocks
S&P 500
Real 10-Year Earnings (avg.)
Bond Yield (55-year avg.)
P/E

Bonds

1355
$59
6.44%
23x

16x

As the cost of money rises, corporate earnings and P/E multiples get
punished

10

We Need to Be at Top of Our Game

11

If market reverts to generational trough P/Es of 5x7x, expect tremendous loss in wealth or time; either we
have i) explicit bear market of 430 today or ii) decade
of flattish S&P while earnings catch-up.
We do not have benefit of P/E expansion ca. 19821999, when it climbed to 44x from 7x and produced a
13% CAGR.
Introduce Earnings Power 1-2-3 Process to help you
navigate choppy investment waters

Resources:

Prof. Robert Shillers website:

http://www.irrationalexuberance.com/

To view the Real 10-Year PE Data, click here:

One can access an Excel file with the data set (used and
described in the book) on stock prices, earnings, dividends
and interest rates since 1871, updated.

Section I

The Growth Trap

13

Many Ways to Make Money on Wall Street

14

Net-net

Sum-of-the-parts

Risk arbitrage

Catalyst

Activist

Short selling

Technical analysis

Growth

Growth Stock: Company with Rising EPS

EPS to $1.42 in 1999 from $0.07 in 1990

15

Benefits of Growth Investing

16

Defer capital gains taxes, so your principal compounds faster

Save money on commissions, bid-ask slippage costs

Trade less, which improves investing results

No exquisite timing required; you can build a position over

many years

Asymmetrical risk-reward. Worst-case, investment goes to zero.

Best-case, multiply your capital several-fold. $10,000 in
Microsoft in 1990 grew to almost $1 million over next ten years.

But Beware of the Growth Trap

Highest P/E (growth)

17

Source: Jeremy Grantham, GMO, Oct. 2007

Lowest P/E (value)

Three (3) Obstacles Confronting Growth Investor

18

1. Poor
earnings
quality

GAAP income statement has four (4) structural

limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.

2. Competitive
advantage
wanes

Successful companies attract imitators. This is good

for consumers, bad for owners.

3. Premium to
intrinsic value

We predict by extrapolation, so growth stocks often

get pushed beyond real worth.

Section II

Obstacle #1: Poor Earnings

Quality

19

The GAAP Income Statement

20

To create comparability, all companies follow generally accepted

accounting principals (GAAP)

Roberts Rules of Order for corporate America

When you open an annual report, 10-K or 10-Q and look at

financials statements, thats GAAP

Many investors take GAAP at face value; they think EPS is hard
number, like

height of Fenways Green Monster (37 feet)

But EPS is a Soft Number

22

GAAP income statement has four (4) structural limitations

A dollar of earnings for one companys may not be comparable to

a dollar of EPS from another company, or for same company from
one year to next

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

23

Investment in fixed capital is ignored, so when capital spending

is greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders equity is free even though owners have an
opportunity cost.

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

24

Investment in fixed capital is ignored, so when capital

spending is greater than depreciation the company may be
profitable on GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders equity is free even though owners have an
opportunity cost.

Notes on Capital Spending

25

Fixed capital is buildings, trucks, telephone networks, etc.

When a company buys fixed capital, it spends the cash today but
for accounting purposes depreciates outlay over assets expected
useful life. Depreciation enables companies to match current
sales with current expenses, and future sales with future
expenses
If capex is greater than depreciation, a company makes
investment in fixed capital. Investment in fixed capital is a use of
cash. This cash outlay has to come from somewhere; e.g.
checking account, liquidate other assets, borrowings, or stock
sales. Will investment produce higher future sales, cost savings?
Beware of capital-intensive companies. The 20% with highest
capital spending growth lagged market by 1.5% a year during
1973-1996, while lowest 20% beat market by 1% a year. (Paul
Sturm, Smart Money, June 2005)

TheStreet.com (TSCM)

Structural Limitation #1: Investment in Fixed Capital

TheStreet.com (TSCM)($mls)
Capital spending (real cash they spent in 2007)
- Depreciation (a noncash charge in GAAP P&L)
= Investment in fixed capital

27

2007
$5
3
$2

Expensing Investment in Fixed Capital Usually Reduces

GAAP Earnings
TheStreet.com (TSCM)($mls)
Net income (inc. $3M of depreciation)
- Fixed capital investment
= Adjusted net income

28

GAAP

Expense

$31
n/a
$31

$31
2
$29

Sidebar: Are Acquisitions a Capex Equivalent?

TheStreet.com (TSCM)(millions)
Net income
- Fixed capital investment
- 20% of 2007 Acquisition ($30/5 years)
= Adjusted net income

GAAP

Expense

$31
n/a
n/a
$31

$31
2
6
$23

Acquisitions are 1) a use of cash, 2) a substitute for capital

spending, and 3) their payoff is uncertain. Depreciate deals over 5
years.

29

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

30

Investment in fixed capital is ignored, so when capital spending is

greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables
and inventory grow faster than payables and accrued
expenses the company may be profitable on GAAP basis but
short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders equity is free even though owners have an
opportunity cost.

Notes on Working Capital

31

Working capital assets include receivables, inventory,

other current assets (but not cash, marketable
securities); working capital liabilities are payables,
accrued expenses. Working capital is WCA - WCL
While it is good to have more assets than liabilities,
when working capital increases from one year to next,
this is an investment in working capital
Investment in working capital is use of cash that does
not appear in GAAP income statement. Still, like fixed
capital investment, it has to be financed somehow
A profitable company can suffer liquidity squeeze if it
cant collect receivables and/or sell inventory in timely
manner

Crocs (CROX)

Structural Limitation #2: Investment in Working Capital

Crocs Inc. (CROX)($mils)

Working capital assets:
Receivables
Inventory
Total WC assets
Working capital liabilities:
Payables
Accrued Expenses
Total WC liabilities

33

Net working capital

Investment in net working capital

12/31/06

12/31/07

$66
86
$152

$153
248
$401

$44
31
$75

$83
57
$140

$77

$261
$184

Expensing Investment in Working Capital Usually

Reduces GAAP Earnings

34

Crocs Inc. ($mils)

2007

Net income
- Investment in working capital
= Adjusted net income

$168
184
$(16)

Sometimes WC is a Source of Cash

Blue Nile (NILE) ($mils)

Net income
- Investment in working capital
= Adjusted net income

2007
$17
(14)
$31

A negative investment in working capital is wonderful; its like having

a job that pays you today for work you will do in two weeks.

35

Structural Limitation #2: Investment in Working Capital

36

Blue Nile (NILE)($mils)

12/31/06

12/31/07

Working capital assets:

Receivables
Inventory
Total WC assets

$2
15
$17

$4
21
$25

Working capital liabilities:

Payables
Accrued Expenses
Total WC liabilities

$67
7
$74

$86
10
$96

$(57)

$(71)
$(14)

Net working capital

Investment in net working capital

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

37

Investment in fixed capital is ignored, so when capital spending is

greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders equity is free even though owners have an
opportunity cost.

Notes on Intangibles

38

Intangible growth-producing initiatives are R&D, advertising, and

employee education. We call them intangibles because we cant
weigh, touch, or measure these assets, in contrast to fixed capital
Companies invest in intangibles to boost revenue, charge higher
prices (brand value), cut costs, improve productivity, etc.
But GAAP says intangibles are expenses, not assets. Thus,
GAAP earnings for brain companies are not comparable to
brick companies
Increased R&D led to both improved operating performance and
superior stock returns, per study of 8,300 companies over 50
years. (Source: Journal of Finance, 2004, Vol. 59)
When we capitalize intangibles we are not eliminating the cost.
Instead, we are deferring it to a later period. This is the matching
principle of accrual accounting: align current sales with current
expenses, future sales with future expenses

Google (GOOG)

Depreciation Intangibles Over Expected Useful Life

Usually Increases GAAP Profits

40

Google (GOOG)($mls) - 2007

GAAP

Depreciate

Profit before R&D

- R&D
= Operating income
Increase (%)

$7,204
2,120
$5,084

$7,204
1,316
$5,888
16%

Structural Limitation #3: Intangibles are Expensed

Google (GOOG)($mls)

2005

2006

2007

R&D (GAAP)

$599

$1,229

$2,120

Depreciation

$200

$410

$707

Year 1
Year 2
Year 3
Total

$200
132

$410
200
132

$707
410
200
$1,316

Depreciation period

41

Depreciation period is the useful life of the asset. If you depreciate

over three years, then you need three years worth of R&D.

GAAP P&Ls Four (4) Structural Limitations

1.

2.

3.

4.

42

Investment in fixed capital is ignored, so when capital spending is

greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders equity is free even though owners have an
opportunity cost.

Notes on Stockholders Equity

43

All companies financed by combination of debt and

equity
Debt comes from banks, bondholders; equity from
owners via retained earnings (GAAP profits minus
dividends)
Debt an expense but equity is free. Why? Noncash
cost; also, different owners have different required
rates of return.
But GAAP-profitable company may destroy value if you
expense owner opportunity costs.

Playboy (PLA)

Playboys Stock is No Miss April

Structural Limitation #4: Stockholders Equity

Playboy (PBA)($mls) - 2007

Pre-Interest income (EBIT + investments)
- Interest - Debt Only ($115)
- Interest Debt & Equity ($283 x 7.1%)
= Pre-tax profit

GAAP
(equity free)

Expense
Equity

$12
5
n/a
$7

$12
n/a
20
$(8)

If the accounting treatment for equity is same as debt, then pre-tax

profit turns into a pre-tax loss

46

Estimating Playboys Interest Debt & Equity (1/2)

Debt*
Equity
Total

Avg. 2
Years

1
Capital
Weighting

$115
168
$283

41%
59%
100%

2
1x2
AT Cost Wtd. Avg. Cost
of Capital
of capital*
2.8%
10.0%

*Pretax cost of debt = $5 million/$115 million = 4.3%; after-tax cost =

4.3% x (1-35%) = 2.8%. Cost of equity = 10-year Treasury + 500 bp,
or minimum 10%.

47

1.2%
5.9%
7.1%

Estimating Playboys Interest Debt & Equity (2/2)

Playboy (PLA)($mls)

2007

Total Capital
X Wtd. Avg. Cost of Capital
Interest Debt & Equity

$283
7.1%
$20

The more equity a firm employs as a percentage of total capital, the

less money it makes if you think equity has a cost

48

Summary

Structural limitation

As a result

1. Omits investment in Company may be profitable on a GAAP

fixed capital
basis but run out of cash if capex is much
bigger than depreciation
2. Omits investment in Company may be profitable on a GAAP
working capital
basis but run out of cash if it cant collect on
receivables, or if inventory doesnt sell

49

3. Intangibles are
expensed

Penalizes forward-looking companies

investing for higher future sales, earnings

4. Equity has a cost

The more equity a firm employs as % total

capital, the less intrinsically profitable it is

How Do We Fix These Structural Limitations?

50

Do we re-build income statement to 1) expense investment in FC,

2) expense investment in WC, 3) depreciate intangibles, and 4)
expenses stockholders equity?
We could, but then we create other problems; e.g., we penalize
companies that are investing in FC, WC. Also, who is arbiter of
cost of equity? (Elvis still alive, some think.)
No single income statement is cure-all. Instead, lets add the
strengths of two alternate P&Ls that have been devised in recent
years to our analysisfree cash flow and Economic Value Added

Metric Wars: Which Alternate P&L is Best?

51

Free Cash Flow

Economic Value Added

Adjustments

1. Expenses investment in fixed

capital. 2. Expenses investment
in working capital

3. Intangibles depreciated over

useful life 4. Stockholders equity is
an expense

Goal

Self-fund? A company does so

when it produces more cash
from ongoing operations than it
consumes.

Create value? A company does so

when it produces a return on capital
that is greater than its cost.

Not this
Ben
Graham

52

This Ben
Graham!

53

Benjamin Graham (1894-1976)

54

Graduated #2 in class from Columbia in 1914 at age 20, then offered

teaching jobs in English, mathematics, and philosophy departments
Instead, went to Wall Street. Nearly ruined by speculation before devising
margin of safety strategy of buying companies selling at two-thirds of
net working capital after subtracting all liabilities Then made 20% a year
for two decades.
Taught popular investing class at Columbia 1928-1956
Warren Buffetts teacher, employer, and friend
Turned class notes into Security Analysis (1934). The Intelligent Investor
published in 1949.
Goal to take advantage of Mr. Markets occasional manic personality
Helped found CFA program in 1960s
Wanted to do something foolish, something creative and something
generous every day. Gave presents to employees on his birthday,
figuring that he was the lucky one

The Intelligent Investor: Grahams Two Types

55

The defensive (or passive)

investor will place his chief
emphasis on the avoidance of
serious mistakes or losses
Pessimistic commercial banker
Expenses investment in fixed and
working capital because they are
uses of cash; also, who knows if
investment will pan out

The determining trait of the

enterprising...investor is his
willingness to devote time and
care to the selection of securities
more attractive than average
Optimistic venture capitalist
Intangibles expensed over useful
life because they are key driver
of higher future sales, earnings;
also, equity is an expense
because stockholders have
opportunity costs

Source: The Intelligent Investor (Harper & Row, 1973)

In Honor of Graham

56

Personality

Pessimistic
commercial
banker

Optimistic venture
capitalist

Income
statement

Defensive
(free cash flow)

Enterprising
(Economic Value
Added)

To learn
more

Cash Flow and

Security Analysis,
Hackel and Livnat

The Quest For Value,

Stewart

Case Study: Enron Corp.

57

Per-share GAAP earnings up 9 of 10 years ending 2000

During the 90s, total return 1,415% vs. 383% for S&P 500

One of Fortunes 10 Stocks to Last the Decade (August 2000)

Board of directors rated among U.S.s five best

Step 1a of 3: Three Income Statements

Enron Corp. year ending Dec. 31, 2000 (millions except per-share)
Income statement
Revenue
- COGS, SG&A, other
- Investment fixed capital (#1)
- Investment working capital (#2)
- Intangibles (#3)
- Interest expense (#4)
- Other
- Taxes
Total expenses
Profit (loss)
Source: Company reports, EarningsPower.com

58

Defensive

GAAP

Enterprising

$100,789
98,836
3,555
1,071
0
838
(1,093)
684
$103,893
$(3,102)

$100,789
98,836
n/a
n/a
0
838
(215)
434
$99,893
$896

$100,789
98,836
n/a
n/a
72
2,609
(55)
765
$102,228
$(1,439)

Step 1b of 3: Quality of Profits

59

Step 1c of 3: Earnings Power Chart

60

Enron: A Second Look

61

2000 was a record year for revenue, net income; total return
+89% vs. -9% for S&P 500
But then management declared bankruptcy in December 2001
after admitting 1997-2001 earnings were overstated; biggest
U.S. corporate failure to date
Stock falls to pennies from high of $85
21,000 employees lose their jobs, pensions
Despite GAAP profits, Enron does not possess authentic
earnings power according to the Earnings Power Chart

Section III

Just Four Types of

Companies

62

Lower-Left Box: Enron

63

Upper-Left Box: HealthSouth (HLSH) (down 83% from $30

peak in mid-1998)

64

Lower-Right Box: Krispy Kreme Donuts (KKD)

88% from $50 peak in mid-2003)

65

(down

Coal Mine Canary

Defensive:

Enterprising:

Both:

Autozone (92-99)

Bethlehem Steel (96-00)

Allou Health & Beauty (98-02)

Centennial Technologies (93-97)

Boston Market (93-97)

Bombay Company (91-94)

CML Group (92-97)

CKE Restaurants (95-97)

Enron (96-00)

EDS (00-02)

Crown Cork & Seal (95-00)

Polaroid (95-00)

Fine Host (95-96)

HealthSouth (96-01)

Sunbeam (93-98)

Gap, The (96-02)

Ikon Office (93-98)

Warnaco (94-99)

Gateway (97-01)

Rite-Aid (95-00)

Xerox (96-00)

Krispy Kreme Donuts (02-04)

Sherwin-Williams (91-00)

Lucent Technologies (97-00)

WorldCom (97-01)

Measurement Specialties (98-01)

Tyco (3/00-12/01)

66

United Airlines (94-01)

Source: EarningsPower.com

Upper-Right Box: Wrigley (WWY) (up 41% 1998-2002 vs. 9%

loss for S&P 500)

67

How to Use the Earnings Power Chart

1.
2.

3.
4.
5.

68

Source new ideas. Long prospects in upper-right box; short

candidates in lower-left box.
Monitor current portfolio. Which of 4 boxes is company in?
Why? Are gains in GAAP confirmed by higher levels of
defensive, enterprising profits? If not, why? Is there a tight or
loose fit between GAAP and defensive, enterprising profits?
What is long-term trend?
Competitors. If your companys competitors are weakening,
your company may be next.
Customers. See #3.
Test management candor, realism. Do they say they had
good year but company moved in lower-left direction? (See
Enron)

Tripe from Enrons Last Annual Report:

Enrons performance in 2000 was a

success by any measure.Our talented
people, global presence, financial strength
and massive market knowledge have
created our sustainable and unique
business. Ken Lay and Jeff Skilling

69

Key Points:

70

The Earnings Power Chart fixes the four (4) structural limitations
of the GAAP income statement
Regardless of size, industry, or capital structure, all companies
are situated in one of Earnings Power Charts four (4) boxes
Which box are the companies you own in? Why?
The Earnings Power Chart is like looking both ways before you
cross the street; it provides a margin of safety.
There are companies in the lower-right, lower left, and upper-left
boxes that will be great stocks. But life is short and our capital is
limited. So unless you have a compelling reason, stick with
upper-right box. These twice-blessed companies have the
authentic earnings power that Wall Street prizes.

Source for an Earnings Power Chart Spreadsheet:

http://www.filespace.org/Sand101/IETC1.2.zip

n.b., I did not make this spreadsheet so user beware. Also,

do not ask me questions about this SS as I use my own
proprietary version.

71

Section IV

Hallmark of Profitable
Growth: The Earnings Power
Staircase

72

Microsoft ca. 1990s: Authentic Earnings Power +

Earnings Power Staircase

$10,000 grows
to almost $1
million

73

Apollo Group: $10,000 grows to $78,000

74

Apple: $10,000 grows to $106,000

75

Cisco Systems: $10,000 grows to $631,000

76

Chicos FAS: $10,000 grows to $73,000

77

Dell Computer: $10,000 grows to $1.3 million

78

First Cash Financial: $10,000 grows to $86,000

79

Garmin: $10,000 grows to $44,000

80

Google: $10,000 grows to $51,000

81

Paychex: $10,000 grows to $257,000

82

Quality Systems: $10,000 grows to $70,000

83

Not All Great Stocks Are Staircase: $10K to $200K

85

Section V

Best Stock: 1997-2006

86

The winner is: Hansen Natural

$10,000 grows to $2.6 million

88

Authentic Earnings Power + Earnings Power Staircase

89

Section VI

Putting It Altogether: The

Earnings Power 1-2-3 Process

90

Three (3) Obstacles Confronting Growth Investor

91

1. Poor
earnings
quality

GAAP income statement has four (4) structural

limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.

2. Competitive
advantage
wanes

Successful companies attract imitators. This is good

for consumers, bad for owners.

3. Premium to
intrinsic value

We predict by extrapolation, so growth stocks often

get pushed beyond real worth.

Our Case Study: American Eagle (AEO)

Highlights

93

Mall-based retailer with 926 stores in U.S., Canada

Three concepts: American Eagle, aerie, and Martin + Osa
HQd in Pittsburgh
Founded 1977
Ranked #2 coolest brand among 12-19 year olds
We compete on trend but not ahead of trend.
Schottenstein family with AEO since 1980; owns $750 million of
stock.
One of 10 best stocks for decade ending 2006

Three (3) Obstacles Confronting Growth Investor

94

1. Poor
earnings
quality

GAAP income statement has four (4) structural

limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.

2. Competitive
advantage
wanes

Successful companies attract imitators. This is good

for consumers, bad for owners.

3. Premium to
intrinsic value

We predict by extrapolation, so growth stocks often

get pushed beyond real worth.

Step 1b of 3: Earnings Power Staircase

95

Step 1c of 3: Earnings Power Staircase

96

Three (3) Obstacles Confronting Growth Investor

97

1. Poor
earnings
quality

GAAP income statement has four (4) structural

limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.

2. Competitive
advantage
wanes

Successful companies attract imitators. This is good

for consumers, bad for owners.

3. Premium to
intrinsic value

We predict by extrapolation, so growth stocks often

get pushed beyond real worth.

Step 2 of 3: Competitive Advantage

98

Strategies, skills, knowledge, or resources that differentiate a

business from its competitors
If a company has a competitive advantage, it probably has
authentic earnings power and may even forge an Earnings
Power Staircase
Warren Buffett says competitive advantage is moat around the
castle. Wider the moat, the more protected the castle
Use the Quality of Profits and Earnings Power Charts to gain
insights into whether company has competitive advantage
The more durable the competitive advantage, the longer we
can project above-average growth in Step 3, Valuation

Morningstars 4 Types of Competitive Advantage

99

Types

Examples

1. Low-cost provider

Wal-Mart, Dell (?)

2. High-switching costs

Paychex, Microsoft

3. Intangibles (e.g., patents,

mindshare, locations, addictive
product, management,
employees)

Pfizer, Starbucks, International

Speedway, Berkshire Hathaway,
Altria (Philip Morris), Best Buy,
Disney

4. Network effect

eBay, Chicago Merc

Most Competitive Advantages Wane over Time: Who Is

Building the 13-Corkscrew Version?

American Eagle Has Mild Competitive Advantage?

10

Competitive advantage

Examples

1. Low-cost provider

no

2. High-switching costs

no

3. Intangibles (e.g., patents,

mindshare, locations, addictive
product, management,
employees)

Jay Schottenstein is long-time

board chair; and familys
interests are aligned with outside
stockholders. But not the most
durable competitive advantage.

4. Network effect

no

If no competitive advantage, keep your forecast period short

Three (3) Obstacles Confronting Growth Investor

10

1. Poor
earnings
quality

GAAP income statement has four (4) structural

limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.

2. Competitive
advantage
wanes

Successful companies attract imitators. This is good

for consumers, bad for owners.

3. Premium to
intrinsic value

We predict by extrapolation, so growth stocks often

get pushed beyond real worth.

Take Analyst Forecasts With a Grain of Salt

10

There is no persistence in long-term earnings growth

beyond chance.growth forecasts are overly
optimistic and add little predictive power. (Source:
The Level and Persistence of Growth Rates, Louis
K.C. Chan, Jason Karceski and Josef Lakonishok)
David Dreman: The average error was 44% annually,
based on 500,000 quarterly estimates of more than
1,500 companies between 1973-1996. (Source:
Contrarian Investment Strategies, Dreman)

Step 3 of 3: American Eagles Intrinsic Value

Low

Medium

High

This Year Earnings

-4%

-4%

-4%

Next Year Earnings

7%

10%

13%

Earnings Years 3, 4 & 5

7%

11%

14.3%

Earnings Years 6-10

3%

4%

5.6%

Earnings Terminal Period

3%

3%

3%

Share Count annual growth

-1%

-1%

-1%

Intrinsic value (inc. net cash)

$36

$41

$47

40%

35%

25%

Weighting
Wtd. Avg. Intrinsic Value

10

$40

Valuation: 5 Margins of Safety

1.
2.
3.
4.
5.

10

Cost of equity (discount rate) is 10%

High growth = consensus; Low, Medium growth is
50%, 75% of High
Growth in years 6-10 is 50% of years 1-5
Intrinsic value estimate 40% based on Low Growth,
35% on Medium, and just 25% on consensus.
Buy when companies sells at 50%-70% of intrinsic
value, depending upon quality of earnings and
durability of competitive advantage

American Eagles Price-Intrinsic Value (PIV)

Stock price
Intrinsic Value
= PIV

$17
$40
43%

Authentic earnings power on sale: At $17, you get $1 of

intrinsic value for $0.43.

10

American Eagles Expected Return

Expected Return

10

= ($40 - $17)/$17
= 134%

The lower your price-intrinsic value (PIV), the higher your

expected return (ER)

Portfolio management: Rank all your companies by ER, from high

to low. Does the company you are thinking of buying offer a
higher ER than the lowest-ranked company you own? If not, then
why buy it?

Sell Discipline

10

Earnings quality: Quality of profits permanently

deteriorate

Loss of competitive advantage

Stock climbs to intrinsic value

Summary

Why Ben Graham and the

Growth Investor?

10

Whats Your Process?

It al starts with a well-defined process that is executed with a high
degree of discipline.
There are a lot of smart people in the investment business, but not
very many of them are consistently successful.
We think the reason is that not many of them have a truly well-defined
process and are truly disciplined in executing it.
Source: He Recruits Managers with Passion and Focus For Stocking-Picking
Teams, Wall Street Journal, Nov. 7, 2005

Avoid Growth Trap - Use Multiple Margins of Safety

11

Next Microsoft wont be cheap on a Ben

Graham net-net basis.
To protect against miscalculation or bad
luck, include multiple margins of safety in
your well-defined process: 1) seek out
authentic earnings power, 2) look for a
durable competitive advantage, and 3)
buy at a discount to intrinsic value

Bonus Material for Bryant College:

- Useful Writing Tips

Useful Writing Tips

11

1. Its vs. its

Its = possession. Example: its dog

Its short for it is. example: Its exciting when my stocks
double in an afternoon

2. Show me, dont tell

me

No: U.S. Global Investors went up a lot in 2006.

Yes: U.S. Global Investors went up 338% in 2006

3. No quites or
verys

No: Its quite/very hot here in Las Vegas.

Yes Its 92 degrees in the shade here in Las Vegas

4. No adverbs

No I honestly believe, or I personally think.

5. Key info at
beginning of sentence,
then cite source

No: According to data from TowerGroup, more than half of all

U.S. investors make fewer than five trades per year. (TMF,
1/30/07)
Yes: More than half of all U.S. investors make fewer than
five trades per year, according to data from TowerGroup,.

and please!

Dont send a cover letter explaining how much you admire

Warren Buffet. Buffett has 2 ts

Its Earnings That Count (McGraw-Hill, 2004)

11

Challenges conventional wisdom that

company has earnings power just
because EPS keeps rising
Introduces Earnings Power Chart to
find conservative growth stocks for
long-term capital gains
Foreword by John C. Bogle, founder
and former CEO of The Vanguard
Group
Endorsed by Charles W. Mulford,
Tom Jacobs, Thornton Oglove,
Morningstars Mark Sellers, Robert L.
Rodriguez, Arne Alsin, Jim Rogers,
John D. Spooner, Kenneth L. Fisher

Biography

11

Hewitt Heiserman Jr. conceived the Earnings Power Chart and the
Earnings Power Staircase, which are featured in his book "It's Earnings
That Count" (McGraw-Hill, 2004). He also writes a column on earnings
power for RealMoney.com. Heiserman graduated from Kenyon College
with Distinction in History, and also received the Faculty Award for
Distinguished Achievement. Heiserman is a member of the Boston
Security Analyst Society and the CFA Institute. Heiserman's work on
earnings quality has appeared in TheStreet.com, BusinessWeek, CBS
MarketWatch, Business 2.0, Better Investing, The Motley Fool, Complete
Growth Investor, Barron's, and the Haverford Trust Company Adviser.
Heiserman has spoken to the New York Society of Security Analysis, the
Boston Security Analysts Society, Fidelity Management an Research, the
Babson Investment Management Association, the American Association of
Individual Investors, and Complete Growth Investors on "Ben Graham
and the Growth Investor." Heiserman is a finance instructor for GersonLehrman Group. He is a trustee for a land conservation group. To learn
more, visit www.EarningsPower.com

Questions?

Hewitt.Heiserman@EarningsPower.com
www.EarningsPower.com

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