Did we sell too early? Time will tell, but the discipline we use called for us to do it. And although we are professional money managers, sometimes we have to shake off the emotions attached to owning stock in a favorite company. So Darden Restaurants is gone from our clients’ portfolios.
Pulling the trigger on a stock whose goods or services we like is no different for us than the average investor. But we do it, because our method sets buy-and-sell price ranges on the basis of the valuations we addressed in a previous column.
That column, written mid-year 2003, addressed the issue of how one knows when to sell. We used Darden as an example:
… Now to the sell side. This is where way too many investors fail. Remember, we are looking to make profits with value issues, not speculating or trying to hit home runs, so we can use a simple approach to setting the price at which we will sell the issue by using a PEG – price, earnings, growth – level.
Let’s say we have chosen to use a PEG of one as our point of reference for selling, meaning we will hold the issue until it sells at a price-to-earnings ratio (p/e) equal to the stock’s growth rate. Secondarily we will look at setting a sell price based on the industry PEG.
Here’s an example, using an issue that we hold for several of our clients (but which we will use purely as an example – not a recommendation, since we do not know your risk tolerance.)
Darden Restaurants
Price = $19
Projected 2004 earnings = $1.42
P/e ratio (price divided by earnings) = 13.3
Projected earnings growth rate = 15 percent
PEG = 13.3/15 = .88
Simple PEG = 1 x growth rate = 15p/e
Targeted price = Projected earnings times growth rate = 15 x 1.42 = $21
This exercise produces a conservative price target of $21, a potential return of 10.5 percent. A more aggressive approach is to assign to the issue the industry PEG, producing a much higher price target.
Industry PEG = 1.55
Projected full valuation = industry PEG of 1.55 x 15 percent growth rate = price to earnings of 23.2 = 1.42 x 23.2 = $32.
Now we have produced a very high valuation (a potential 68 percent return) that must be judged in terms of overall market trends. A price-to-earnings ratio in the 20s for a stock growing at a projected 15 percent a year is not uncommon in a well-defined bull market, but it should be considered out of the norm in a poorly defined market trend.
A cautionary note: Both projected earnings and projected earnings growth rates are variables that must be watched closely. A change in either, whether revised up or down, will impact the targeted price. An upward revision is a serendipity that calls for raising your targeted price; a downward revision may mean a fast exit and back to the drawing board.
Notice the last sentence in the cautionary note. Two factors changed in the above equation. The growth rate of the company is now estimated to be 13 percent rather than 15 percent, and the earnings on which the ownership decisions were made shifted to the next year – 2005. Applying the method above provides a target range of a very conservative valuation of $22 to an aggressive, high valuation price of $34, with a midpoint of $28.
We sold our clients’ positions just above that midpoint valuation for a respectable 47-percent-plus return.
I really like the company’s products and services, especially those provided at Olive Garden and Red Lobster, but being a customer has to be separated from owning the stock. So it joins a list of issues we have sold when the decision went against our personal preferences.
That’s difficult for almost all investors, but it is necessary if “buy low, sell high” is your mantra and if you have established a consistent discipline.
For some investors, selling a stock means they will never buy it again, which makes little sense to us. Darden may well pop up on our buy candidates list if our screening processes reveal that it meets our undervalued criteria.
For example, using an earnings estimate of $1.70 for the current year and $1.88 for 2006, it would come under consideration for purchase should it trade below $22. But, as noted in the column quoted above, growth rates and earnings estimates are precisely that – estimates – and they need to be monitored closely. And using a PEG method of stock selection is only one of a number of screens we employ in selecting our purchase and sale candidates.
Next month we will discuss several others. In the meantime: Think spring.
Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.
