Markets & Economy

Billionaires, politicians and business leaders have converged on Switzerland for their annual economic outlook confab as the U.S. dollar takes a nosedive against the euro but U.S. stock markets continue to climb. Earnings reporting season is well underway, bringing high expectations that tax cuts and economic growth will translate into higher profits for American corporations and stronger outlooks for this year and next. The S&P 500 traded above 2,800 as of Thursday, led by consumer discretionary stocks (up 9.4% this year) and technology (up 7.6%). The laggards are telecommunications (down 0.5%) and utilities (down 4%). The index is now trading at a multiple of 23, while the Dow Jones industrial average trades at 21 times the last 12-month earnings.

Some positive numbers:

  1. Mortgage applications rose 4.5 percent last week compared to the previous week as borrowers tried to get ahead of rising rates. Application volume was 6% higher than the same week last year, the Mortgage Bankers Association said.
  2. Satisfaction with the U.S. economy is as high as it was during the dotcom boom in the late 1990s, according to an NBC News/WSJ poll. Sixty nine percent of those surveyed said they were satisfied with economic conditions, up from 37% in 2015.
  3. About 70% of consumers believe the tax reform changes will be positive, according to the University of Michigan's survey of consumer attitudes.
  4. Industrial production increased more than expected in December, mostly because a cold snap boosted demand for heating. The Fed also said industrial output rose 0.9% in December on gains from mining production.

Some not-so-positive numbers:

  1. Comments by the Treasury Secretary made the currency markets think the Trump administration was changing a long-held strong-dollar stance, sending the dollar down sharply against other currencies, including the euro.
  2. Crude oil is back to trading above $65 a barrel, levels it hasn't seen since 2014.
  3. The supply of houses for sale dropped to a record low in December, pushing up prices and potentially side-lining some first time buyers as rates are set to rise. Existing home sales fell 3.6% in December.
  4. The Trump administration slapped tariffs on washing machines and solar panels, a move critics say will raise prices for consumers.

Recommended reading

Taking a look around at what's being written about the stock market these days, a theme comes into focus: At all-time highs and rising, the market could take a turn for the worse, and when that happens it will be swift and furious. But of course, no one really knows when that will happen and until then, no one wants to miss out on this stunning rally. Here are some recent blog posts and articles, in case you missed them.

Bond Fear Pimco's Joachin Fels thinks people should be worried because there isn't enough fear to go around. The firm has cut exposure to corporate credits on concern that a sell-off may be coming. Read more

Don't Miss It That old middle school feeling - FOMO - is ruling retail investors these days. Fear of missing out is what pushed the S&P 500 to its best start to a year since 1999. Read more

Gold Shines Name the asset class that has performed the best since the Fed raised rates in December. It's gold, which has beaten the S&P, European stocks, the 10-year bond, the dollar and even bitcoin. Read more

Commodities Climb DoubleLine's Jeff Gundlach says the S&P 500 will be down this year because all the indicators that say there isn't a recession coming are already priced in. Commodities, on the other hand, seem to be a winning bet. Read more

Survival Guide A recent WSJ story outlined four ways investors can survive a market bubble. The options include selling early, staying in until later (but being prepared to bail quickly), staying cautious or looking elsewhere. Read more

Contrarian Ways Rob Arnott, the founder of Research Affiliates, shared some thoughts about "smart-beta" investing, which he says has gotten so mainstream it has lost its original meaning. The strategies are supposed to be contrarian. Read more

Correction Coming? Market historian James Stack told the New York Times recently what everyone fears: the market party will come to an end, eventually. And he says a correction would even be healthy. Read more

Debt Woes Americans have racked up more debt than their assets and income can support, according to billionaire hedge fund manager Ray Dalio, and this will be a drag on growth and markets. Read more

Euphoria Lacking Jeremy Grantham says the market is priced "exceptionally" high but it isn't exhibiting the euphoria necessary to make it a bubble. Read more

Since our last newsletter, the S&P 500 returned 2.6%, while the Hot List returned -1.6%. So far in 2018, the portfolio has returned -0.1% vs. 6.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 263.3% vs. the S&P's 183.8% gain.

News on Hot List Stocks

Foot Locker (FL) - The athletic shoe and apparel retailer announced a $15 million strategic investment in Carbon38, a luxury activewear brand.

United Therapeutics (UTHR) - TAI Diagnostics closed a $10 million funding round with United Therapeutics. TAI makes tests that monitor the health of transplant recipients.

NetEase (NTSE) - The Chinese gaming company will announce fourth quarter and full fiscal year 2017 results on February 7.

PetMed Express (PETS) - The shares soared after it reported fiscal third quarter earnings that beat expectations and announced a 25% increase in its quarterly dividend.

Making a Case for the Unpopular

It may be hard to remember, but at one point more than a decade ago, value stocks were in favor. For seven years from 2000 to 2007, they outshined growth stocks by a big margin. Then, it all went downhill, and growth stocks have had their day ever since. Some say conditions may be changing again.

This has been said before, of course. In 2015 and again in 2016 it looked as though the pendulum was swinging back. But conditions still favored growth stocks. Low interest rates and a growing economy boosted some of the glitziest tech names last year, including Facebook, Amazon, Netflix and Google's Alphabet, the so-called FANG stocks.

The argument in favor of value is rational. Value stocks do well when rates are rising, as they are now that the Fed has restarted its efforts to normalize interest rates. It is expected to raise three or even four times this year, and if the economy heats up more than expected, it might be forced to raise even more quickly.

All that is good news for value stocks, which outshine growth stocks under those conditions because their future cash flows compare less favorably.

But those tech stocks have proven stubbornly persistent and the long stretch of underperformance for value stocks has led even savvy professional managers to question whether the strategy even works.

Here are four reasons for value investors to have faith:

  1. This is a long-term approach. A 2016 Bank of America study found that value stocks have done better than growth 4% annually since 1926. That means a value portfolio returns triple that of a growth stock portfolio over a 30-year timeframe. Major factors underpinning the value philosophy stand the test of time: price/book, price/earnings, price/cash flow all provide sold ways to evaluate stocks of good companies that are undergoing temporary and recoverable issues. The trick is to stick to the strategy and avoid the temptation of jumping in and out as value moves in and out of favor.
  2. Patience is truly a virtue for value investors. Compare value to growth every five years going back to 1945, and value outperforms the majority of the time. Just six times has the reverse been the case, three times since 1990, including the current period. What's more, every time the tables have turned from growth back to value, the latter has bounced back even stronger.
  3. There is a huge gap in the valuation of the highest priced stocks right now and the lowest, which means growth stocks are getting more expensive relative to value. The current price/book value gap is in the 93rd percentile of historical data. In other words, value stocks have only been this cheap relative to growth 7% of the time.
  4. Value needs a catalyst and that may be right around the corner with interest rates likely to be what sets things off. Data show when the 10-year Treasury is rising, value stocks beat growth stocks (for the most part). And as noted before, the Fed is set to raise rates three times this year as it moves back to a more normal environment off the historically low rates we've seen in the last decade.

Is it possible everything has shifted to a new dimension, a new normal? The historical average PE for the S&P 500 going back to 1900 is 17, but in the last quarter-century it is 26. Businesses have gotten more efficient, accounting standards have changed, and public reporting standards and the way investors evaluate companies have improved.

But one thing long-term investors like Warren Buffett know is that eventually conditions revert back to the mean. Value will come back in favor even if it's impossible to predict precisely when that will happen. Fortune favors the prepared.

Portfolio Holdings
Ticker Date Added Return
LGIH 11/17/2017 13.7%
IPGP 1/12/2018 -0.2%
THO 10/20/2017 14.6%
FL 1/12/2018 10.5%
SIG 10/20/2017 -17.0%
CTB 9/22/2017 9.2%
UTHR 1/12/2018 -2.0%
NTES 11/17/2017 -10.3%
TOL 12/15/2017 4.2%
PETS 1/12/2018 -13.1%


Guru Analysis
Disclaimer: The analysis is from Validea's selection and interpretation of content from the guru's book or published writings, and is not from nor endorsed by the guru. See Full Disclaimer

LGIH   |   IPGP   |   THO   |   FL   |   SIG   |   CTB   |   UTHR   |   NTES   |   TOL   |   PETS   |  

LGI HOMES INC

Strategy: Growth Investor
Based on: Martin Zweig

LGI Homes, Inc. is a homebuilder and land developer. The Company is engaged in the design, construction, marketing and sale of new homes in markets in Texas, Arizona, Florida, Georgia, New Mexico, South Carolina, North Carolina, Colorado, Washington and Tennessee. The Company operates through five segments: the Texas division, the Southwest division, the Southeast division, the Florida division and the Northwest division. The Texas division includes homebuilding operations in Houston, Dallas/Fort Worth, San Antonio and Austin locations. The Southwest division includes homebuilding operations in Phoenix, Tucson, Albuquerque, Denver and Colorado Springs locations. The Southeast division includes homebuilding operations in Atlanta, Charlotte and Nashville locations. The Florida division includes homebuilding operations in Tampa, Orlando, Fort Myers and Jacksonville locations. The Northwest division includes homebuilding operations in Seattle location.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. LGIH's P/E is 16.77, based on trailing 12 month earnings, while the current market PE is 28.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: PASS

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. LGIH's revenue growth is 76.43%, while it's earnings growth rate is 63.45%, based on the average of the 3, 4 and 5 year historical eps growth rates. Therefore, LGIH passes this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (69.2%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (45.6%) of the current year. Sales growth for the prior must be greater than the latter. For LGIH this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. LGIH's EPS ($1.40) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. LGIH's EPS for this quarter last year ($0.86) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. LGIH's growth rate of 62.79% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: FAIL

Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for LGIH is 31.73%. This should be less than the growth rates for the 3 previous quarters which are 38.89%, -8.77% and 43.75%. LGIH does not pass this test, which means that it does not have good, reasonably steady earnings.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, 28.89%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 62.79%, (versus the same quarter one year ago) then the stock passes.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: FAIL

The EPS growth rate for the current quarter, 62.79% must be greater than or equal to the historical growth which is 63.45%. Since this is not the case LGIH would therefore fail this test.


EARNINGS PERSISTENCE: PASS

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. LGIH, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 0.50, 1.07, 1.33, 2.44 and 3.41, passes this test.


LONG-TERM EPS GROWTH: PASS

One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. LGIH's long-term growth rate of 63.45%, based on the average of the 3, 4 and 5 year historical eps growth rates, passes this test.


TOTAL DEBT/EQUITY RATIO: FAIL

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. LGIH's Debt/Equity (103.90%) is considered high relative to its industry (50.34%) and fails this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For LGIH, this criterion has not been met (insider sell transactions are 82, while insiders buying number 42). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

IPG PHOTONICS CORPORATION

Strategy: Contrarian Investor
Based on: David Dreman

IPG Photonics Corporation is a developer and manufacturer of a line of fiber lasers, fiber amplifiers, diode lasers, laser systems and optical accessories that are used for various applications. The Company offers a line of lasers and amplifiers, which are used in materials processing, communications and medical applications. The Company sells its products globally to original equipment manufacturers (OEMs), system integrators and end users. The Company's manufacturing facilities are located in the United States, Germany and Russia. The Company offers laser-based systems for certain markets and applications. Its products are designed to be used as general-purpose energy or light sources. Its product line includes High-Power Ytterbium CW (1,000-100,000 Watts), Mid-Power Ytterbium CW (100-999 Watts), Pulsed Ytterbium (0.1 to 200 Watts), Pulsed and CW, Quasi-CW Ytterbium (100-4,500 Watts), Erbium Amplifiers and Transceivers.

MARKET CAP: PASS

Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. IPGP has a market cap of $13,868 million, therefore passing the test.


EARNINGS TREND: PASS

A company should show a rising trend in the reported earnings for the most recent quarters. IPGP's EPS for the past 2 quarters, (from earliest to most recent quarter) 1.91, 2.11 have been increasing, and therefore the company passes this test.


EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: PASS

This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. IPGP passes this test as its EPS growth rate over the past 6 months (52.89%) has beaten that of the S&P (3.94%). IPGP's estimated EPS growth for the current year is (46.80%), which indicates the company is expected to experience positive earnings growth. As a result, IPGP passes this test.


This methodology would utilize four separate criteria to determine if IPGP is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


P/E RATIO: FAIL

The P/E of a company should be in the bottom 20% of the overall market. IPGP's P/E of 37.91, based on trailing 12 month earnings, is higher than the bottom 20% criterion (below 14.36), and therefore fails this test.


PRICE/CASH FLOW (P/CF) RATIO: FAIL

The P/CF of a company should be in the bottom 20% of the overall market. IPGP's P/CF of 32.25 does not meet the bottom 20% criterion (below 7.84), and therefore fails this test.


PRICE/BOOK (P/B) VALUE: FAIL

The P/B value of a company should be in the bottom 20% of the overall market. IPGP's P/B is currently 7.05, which does not meet the bottom 20% criterion (below 1.15), and it therefore fails this test.


PRICE/DIVIDEND (P/D) RATIO: FAIL

The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). IPGP's P/D is not available, and hence an opinion cannot be rendered at this time.


This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


CURRENT RATIO: PASS

A prospective company must have a strong Current Ratio (greater than or equal to the average of it's industry [3.41] or greater than 2). This is one identifier of financially strong companies, according to this methodology. IPGP's current ratio of 9.02 passes the test.


PAYOUT RATIO: PASS

A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for IPGP is 0.00%. Unfortunately, its historical payout ratio is not available. Nonetheless it passes the payout criterion, as this is a very low payout.


RETURN ON EQUITY: PASS

The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 17.38%, and would consider anything over 27% to be staggering. The ROE for IPGP of 21.36% is high enough to pass this criterion.


PRE-TAX PROFIT MARGINS: PASS

This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. IPGP's pre-tax profit margin is 38.38%, thus passing this criterion.


YIELD: FAIL

The company in question should have a yield that is high and that can be maintained or increased. IPGP's current yield is not available (or one is not paid) at the present time, while the market yield is 2.28%. Hence, this criterion cannot be evaluated.


LOOK AT THE TOTAL DEBT/EQUITY: PASS

The company must have a low Debt/Equity ratio, which indicates a strong balance sheet. The Debt/Equity ratio should not be greater than 20% or should be less than the average Debt/Equity for its industry of 47.00%. IPGP's Total Debt/Equity of 2.55% is considered acceptable.

THOR INDUSTRIES, INC.

Strategy: Growth/Value Investor
Based on: James P. O'Shaughnessy

Thor Industries, Inc. manufactures a range of recreational vehicles (RVs) in the United States and sells those vehicles primarily in the United States and Canada. The Company's segments include towable recreational vehicles, which consists of the operations of Airstream, Inc. (Airstream) (towable); Heartland Recreational Vehicles, LLC (Heartland) (including Bison Coach, LLC (Bison), Cruiser RV, LLC (CRV) and DRV, LLC (DRV)); Jayco, Corp. (Jayco) (including Jayco towable, Starcraft and Highland Ridge), Keystone RV Company (Keystone) (including CrossRoads and Dutchmen) and K.Z., Inc. (KZ) (including Livin' Lite RV, Inc. (Livin' Lite)); motorized recreational vehicles, which consists of the operations of Airstream (motorized), Jayco (including Jayco motorized and Entegra Coach) and Thor Motor Coach, Inc. (Thor Motor Coach), and Other, which includes the operations of its subsidiary, Postle Operating, LLC (Postle).


MARKET CAP: PASS

The first requirement of the Cornerstone Growth Strategy is that the company has a market capitalization of at least $150 million. This will screen out the companies that are too illiquid for most investors, but still include a small growth company. THO, with a market cap of $7,980 million, passes this criterion.


EARNINGS PER SHARE PERSISTENCE: PASS

The Cornerstone Growth methodology looks for companies that show persistent earnings growth without regard to magnitude. To fulfill this requirement, a company's earnings must increase each year for a five year period. THO, whose annual EPS before extraordinary items for the last 5 years (from earliest to the most recent fiscal year) were 2.86, 3.29, 3.79, 4.91 and 7.09, passes this test.


PRICE/SALES RATIO: PASS

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy. THO's Price/Sales ratio of 1.03, based on trailing 12 month sales, passes this criterion.


RELATIVE STRENGTH: PASS

The final criterion for the Cornerstone Growth Strategy requires that the Relative Strength of the company be among the top 50 of the stocks screened using the previous criterion. This gives you the opportunity to buy the growth stocks you are searching for just as the market is embracing them. THO, whose relative strength is 80, is in the top 50 and would pass this last criterion.

FOOT LOCKER, INC.

Strategy: Contrarian Investor
Based on: David Dreman

Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates through two segments: Athletic Stores and Direct-to-Customers. The Company is an athletic footwear and apparel retailer, which include businesses, such as include Foot Locker, Kids Foot Locker, Lady Foot Locker, Champs Sports, Footaction, Runners Point, Sidestep and SIX:02. The Direct-to-Customers segment is multi-branded and sells directly to customers through Internet and mobile sites and catalogs. The Direct-to-Customers segment operates the Websites for eastbay.com, final-score.com, eastbayteamsales.com and sp24.com. Additionally, this segment includes the Websites, both desktop and mobile, aligned with the brand names of its store banners (footlocker.com, ladyfootlocker.com, six02.com kidsfootlocker.com, champssports.com, footaction.com, footlocker.ca, footlocker.eu, runnerspoint.com and sidestep-shoes.com).

MARKET CAP: PASS

Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. FL has a market cap of $6,356 million, therefore passing the test.


EARNINGS TREND: PASS

A company should show a rising trend in the reported earnings for the most recent quarters. FL's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.39, 0.81 have been increasing, and therefore the company passes this test.


EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: FAIL

This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. FL fails this test as its EPS growth rate for the past 6 months (-40.44%) does not beat that of the S&P (3.94%).


This methodology would utilize four separate criteria to determine if FL is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


P/E RATIO: PASS

The P/E of a company should be in the bottom 20% of the overall market. FL's P/E of 13.21, based on trailing 12 month earnings, meets the bottom 20% criterion (below 14.36), and therefore passes this test.


PRICE/CASH FLOW (P/CF) RATIO: FAIL

The P/CF of a company should be in the bottom 20% of the overall market. FL's P/CF of 9.22 does not meet the bottom 20% criterion (below 7.84), and therefore fails this test.


PRICE/BOOK (P/B) VALUE: FAIL

The P/B value of a company should be in the bottom 20% of the overall market. FL's P/B is currently 2.42, which does not meet the bottom 20% criterion (below 1.15), and it therefore fails this test.


PRICE/DIVIDEND (P/D) RATIO: FAIL

The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). FL's P/D of 42.19 does not meet the bottom 20% criterion (below 20.92), and it therefore fails this test.


This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


CURRENT RATIO: PASS

A prospective company must have a strong Current Ratio (greater than or equal to the average of it's industry [2.38] or greater than 2). This is one identifier of financially strong companies, according to this methodology. FL's current ratio of 4.41 passes the test.


PAYOUT RATIO: FAIL

A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for FL is 29.88%, while its historical payout ratio has been 24.97%. Therefore, it fails the payout criterion.


RETURN ON EQUITY: PASS

The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 17.38%, and would consider anything over 27% to be staggering. The ROE for FL of 19.74% is high enough to pass this criterion.


PRE-TAX PROFIT MARGINS: PASS

This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. FL's pre-tax profit margin is 10.14%, thus passing this criterion.


YIELD: FAIL

The company in question should have a yield that is high and that can be maintained or increased. FL's current yield is 2.37%, while the market yield is 2.28%. FL fails this test.


LOOK AT THE TOTAL DEBT/EQUITY: PASS

The company must have a low Debt/Equity ratio, which indicates a strong balance sheet. The Debt/Equity ratio should not be greater than 20% or should be less than the average Debt/Equity for its industry of 57.50%. FL's Total Debt/Equity of 4.74% is considered acceptable.

SIGNET JEWELERS LTD.

Strategy: P/E/Growth Investor
Based on: Peter Lynch

Signet Jewelers Limited is a retailer of diamond jewelry. The Company's segments include the Sterling Jewelers division; the Zale division, which consists of the Zale Jewelry and Piercing Pagoda segments; the UK Jewelry division, and Other. The Sterling Jewelers division's stores operate in the United States principally as Kay Jewelers (Kay), Kay Jewelers Outlet, Jared The Galleria Of Jewelry (Jared) and Jared Vault. The Zale division operates jewelry stores (Zale Jewelry) and kiosks (Piercing Pagoda), located primarily in shopping malls across the United States, Canada and Puerto Rico. Zale Jewelry includes the United States store brand, Zales, and the Canadian store brand, Peoples Jewellers. Piercing Pagoda operates through mall-based kiosks. The UK Jewelry division operates stores in the United Kingdom, Republic of Ireland and Channel Islands. The Other segment includes the operations of subsidiaries involved in the purchasing and conversion of rough diamonds to polished stones.


DETERMINE THE CLASSIFICATION:

SIG is considered a "True Stalwart", according to this methodology, as its earnings growth of 13.45% lies within a moderate 10%-19% range and its annual sales of $6,230 million are greater than the multi billion dollar level. This methodology looks for the "Stalwart" securities to gain 30%-50% in value over a two year period if they can be purchased at an attractive price based on the P/E to Growth ratio. SIG is attractive if SIG can hold its own during a recession.


YIELD ADJUSTED P/E TO GROWTH (PEG) RATIO: PASS

The Yield-adjusted P/E/G ratio for SIG (0.61), based on the average of the 3, 4 and 5 year historical eps growth rates, is O.K.


EARNINGS PER SHARE: PASS

The EPS for a stalwart company must be positive. SIG's EPS ($5.76) would satisfy this criterion.


TOTAL DEBT/EQUITY RATIO: PASS

This methodology would consider the Debt/Equity ratio for SIG (35.92%) to be normal (equity is approximately twice debt).


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for SIG (7.72%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for SIG (-18.20%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

COOPER TIRE & RUBBER CO

Strategy: Growth Investor
Based on: Martin Zweig

Cooper Tire & Rubber Company is a manufacturer and marketer of replacement tires. The Company specializes in the design, manufacture, marketing and sales of passenger car, light truck, medium truck, motorcycle, and racing tires. The Company operates through four segments: North America, Latin America, Europe, and Asia. The North America segment comprises its operations in the United States and Canada. The Americas Tire Operations segment manufactures and markets passenger car and light truck tires, for sale in the United States replacement markets. The Latin America segment comprises its operations in Mexico, Central America, and South America. The European segment has operations in the United Kingdom and the Republic of Serbia. Its the United Kingdom entity manufactures and markets passenger car, light truck, motorcycle and racing tires and tire retread material. As of December 31, 2016, the Company operated nine manufacturing facilities and 20 distribution centers in 10 countries.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. CTB's P/E is 9.96, based on trailing 12 month earnings, while the current market PE is 28.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: FAIL

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. CTB's revenue growth is -5.38%, while it's earnings growth rate is 15.38%, based on the average of the 3, 4 and 5 year historical eps growth rates. Therefore, CTB fails this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (-2.3%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (-2.6%) of the current year. Sales growth for the prior must be greater than the latter. For CTB this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. CTB's EPS ($1.18) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. CTB's EPS for this quarter last year ($0.90) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. CTB's growth rate of 31.11% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: FAIL

Compare the earnings growth rate of the past four quarters with long-term EPS growth rate. Earnings growth in the past 4 quarters should be at least half of the long-term EPS growth rate. A stock should not be considered if it posted several quarters of skimpy earnings. CTB had 2 quarters of skimpy growth in the last 2 years.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, -19.64%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 31.11%, (versus the same quarter one year ago) then the stock passes.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: PASS

The EPS growth rate for the current quarter, 31.11% must be greater than or equal to the historical growth which is 15.38%. CTB would therefore pass this test.


EARNINGS PERSISTENCE: FAIL

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. CTB, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 3.49, 1.73, 3.42, 3.69, and 4.51, fails this test.


LONG-TERM EPS GROWTH: PASS

One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. CTB's long-term growth rate of 15.38%, based on the average of the 3, 4 and 5 year historical eps growth rates, passes this test.


TOTAL DEBT/EQUITY RATIO: PASS

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. CTB's Debt/Equity (28.43%) is not considered high relative to its industry (59.55%) and passes this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For CTB, this criterion has not been met (insider sell transactions are 159, while insiders buying number 276). Despite the lack of an insider buy signal, there also is not an insider sell signal, so the stock passes this criterion.

UNITED THERAPEUTICS CORPORATION

Strategy: P/E/Growth Investor
Based on: Peter Lynch

United Therapeutics Corporation is a biotechnology company. The Company is focused on the development and commercialization of products for the treatment of chronic and life-threatening conditions. The Company markets and sells four commercial therapies in the United States to treat pulmonary arterial hypertension (PAH): Remodulin (treprostinil) Injection; Tyvaso (treprostinil) Inhalation Solution (Tyvaso); Orenitram (treprostinil) Extended-Release Tablets (Orenitram); and Adcirca (tadalafil) Tablets (Adcirca). The Company markets and sells an oncology product in the United States, Unituxin (dinutuximab) Injection (Unituxin), which is approved for treatment of neuroblastoma. The Company is also engaged in early-stage research and development of a number of organ transplantation-related technologies.


DETERMINE THE CLASSIFICATION:

This methodology would consider UTHR a "fast-grower".


P/E/GROWTH RATIO: PASS

The investor should examine the P/E (12.20) relative to the growth rate (42.31%), based on the average of the 3, 4 and 5 year historical eps growth rates, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for UTHR (0.29) is very favorable.


SALES AND P/E RATIO: PASS

For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth high enough to support a P/E above this threshold. UTHR, whose sales are $1,669.6 million, needs to have a P/E below 40 to pass this criterion. UTHR's P/E of (12.20) is considered acceptable.


INVENTORY TO SALES: PASS

When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for UTHR was 5.55% last year, while for this year it is 6.25%. Since inventory has been rising, this methodology would not look favorably at the stock but would not completely eliminate it from consideration as the inventory increase (0.71%) is below 5%.


EPS GROWTH RATE: PASS

This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for UTHR is 42.3%, based on the average of the 3, 4 and 5 year historical eps growth rates, which is considered 'OK'. However, it may be difficult to sustain such a high growth rate.


TOTAL DEBT/EQUITY RATIO: PASS

This methodology would consider the Debt/Equity ratio for UTHR (11.97%) to be acceptable (equity is three to ten times debt). This ratio is one quick way to determine the financial strength of the company.


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for UTHR (9.27%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for UTHR (17.25%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

NETEASE INC (ADR)

Strategy: Contrarian Investor
Based on: David Dreman

NetEase, Inc. (NetEase) is a technology company. The Company operates an interactive online community in China and is a provider of Chinese language content and services through its online games, Internet media, e-mail, e-commerce and other businesses. The Company operates through three segments: Online Game Services; Advertising Services, and E-mail, E-commerce and Others. Its online games business primarily focuses on offering personal computer (PC)-client massively multi-player online role-playing games (PC-client MMORPGs), as well as mobile games to the Chinese market. The NetEase Websites provide Internet users with Chinese language online services centered over three core service categories, which include content, community and communication. Its online advertising offerings include banner advertising, direct e-mail, sponsored special events, games, contests and other activities. It offers free and fee-based premium e-mail services to its individual users and corporate users.

MARKET CAP: PASS

Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. NTES has a market cap of $43,539 million, therefore passing the test.


EARNINGS TREND: PASS

A company should show a rising trend in the reported earnings for the most recent quarters. NTES's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.12, 3.01 have been increasing, and therefore the company passes this test.


EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: PASS

This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. NTES passes this test as its EPS growth rate over the past 6 months (2,050.00%) has beaten that of the S&P (3.94%). NTES's estimated EPS growth for the current year is (16,050.91%), which indicates the company is expected to experience positive earnings growth. As a result, NTES passes this test.


This methodology would utilize four separate criteria to determine if NTES is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


P/E RATIO: FAIL

The P/E of a company should be in the bottom 20% of the overall market. NTES's P/E of 21.08, based on trailing 12 month earnings, is higher than the bottom 20% criterion (below 14.36), and therefore fails this test.


PRICE/CASH FLOW (P/CF) RATIO: FAIL

The P/CF of a company should be in the bottom 20% of the overall market. NTES's P/CF of 19.82 does not meet the bottom 20% criterion (below 7.84), and therefore fails this test.


PRICE/BOOK (P/B) VALUE: FAIL

The P/B value of a company should be in the bottom 20% of the overall market. NTES's P/B is currently 6.08, which does not meet the bottom 20% criterion (below 1.15), and it therefore fails this test.


PRICE/DIVIDEND (P/D) RATIO: FAIL

The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). NTES's P/D of 90.91 does not meet the bottom 20% criterion (below 20.92), and it therefore fails this test.


This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


CURRENT RATIO: PASS

A prospective company must have a strong Current Ratio (greater than or equal to the average of it's industry [1.43] or greater than 2). This is one identifier of financially strong companies, according to this methodology. NTES's current ratio of 2.93 passes the test.


PAYOUT RATIO: PASS

A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for NTES is 19.43%, while its historical payout ratio has been 63.00%. Therefore, it passes the payout criterion.


RETURN ON EQUITY: PASS

The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 17.38%, and would consider anything over 27% to be staggering. The ROE for NTES of 32.76% is high enough to pass this criterion.


PRE-TAX PROFIT MARGINS: PASS

This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. NTES's pre-tax profit margin is 31.04%, thus passing this criterion.


YIELD: FAIL

The company in question should have a yield that is high and that can be maintained or increased. NTES's current yield is 1.10%, while the market yield is 2.28%. NTES fails this test.


LOOK AT THE TOTAL DEBT/EQUITY: PASS

The company must have a low Debt/Equity ratio, which indicates a strong balance sheet. The Debt/Equity ratio should not be greater than 20% or should be less than the average Debt/Equity for its industry of 99.81%. NTES's Total Debt/Equity of 12.74% is considered acceptable.

TOLL BROTHERS INC

Strategy: P/E/Growth Investor
Based on: Peter Lynch

Toll Brothers, Inc. is engaged in designing, building, marketing, selling and arranging financing for detached and attached homes in luxury residential communities. The Company operates through two segments: Traditional Home Building and Toll Brothers City Living (City Living). Within the Traditional Home Building segment, it operates in five geographic segments in the United States: the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey and New York; the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania and Virginia; the South, consisting of Florida, North Carolina and Texas; the West, consisting of Arizona, Colorado, Nevada and Washington, and California. City Living is the Company's urban development division. Its products include Traditional Home Building Product and City Living Product. Its Traditional Home Building Product includes detached homes, move-up, executive, estate, and active-adult and age-qualified lines of home.


DETERMINE THE CLASSIFICATION:

TOL is considered a "True Stalwart", according to this methodology, as its earnings growth of 18.73% lies within a moderate 10%-19% range and its annual sales of $5,815 million are greater than the multi billion dollar level. This methodology looks for the "Stalwart" securities to gain 30%-50% in value over a two year period if they can be purchased at an attractive price based on the P/E to Growth ratio. TOL is attractive if TOL can hold its own during a recession.


INVENTORY TO SALES: PASS

When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for TOL was 142.26% last year, while for this year it is 125.22%. Since inventory to sales has decreased from last year by -17.04%, TOL passes this test.


YIELD ADJUSTED P/E TO GROWTH (PEG) RATIO: PASS

The Yield-adjusted P/E/G ratio for TOL (0.81), based on the average of the 3, 4 and 5 year historical eps growth rates, is O.K.


EARNINGS PER SHARE: PASS

The EPS for a stalwart company must be positive. TOL's EPS ($3.18) would satisfy this criterion.


TOTAL DEBT/EQUITY RATIO: PASS

This methodology would consider the Debt/Equity ratio for TOL (71.06%) to be mediocre. If the Debt/Equity ratio is this high, the other ratios and financial statistics for TOL should be good enough to compensate.


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for TOL (10.58%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for TOL (-30.57%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

PETMED EXPRESS INC

Strategy: Patient Investor
Based on: Warren Buffett

PetMed Express, Inc. (PetMed Express), doing business as 1800PetMeds, is a pet pharmacy. The Company markets prescription and non-prescription pet medications, and other health products for dogs and cats, direct to the consumer. It offers a selection of products for dogs and cats. Its product line contains approximately 3,000 stock keeping units (SKUS) of pet medications, health products and supplies. Its products include brands of medication, such as Frontline Plus, K9 Advantix II, Advantage II, Heartgard Plus, Sentinel, Revolution and Rimadyl. It also offers additional pet supplies for sale on its Website, which are drop shipped to its customers by third parties. These pet supplies include food, beds, crates, stairs, strollers and other pet supplies. Its products included Non-Prescription Medications (Over the Counter (OTC)) and supplies, and Prescription Medications (Rx). Its customers are located in California, Florida, Texas, New York, Virginia and Georgia, among others.

STAGE 1: "Is this a Buffett type company?"

A bedrock principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers. While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.


LOOK FOR EARNINGS PREDICTABILITY: PASS

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 0.82, 0.98, 1.14, 0.92, 0.80, 0.86, 0.90, 0.87, 1.01, 1.17. Buffett would consider PETS's earnings predictable, although earnings have declined 3 time(s) in the past seven years, with the most recent decline 3 years ago. The dips have totaled 35.7%. PETS's long term historical EPS growth rate is 6.9%, based on the 10 year average EPS growth rate.


LOOK AT THE ABILITY TO PAY OFF DEBT PASS

Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. PETS has no long term debt and therefore would pass this criterion.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY: PASS

Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for PETS, over the last ten years, is 25.5%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 29.2%, 29.6%, 27.1%, 21.2%, 20.1%, 28.2%, 25.8%, 23.3%, 25.0%, 25.7%, and the average ROE over the last 3 years is 24.6%, thus passing this criterion.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON TOTAL CAPITAL: PASS

Because some companies can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. To screen this out, for non-financial companies Buffett also requires that the average Return On Total Capital (ROTC) be at least 12% and consistent. In addition, the average ROTC over the last 3 years must also exceed 12%. Return On Total Capital is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for PETS, over the last ten years, is 25.5% and the average ROTC over the past 3 years is 24.6%, which is high enough to pass. It is not enough that the average be at least 12%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROTC must be at least 9% for Buffett to feel comfortable that the ROTC is consistent. The ROTC for the last 10 years, from earliest to latest, is 29.2%, 29.6%, 27.1%, 21.2%, 20.1%, 28.2%, 25.8%, 23.3%, 25.0%, 25.7%, thus passing this criterion.


LOOK AT CAPITAL EXPENDITURES: PASS

Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. PETS's free cash flow per share of $1.03 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.


LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS: FAIL

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $4.78 and compares it to the gain in EPS over the same period of $0.35. PETS's management has earned shareholders a 7.3% return on the earnings they kept. This is unacceptable to Buffett, as management is not profitably allocating retained earnings. Essentially, investors would be better off if the company paid all earnings out to shareholders and let them invest the earnings on their own.


HAS THE COMPANY BEEN BUYING BACK SHARES: BONUS PASS

Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. PETS's shares outstanding have fallen over the past five years from 21,110,001 to 20,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.

The preceding concludes Buffett's qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate PETS quantitatively.

STAGE 2: "Should I buy at this price?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.


CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]

Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $1.69 and divide it by the current market price of $46.03. An investor, purchasing PETS, could expect to receive a 3.67% initial rate of return. Furthermore, he or she could expect the rate to increase 6.9% per year, based on the 10 year average EPS growth rate, as this is how fast earnings are growing.


COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: PASS

Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 2.25%. Compare this with PETS's initial yield of 3.67%, which will expand at an annual rate of 6.9%, based on the 10 year average EPS growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.


CALCULATE THE FUTURE EPS: [No Pass/Fail]

PETS currently has a book value of $5.34. It is safe to say that if PETS can preserve its average rate of return on equity of 24.6% and continues to retain 42.81% of its earnings, it will be able to sustain an earnings growth rate of 10.6% and it will have a book value of $14.56 in ten years. If it can still earn 24.6% on equity in ten years, then expected EPS will be $3.59.


CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now take the expected future EPS of $3.59 and multiply them by the lower of the 5 year average P/E ratio or current P/E ratio (27.2) (5 year average P/E in this case), which is 16.9 and you get PETS's projected future stock price of $60.79.


CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now add in the total expected dividend pool to be paid over the next ten years, which is $14.21. This gives you a total dollar amount of $75.00. These numbers indicate that one could expect to make a 5.0% average annual return on PETS's stock at the present time. The return is unacceptable to Buffett.


CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]

If you take the EPS growth of 6.9%, based on the 10 year average EPS growth rate, you can project EPS in ten years to be $3.30. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio or current P/E ratio (27.2) (5 year average P/E in this case), which is 16.9. This equals the future stock price of $55.83. Add in the total expected dividend pool of $14.21 to get a total dollar amount of $70.04.


CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]

Now you can figure out your expected return based on a current price of $46.03 and the future expected stock price, including the dividend pool, of $70.04. If you were to invest in PETS at this time, you could expect a 4.29% average annual return on your money. Buffett likes to see a 15% return, and would even go down to 12%.


LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: FAIL

Based on the two different methods, you could expect an annual compounding rate of return somewhere between 4.3% and 5.0%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 4.6% on PETS stock for the next ten years, based on the current fundamentals. Buffett accepts a 12% return, although 15% is preferable. This return is unacceptable to Buffett, thus failing the criterion.


Watch List

The top scoring stocks not currently in the Hot List portfolio.

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Score
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PFG PRINCIPAL FINANCIAL GROUP INC 59%
MAN MANPOWERGROUP INC. 58%
HIBB HIBBETT SPORTS, INC. 56%
AGX ARGAN, INC. 56%
KORS MICHAEL KORS HOLDINGS LTD 54%
CBG CBRE GROUP INC 52%
MCK MCKESSON CORPORATION 52%



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