 Dave Neverson and team in spirited debate We asked the team to select a list of their favorite stocks that they wanted to invest in. As you would expect the list included the makers of those products that the kids use on a regular basis. The usual suspects: Microsoft, Sony, and Apple Computer. One company I had not heard of which was popular with the kids was GameStop. We eventually whittled the list down to three stocks – Apple, and GameStop, and Phoenix Companies.
The following table highlights the fundamentals of the stocks chosen by the team. We did not perform fundamentals on Phoenix Companies because the investment was made so close to its quarterly earnings being announced and therefore, may not be as meaningful.
| | | Apple
Computer | GameStop | | | Ticker | | AAPL | GME | | | Current Stock Price (8/18/06) | $67.91 | $44.43 | | | | YTD Change | (11.0%) | 15.3% | | | Earnings per Share: | | | | | | 2005 | $1.44 | $1.76 | | | | 2006E | $2.15 | $2.01 | | | Price / Earnings Ratio | | | | | | 2005 | 47.2x | 25.2x | | | | 2006E | 31.6x | 22.1x | | Three Year EPS CAGR
(2003-2005) | 316.3% | 23.2% | | | 2005 Sales (in millions) | $13,931 | $3,092 | | | | Y-O-Y Growth | 68.3% | 67.8% | |
We held a few investment meetings with the kids where board member, David Neverson, handed out several research reports on each stock and we discussed the importance of understanding (i) the ticker symbol, (ii) stock price and (iii) earnings per share. We also reviewed how to professional investors look at the fundamentals of investments in order to determine whether an investment makes sense financially, as well as from a common sense perspective. The fundamentals we focused on were price-to-earnings ratio ("P/E ratio" or "P/E multiple") and earnings growth rate. FundamentalsPrice-to-earnings Ratio
A stock's price to earnings ratio is literally its share price divided by its earnings per share. It is one measurement as to how cheap or expensive a stock is. All things being equal between two stocks (the industry they compete in, expected earnings growth rate, etc.), a higher P/E ratio would reflect that a stock is more expensive than the other, and vice versa. A perfect analogy would be that if two professional basketball players had the same off-court image and same statistics, i.e. points, rebounds, assists, and steals, you would expect them to make the same salary. If not, an industry expert would consider the player with the higher salary to be "overpaid" or to have a "rich" contract.
Earnings Growth Rate
A company's earnings belong to the shareholders. That said, it is only common sense to think that if Company One's earnings are expected to grow faster than Company Two's earnings then Company One (and its earnings stream) would be more valuable than that of Company Two. This "upside potential" may also explain why two professional basketball players with the same stats today may have two different contracts.
Let's assume that Player One and Player Two both average 18/ppg today. However, Player One's point production by year five of his contract is expected to grow to 30/ppg versus 22/ppg for Player Two. It would make sense that Player One's team (assuming equal talent around both players) would win more games, sell more season tickets, sell more popcorn, sell more apparel, and make more money. That said, a team owner should be willing to offer a higher contract to Player One than to Player Two.
As a rule of thumb, there should be a strong correlation between a stock's P/E multiple and its expected earnings growth. For instance, if a stock's expected earnings growth rate is 25% then it should trade at around 25 times earnings/share at a P/E ratio of 25. In the above example, Apple and GameStop trade at a multiple of 2006 expected earnings ("2006E") of 31.6x and 22.1x, respectively. On the surface, this type of "bottoms up" analysis would imply that Apple is more expensive than GameStop. However, the three year compound annual growth rate ("CAGR") in the earnings of Apple is 316.3% versus 23.2% for GameStop, implying that the differential in the P/E ratios for the two companies may be justified.
Obviously the CAGR in Apple's earnings is an anomaly and may be due to some "noise" in its historical earnings which may be causing the growth rate to be faulty or unrealistic. However, the 23.2% earnings growth rate for GameStop seems to correlate pretty strongly to the its P/E multiple of 22.1x earnings, reinforcing the rule of thumb mentioned earlier. Overall, assuming past is prolong for growth in earnings of Apple and GameStop, common sense tells me that investors have done their homework in awarding Apple a higher P/E multiple versus that of GameStop. Due DiligenceApple (Recommended by Ralphie Baker III)
We all know that Apple makes interesting computers but the kids are interested in Apple more for its coolest product, the iPod. Personally, I am overloaded with technology. I have a cell phone, stereo, digital television, camcorder, a VCR and a blackberry that I use at about 70% of their technological capacity. I just do not have time to read each manual thoroughly and the cost (time and efforts) to master the other 30% is just not worth it to me. I do not own an iPod so the kids and Mr. Neverson had to educate me.
What the Kids Say
The iPod digitally stores the music in some type of MP3 file. Apple also has iTunes which is a music store/music organizer. iTunes stores your music library and you can create play lists and another part connects to the internet with Apple’s internet store where you can download music, music videos, television shows and podcasts. So it involves two different types of medium – music and videos. We understand that the MP3 software is needed in order convert the music into MP3 format.
Apple decided to leverage the MP3 format to download music and the Company continues to add additional services such video.
The iPod has become a status symbol and you are an "outlier" if you do not own one. Everyday on the train you will see a person with an iPod. One player said the iPod was so addictive that his mother takes it into the shower with her, which was a little too much information.
The iPod is so easy to use that it takes about 30 minutes to an hour to figure out everything that you need to know in terms of using it.
Competitors
Dell, Creative Zen, Sandisk have tried to compete with the iPod to no avail. Nothing has really come close to competing with the iPod. The product's platform has become so user friendly and is so technologically advanced that it is cool to have one. It also cuts across racial lines and ages where people of all ages use the iPod on a regular basis.
Risks
Microsoft . . . period. The kids and I had an interesting debate about the power of Microsoft. I relayed the story of how Microsoft practically ran competing products such as the Macintosh operating system, lotus, etc. out of business by gaining market share with its own competing products (MS-DOS and excel). In economics there is a term called "network externalities" which implies that when a user joins a network such as Microsoft’s operating system, the power of that next user is not linear but exponential (I’m showing off). Microsoft eventually set the standard and customers eventually decided there was no need to buy competing products. I posed the question as to whether Microsoft could do the same with the iPod.
The kids and the precocious Mr. Neverson acknowledged that Microsoft has committed to entering the market using the product. However, they countered that Microsoft does not have stores to sell the product or educate consumers.
Furthermore, the only downside they saw about the iPod was that you had to send it to the store to change the battery. You cannot buy batteries just anywhere, which I found interesting.
Gamestop (Recommended by Alexander Williams)
I had never heard of GameStop until Christmas of 2005. I took my son and my nephew to the Tysons Corner mall in Northern, VA to buy my nephew a Christmas present. We walked around for about 30 minutes when they saw GameStop and immediately started running and screaming. My nephew wanted a video game (seemingly only from GameStop) because according to him, GameStop had the best selection.
When I told them that I had never heard of GameStop, the boys looked at me as if I was from planet Mars. What I observed was that it was not enough for my nephew to tell his friends that he got a cool game for Christmas, but he had to say he purchased it from GameStop. This past summer when Alexander Williams suggested we invest in GameStop, trust me, he did not have to tell me twice.
What the Kids Say
GameStop has the potential to grow, so there is more upside with earnings and potentially the stock.
Recently GameStop and EB ("Electronics Boutique") Games merged to become the largest video game store in the country. I was actually surprised that they knew this, but one of the kids said that on a recent visit to GameStop a salesperson said they were also affiliated with EB Games.
Electronics Boutique made its name selling used games. They created an aftermarket for games by buying and selling used games.
Competition
Best Buy, Target, and Circuit City sell video games as well. But the best quality and selection is at GameStop. One player even said that "I went to the PC section of one store (no name indicated) and the box to the game was ripped open. I also had to take some games back because they did not work. Only once did I have to take a game back to GameStop because of a malfunction, but the game was used."
Also GameStop and Electronics Boutique specialize in games. The salespeople are very knowledgeable and actually use the product, while the salespeople at Target and Wal-Mart are not as knowledgeable.
Risks
Comparable store sales decline or stock gets discovered and becomes overvalued.
Phoenix Companies, Inc. (Recommended by Coach Baker)
Phoenix Companies, Inc. (ticker: PNX) provides life insurance, annuities and asset management products. It distributes its products mainly through financial planners, banks, and broker-dealers. Many think that the life insurance sector is attractive and may be a seller's market given (i) the number of acquisitive strategic buyers and (ii) the amount of capital pouring into private equity firms with an appetite for insurance. The private market valuation may lend a "floor" to the stock over the long-term.
What the Kids Say
"Whatever you say coach."
Competition
A plethora of life insurance companies.
Risks
The favorable changes being implemented by management may not be immediately reflected in the stock price.
Results of the FundSince September 2006 (two months), the fund is up approximately 8.5%. In particular, Apple is up 17.5% and GameStop is up 15.7%. As far as the return on Phoenix, Mr. Baker had no comment other than to say "It’s still early".
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