Avista provides case study to learn the art of investing

Avista closed Nov. 15 at $46.96. What does that tell us?

Not much.

The only thing one can learn from a stock price — and forgive me if this sounds flip — is how much one share costs. On its own, the stock’s price offers no additional information. It is, at best, just data. A stock price is not intelligence, and that’s what you need to choose the right stocks for you.

Investors determine the current price of all stocks by buying and selling. If, tomorrow, you and I put in orders to buy Avista shares at $70, the market would immediately rise to that price. It’d remain there as long as we had enough money to keep buying. (Or until we got into hot water for colluding to fix prices, which is a no-no.) The point to remember is sellers get the best available price; buyers get the lowest available offer. That’s the way the market works.

But it’s not the way the market starts.

A stock’s price is initially set by investment bankers, who arrange stock sales for companies. A company seeking to raise $1 billion, for example, theoretically could sell 1,000 shares for a $1 million apiece — but people might be leery of such a giant price tag. At the other end of the spectrum, the company could opt to sell a billion shares for a buck apiece — but people might think that price is too low. The trick is to find a price that “seems” right, though the two numbers being multiplied together really don’t matter as long as the result hits the target. The past 50 new offerings of stock had an issue price of less than $50. The average offering price of the 10 most-recent initial public offerings of stock — which comprised $1.3 billion worth of investor capital — was $11.60. (See chart.)

Those are fun facts. But those stock prices and every other must be contextualized if they are to mean anything useful.

Today, we’ll look at two common investment perspectives, growth investing and income investing. Using such a mental framework can help you elevate market data like price into actionable investment intelligence you can use to make decisions for your portfolio.

GROWTH

Growth investors want companies with hot businesses. They make money buying them low and selling them high, pocketing the difference. These trades typically have multiyear holding periods. Growth investors are obsessed owning these enterprises as they increase revenue and earnings. They use this data to contextualize stock prices. Remember: Price is what you pay. Value is what you get.

One tool for gauging the value of growth is the price-to-earnings ratio, which is share price divided by per-share earnings for the past 12 months. These ratios smooth out the arbitrary differences in stock price and provide an apples-to-apples basis for comparison to the overall market, to the company’s sector, its peer group and, lastly, to itself.

Earnings multiples, referred to generally as “valuation” change over time based on prevailing market sentiment. Earnings multiples tend to rise in bull markets and fall in bear markets.

Avista’s stock price is $47.77. Its trailing 12-month earnings (the most recent four quarters) add up to $2.99. To determine the P/E, take $47.77 and divide by $2.99, which is 15.98.

Avista’s stock price is equal to about 16 times its earnings. The S&P 500 Index, to provide a bit more context, is trading at 22.5 times earnings.

What does the ratio mean? The higher the P/E, the greater the market’s expectation for future earnings growth. Companies with low or no growth have low P/E ratios, and vice versa. Think of the P/E ratio as the price investors must pay for a dollar of future earnings. A dollar of Avista earnings costs $16. A dollar of S&P 500 earnings is a little pricier, at $22.50.

Isn’t a dollar of earnings from one company pretty much the same as a dollar of earnings at another? No.

Consider: A dollar of earnings at current market disruptor Shake Shack, on the other hand, commands $94. Why? Because the market it competes in — restaurants — can absorb almost unlimited growth. For the past few years, Shake Shack has added $100 million a year to its annual revenue — and has, so far, maintained reasonable profitability even as its focus is on expanding its national footprint. A growth investors doesn’t look at a stock for what it has done, she focuses on what it will do in the future. That’s where all profits live. (We’ll take a look at how that could play out in a moment.)

Companies in some sort of trouble often see their valuation sag, both relative to their peers and to their own previous valuation. But be careful: There’s no magic formula with P/E ratios that always works to find winners. Investing offers no guarantees. The P/E ratio is just one tool that can be used to evaluate price.

HOW TO BEST USE THE P/E: Keep things simple. If a stock’s earnings multiple is lower than the composite price-to-earnings ratio of the Standard & Poor’s 500 Index, then it’s not a growth stock. That’s not good or bad, it’s just a way to classify a potential investment.

In this case, Avista misses the cut. Had it not, we’d have wanted to add detail to the picture with some further context.

Let’s take a look at the other arrows in the growth investor’s quiver.

• The business case

Growth investors crave compelling stories. Their Holy Grail is some sort of white-hot catalyst that will supercharge the company’s performance. The prototype for such a catalyst is the iPhone, which propelled Apple shares into the stratosphere and turned hordes of stockholders into millionaires. (Apple is today worth more than a trillion smackers.) Growth investors clamor for hit products and services. They’re fascinated by the prospect of The Next Big Thing. Their favorite type of real estate is the ground floor.

Learning about a company takes a lot of work. It takes time and patience to truly understand a company from an owner’s perspective.

Start with the business press. Fortune, Barron’s and Bloomberg are great places to find the sorts of stories that growth investors crave. Your broker likely will have its own research as well as third-party research reports. Make sure you note the difference between fundamental information about the company’s business (which you want) and technical analysis, which you do not.

Investors seeking a greater level of detail can turn to subscription-based services like FactSet, YCharts or ValueLine, which can help cut through the noise and focus on the most important information. Prepare to pay handsomely for it — though do check with your library about what resources it has.

Finally, take a read through the company’s latest 10-K filing with the Securities and Exchange Commission. Companies are obligated to tell the SEC pretty much everything, and this is where the financial press gets its information. Smart investors skip the middleman and keep an eye on SEC filings — they can be dry, stick to the discussion of the company’s business and the section where management goes over earnings. Investors willing to pore over SEC filings usually also listen in on their companies’ conference calls with Wall Street analysts, which you can find on most public companies’ investor relations web sites.

HOW TO GET THE MOST FROM BUSINESS RESEARCH: Maintain healthy skepticism — prosecute every word, parse every sentence. Investors are wise to reject hype, embrace smart analytics, pursue hyperrationality and constantly evaluate whether company information passes the sniff test.

One example to watch for: Drug companies. Every new drug sounds like the greatest thing since sliced bread. I’ve heard hundreds of reports on promising new drugs and the fact is I wanted to buy every one of them. But what are the odds of actually finding the company working on the next Lipitor-like blockbuster? Not so hot.

Consider: There are, the Pharmaceutical Research and Manufacturers of America says, 7,000 drugs in various stages of clinical development in the United States. Last year, the Food and Drug Administration approved 59 of them for sale.

Note the theme: Context is key.

• Revenue and earnings trends.

Public companies report their results on a standardized document that details profit or loss. This is the only financial document growth investors really care about: They leave the balance sheet to value investors and the cash-flow statement to the income folks. The top line of the income statement is revenue. Growth investors like to see it grow each quarter and each year. Their motto: Keep the top line on the upswing and everything else will take care of itself.

Ideally, revenue and earnings should move — if to varying degree — pretty much in tandem. These might look like just numbers, but smart analysts use them to gauge managerial effectiveness. As revenue rises, so should earnings. Strong operators, in fact, manage to increase revenue while cutting costs, which juices results nicely over time.

HOW TO GET THE MOST OUT OF THESE TRENDS: Growth trends should be glaringly obvious. Don’t try to persuade yourself. If a company isn’t showing growth, don’t force it. Assess revenue expansion by comparing the company to its peers. Growth companies should be winners. Don’t settle.

• Insider transactions.

Company executive and others with access to sensitive company information are referred to as “insiders.” They’re legally required to inform regulators when they buy or sell shares in the company. Growth investors like to peruse this data to see who’s buying. After all, who knows better than the people who work there how well the company is really doing? These are reported to the SEC, and you can search there, or you can look at sources that aggregate that information — Yahoo Finance is one good option among many.

About 1.1% of Avista’s 66.1 million shares are held by company insiders, which pales in comparison to the 78% of shares that are held by institutions like mutual funds, pension plans and endowments. So far this year, Avista insiders have been selling Avista shares, not buying them. The last purchases reported to the SEC were in October 2017.

HOW TO USE INSIDER DATA: Keep an eye on patterns. If you see what looks like a lot of buying, put it in — wait for it — the right context. Many executives collect the majority of their compensation through stock options, which give them the right to buy stock at a certain price during a certain period of time. When they exercise these options, it looks like they’re buying and selling — because they are — but it might be something that’s happening on autopilot rather than by design.

We can see that a lot of Avista folks exercised options two years ago and bought shares for about 30 cents a piece. As a rule, options grants must be held for a certain period before they can be sold.

Bottom line: Don’t read too much into insider transactions without asking yourself what you would do in the same situation. If you were allowed to buy 1,000 (or, in some cases, 50,000) shares for $0.30 each, wouldn’t you sell them for $46 the first day you could? Me, too. This is what you’re most likely to run into.

But not always, which is why it’s worth checking. When you see irregular, heavy buying from insiders for any stock in the bottom half of its 52-week range, it might be worthwhile to look into why. Remember: Money always goes where it is treated best.

• Analyst’s expectations

You might think your financial adviser sits down and carefully chooses your investments so as to maximize your return. And she well might. But what’s more likely is a Monte Carlo simulation.

This is going to take a lot of magic out of the market, but it’s something you should know about. Am I suggesting that your trusted adviser is playing games with your hard-earned moolah? Well, in a sense, yes. Absolutely.

It works like this: Your adviser has you complete a questionnaire to determine your risk profile. The answers are fed into a computer along with your age, family status and account balance. You might also be asked to outline some general financial goals. With this information, your adviser in the office down the street knows where you are starting and where you want to end up. This gives the adviser a sense of what kind of return you’re after.

At the same time in offices in New York and elsewhere, your brokerage firm’s research department is looking at what stocks are available and how they’re likely to perform. They sort these companies by risk and potential reward, then rate them. The researchers choose the most promising companies for various recommended lists. The computer selects the securities that are most likely to deliver the results the investor is seeking while adhering to the investor’s preferences and wishes.

Does this work? Surprisingly well. The only real question for investors is whether the results justify the fees the adviser charges. (As a rule, I think the answer is not usually, though there are plenty of exceptions.)

But we can still exploit this information, because Wall Street firms don’t keep these ratings a secret. Smart investors, after they’ve found a stock they think warrants their attention, will survey analyst’s opinions and even read the fine print that supports them. The idea is to get a sense of expert’s consensus about the stock. We can assume these extremely well paid analysts know at least as much as we do, if not far more.

HOW TO BEST USE ANALYST DATA: Venture over to a site like Yahoo Finance, which aggregates analyst forecasts. Yahoo has a lot of specifics as far as revenue estimate and various earnings scenarios, which can be pretty revealing. But what you really want to see is not the to-the-penny estimates for earnings and other yardsticks but rather than prevailing sentiment among analysts.

AND A WORD ABOUT YOUR ADVISER: An adviser’s goal is to provide you the best portfolio for your situation — not necessarily to beat the market. If beating the Street is what you want your adviser to be doing with your money, then it’s a good idea to sit down for a meeting to discuss your wishes.

• The best-case scenario.

All growth investors want to see the numbers. The smart ones fiddle around with them to see what they really mean.

Let’s go back to Shake Shack. Assume we’ve read the press, looked at the best research, pored over the SEC filings and listened on a few earnings calls. We decide we want to get in on the action. We want to identify the opportunity, set a goal and cement a plan. Choosing the stock is just the first step: The trick to successful investing isn’t when to buy, it’s when to sell. I recommend choosing your sell price the same day you buy.

There is no linear progression here. We just have to think through the numbers and how they relate to each other.

I know that sounds fun. But it’s even better in the context of a cheeseburger: Shake Shack’s stock price is $63.50. Its trailing earnings are $0.68. From 2017 to 2018, it posted 28% growth in its top line, which is approaching a half-billion dollars a year. Shares are currently valued at 94 times earnings.

What’s next? No one knows. And while past performance is no guarantee of future results, it’s also the only thing we have to go on. So, let’s play a little.

Current trailing earnings are $0.68 a share. We project future revenue growth of 25% a year, which would work out to $2.07 per share in five years.

When you forecast earnings, you have to check revenue: Does this level of growth push revenue to an unrealistic level? No: The National Restaurant Association pegs the total industry at nearly $900 billion. Shake Shack has about 1/1800th of the market. There’s plenty of space to expand.

As that growth emerges, the P/E ratio will decline. That’s normal.

How far will it fall? To get a sense of that, I cheated and cribbed a few numbers from Chipotle Mexican Grill. It’s about 10 times larger than Shake Shack in terms of market cap. Its revenue, at about $5.3 billion a year, also is about 10 times the Shack’s. Chipotle’s top-line growth, however, has been slower — only about 9% from 2017 to 2018 — though it still commands an earnings multiple of 67 times earnings.

So we take Shake Shack’s anticipated future earnings of $2.07 and multiply it times an expected rational future P/E ratio of 67. This implies a five-year, fair-market value on Shake Shack shares of $138.69. If we bought at current prices, that would mean a total gain of 118.4%, which equates to a compound annual growth rate of 16.8% a year. That’s two-thirds more than the historical long-term compound rate of the S&P 500. That’s precisely what growth investors are after.

How likely is Shake Shack’s P/E to mirror Chipotle? There’s no way to tell. It could be better; it could be worse. Smart investors run those numbers, too.

Putting it Together

That’s certainly not all, but it is a lot. But a lot should go into choosing a stock. If you’re concerned that the pieces and parts of growth investing are Just Too Much, don’t get overwhelmed. Consider creating a decision model to keep everything organized. I promise it’s a better approach that just buying some stock you heard about at a cocktail party, though there’s no denying it’s a lot of work.

Choose a stock. Give your assessment of each of the factors we examined. Structure the model to generate a score and invest only in companies that meet your minimum. Track your results and refine your system. Will this take time and effort? Tons. When it works 90% of the time, please email it to me. (I’d like to retire someday myself.)

Here’s one way to organize such a model:

Decision Model

Assessment Weight

The Business Case: 60 30%

• Truly Excellent, 90-100

• Pretty Good, 75-89

• About Average, 60-74

• Below Average (Less than 60)

PE Ratio: 0 20%

• Lower than S&P 500, 0

• In line with the market, 75

• Exceeds benchmark, 100

Revenue/Earnings Trends: 50 20%

• Three years of 25% or more annual growth, 100

• Three years of 15% or more annual growth, 75

• Flat revenue, 50

• Declining revenue, 0

Insider Transactions: 75 10%

• Strong Buying, 80-100

• Neutral, 75 — Strong selling, 0

Analyst’s Expectations: 50 10%

• 75% or more “buy” recommendations, 80-100

• 50% or more “buy” recommendations, 50

• Sell/hold recommendations exceed “buy,” 0

The Best Case Scenario: 50 10%

• Unlimited room for indefinite growth, 100

• Strong multiyear potential, 80

• Company seems fairly or over-valued given rational growth potential, 50

• Market approaching saturation, 50

• Conditions generally unfavorable, 0

WEIGHTED GROWTH SCORE: 45.5

Strong growth stocks ought to achieve at least an 80. Truly great growth stocks likely start at 90. Don’t second-guess your numbers. You have thousands of potential investments: Don’t settle. Find the ones that meet your needs. It takes time because it’s difficult.

INCOME

Growth investors want to see ever-increasing revenue on the financial statements. Income investors want to see checks in their mailboxes.

Earnings, after all, belong to the company, which, in the case of a growing enterprise, is as likely as not to spend the money to expand the business. Some companies, however, allocate a portion of their cash earnings to be paid directly to stockholders in the form of cash dividends. This is the income that income investors yen for.

Dividends are expressed in terms of “yield,” which is calculated by dividing the annual dividend by the stock price. A $20 stock with a $1 quarterly dividend is said to “yield” 25%. How? Take the quarterly dividend by four to get the annual payout — in this case, $4 — then divide by the $20 stock price to get 25%.

To be sure, that’s a rich dividend: The average company in the S&P 500 Index pays 1.86%. To put it another way, for every $100 an investor parks in an S&P fund, she can expect to collect $1.86 a year in dividends. Growth investors tend to aim for higher than that, and yields in the 5% to 7% range are readily available. While it is difficult to make the case that that’s a robust return, it’s far and away more than what investors can earn with the 0.1% that savings accounts are paying.

Who pays dividends?

Not all companies pay dividends. Some, as I mentioned, just don’t want to while they focus on growth. They’d rather deploy that cash toward more productive avenues than fattening shareholders’ wallets.

Other companies have an interesting problem: They don’t have anything to spend the money on. These businesses have successfully navigated their startup phases. They grew. They refined their business through the shakeout phase and are now described as “mature” companies. At the end of the day, these companies wind up with a pile of cash, and, in the absence of any other option, they pass it along to their owners. Among the best dividend payers are electric utilities, telecoms and real-estate investment trusts.

How Income Investors differ from growth investors

Growth investors can stomach a higher degree of risk because they tend to have different time horizons.

Investors begin in the accumulation phase as they gather assets. They earn, save and invest. Their time horizons are long: An investor who starts socking money into a 401(k) at age 21, for example, might well have 50 years until he needs to draw on the funds, which means he has time to expose the assets to market risk.

The market has historically returned about 10% a year. Sometimes that’s a 30% annual gain, sometimes it’s a 30% loss, but over time, the returns work out to a roughly 10% compound annual rate. If you have 25 years, or even five, before you need to money, there’s less downside to market risk — the investor has plenty of time to make up any losses and to build on gains.

But time, Ovid notes, devours all things. The accumulation phase ends; sooner or later a prudent investment plan calls for the money to be spent. The is the draw-down phase. This is when the investors need the money — their nest eggs might well be the only source of income for the period between age 59 1/2, when the funds can be accessed without penalty, and whatever age the retiree opts to begin receiving Social Security. In that instance, a 30% loss would be devastating. So investors, as they age, begin to forgo the overall market’s upside potential for the relative safety of dividends. This is not settling for less, this is an attempt to glean the highest possible return at the lowest level of risk.

FINDING WORTHY DIVIDENDS

Dividend yield, like price, tells us very little on its own. It, too, must be contextualized. Otherwise the only trick to dividend investing would be to buy the stocks with the highest yields. That, however, can be a recipe for disaster.

Consider: ABC Corp. is trading at $100 and yields 3.5%. If its stock falls to $50 on some sort of bad news, that dividend will rise to 7.0%. Conversely, good news could push the stock price higher, which would reduce the dividend. How do prudent investors control for all these possible variables? They create an income-focused decision model.

These are a few factors I would include in such an exercise:

• Market Cap

A stock price tells you nothing, but a stock price and the number of shares outstanding can be helpful. That number is known as “market capitalization,” and, as a guideline, the larger the market cap the more secure the dividend.

An S&P 500 member gets an automatic 100 on this measure. CNBC.com has a free stock screener that will allow you to search for companies based on dozens of factors, including index membership.

Give large-cap companies — those with a value of at least $10 billion — a 90.

Mid-caps ($2 billion to $10 billion in market cap) get a 75. Small-cap dividends, from companies with a market cap of less than $2 billion, are not recommended. Stick with the big dogs. Avista, with $3 billion in market vale, is a solid mid-cap dividend payer.

• Dividend yield

No need to beat this dead horse. Avista’s yield is 3.23%. Here’s how to score it:

+5% 100

3.5% to 4.9% 75

Less than 3.5% 50

• Payout ratio

The dividend payout ratio is the percentage of net income a firm pays to its stockholders in dividends. To determine this, grab net earnings from the income statement. In 2018, that was $134.4 million. Next, look at the cash-flow statement for Dividends Paid.” In 2018, Avista paid out $98.0 million. Its payout ratio is 98/134, or 73.1%.

That’s high but not elevated. Avista is retaining enough of its earnings to meet its long-term obligations and finance operations. I don’t get nervous about payout ratio until it exceeds 75% for two consecutive quarters.

It is possible to pay out more in dividends than the company earned for the period, but it means dipping into the company’s piggy bank. For some companies, this might be a normal course of business to account for seasonal variations. For others, it can be a huge red flag.

Dividend payout ratios between 35% and 55% are considered healthy. Assign such payers a 90. Give 55% to 75% an 80. A high ratio, between 75 and 95%. earns a 75. Very high payouts — anything beyond 95% — should be avoided. Give them a goose egg. Dividend investors desire safety above all.

• Dividend history

Income investors like to see long strings of steady payouts that increase over time. If you see five years of dividend growth, give the company a 100. Three years earns a 75. If a company has skipped a dividend, or decreased it, in the past five years, it flunks with a zero. Dividend histories are easy to find online: The best site is Yahoo Finance. Enter AVA in the quote bar to access the stock. You’ll see a row of blue links beginning with Summary. Click Historical Data. When the window opens, choose a date range in the Time Period field, then select Dividends Only under the “Show” drop-down. Press the blue Apply button and the site will show the dividends.

Avista’s dividends

• Volatility

Income investors like smooth sailing — they don’t want to see a lot of bumpy ups and downs. The Wall Street measure for this is called beta. It compares the daily price fluctuations of a given security with those of the S&P 500 Index. The S&P’s volatility is always 1.0. A stock with greater volatility than the market will exceed 1.0; a stock less volatile than the index will have a beta of less than 1.0. Avista’s beta is 0.57. It’s a stable stock with a stable business in a heavily regulated (read: stable) industry. Shake Shack, on the other hand, has a beta of 1.23. Its price is 23% more volatile than the stock market overall.

Beta of 0.60 or lower earns a 100. From 0.60 to 0.75, assign a 75. From 0.75 to 1.0, assign a 50. Any stock with a beta exceeding 1.0 is likely not a prudent income stock.

Results

METRIC SCORE WEIGHTING

Market Cap 75 10% 7.5

Yield 50 25% 12.5

Payout ratio 80 25% 16

Dividend history 100 25% 2.5

Volatility 100 15% 1.5

TOTAL 81%