Frank Lloyd Wright’s three-legged chairs provide an important lesson in stock selection for clubs and individuals as well. BetterInvesting’s approach to stock analysis is based on three primary areas of consideration: growth, quality and value. As with Wright’s chairs, ignore any of those elements and the strategy falls over on itself. Meanwhile, adding factors may not add to the success of the methodology – four may work, but five- and six-legged chairs don’t provide much advantage.
Let’s take a look at this hypothetical three-legged chair of investing and how an investment club should be evaluating companies for its portfolio using this approach.
Growth is a key element because over time, the growth of a company’s stock price will follow the growth of its earnings. Find a company growing well according to its size, for which prospects in the future look equally as good as the historical record, and you have found a company that could see its share price grow in the future.
Once you’ve found a growing company, next check its quality. The single best factor to review is the company’s pre-tax profit margins. High-quality companies will deliver pre-tax margins that are higher than those of competitors and that are stable or growing in the recent past.
A company’s pre-tax margin is a vital measure of management efficiency. Higher margins protect a company from some of the problems that come with economic downturns, industry-wide issues or competitive pressures.
Finally, and only after a company passes the first two tests, do you move on to valuation. Review the historical trends of the stock’s P/E ratio, and adjust your expected P/E ratios to accommodate future growth expectations. No matter how terrifically-stupendously-fantastically-wonderful the company is, if you pay too much for its stock, you will never see the returns you hope for.
As you can see, each of these three legs is interconnected with the others. Remove one and the stool falls over. Depending on the terrain, you may certainly wish to add a fourth leg – perhaps technical considerations or safety factors – and these may help increase your potential returns. Adding more legs, though, is counterproductive.