The points here are summarised from an interview with Howard Ward (Gabelli Funds) conducted by Kirk Kazanjian in his book Wizards of Wall Street.
Without question, 1992 and 1993 both were difficult years for you [Aside: drug stocks hammered due to health-care spending concerns + threat of federal health-care and drug-price regulation when the Clintons took office. Philip Morris in April 1993 cut the price of Marlboro cigarettes by 40% overnight. Investors clobbered not only Philip Morris, but all of the consumer staples stocks].
What did you learn during that time?
- Leading brands are valuable assets.
- All of the private label consumer-brand companies (e.g. American Safety Razor, Cott’s, Perrigo) failed to have a lasting or measurable impact on the blue chip multinationals (e.g. Gillete, P&G, Coke, Philip Morris).
How do you figure out how much you’re willing to pay for a stock?
- Developed an earnings valuatino model that tells me what the logical price for a stock is, using a five-year time horizon (don’t work well for cyclical stocks).
- Take the current year’s earnings estimate, grow the earnings by 5 years using a 5-year growth rate.
- Then look at what kind of P/E multiple the market is willing to pay for the stock in 5 years time. Typically will use a P/E number that’s 10% lower than what the market is currently paying and won’t use any multiple that exceeds 30.
- Multiply the year 5 earnings with the year 5 P/E to get the stock price 5 years later.
- Discount that number back for 5 years using the 10-year Treasury rate + 2%. The +2% part is the equity risk premium.
- The discounted present value is the fair value of the stock.
Do you sell when it reaches your target price?
- No. From experience, a stock that is rising rapidly is frequently a leading indicator of an up-side earnings surprise.
- Don’t typically start reducing a position until the stock is at least 10% overvalued.
- Won’t eliminate a position until its about 20% overvalued.