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All About Take Stock
A Workshop by Ellis Traub February 2007

Published by:

ICLUBcentral Inc.

1430 Massachusetts Avenue Cambridge, MA 02138 617-491-3300 www.iclub.com

StockCentral.com is an online community that provides highquality data, insightful discussion, and intuitive software for the people who need it most -- individual investors. Whether you’re managing your own portfolio, running an investment club, or helping to educate your fellow investors, StockCentral gives you the exclusive web-based tools and support you need: Community Gain insight through peer discussion and workshops led by industry experts in our message board forums. Data Examine historical data and detailed financial reports using the StockCentral Data Service, provided by Hemscott Americas (used by Yahoo! Finance and Forbes). Screening & Analysis Identify winners for your portfolio with the StockCentral Screener and then generate an Instant Stock Analysis with Take Stock Online. Plus, you’ll have instant access to other smart features like an investing Event Calendar, Doug Gerlach’s Blog, an Investing Book Store, Member Discounts, and much more! Start your free full-featured trial today at www.stockcentral.com

Table of Contents
An Introduction to Take Stock Meeting the Challenge Eliminating Outliers A Look Under the Hood Portfolio Management Tasks Pedagogy 3 4 6 9 13 14

About the Author
Ellis Traub, renowned financial author and public speaker, is one of the most respected names in the world of fundamental investing. After embracing the methodology behind qualitative growth analysis, he was able to turn his financial life around and has since devoted himself to helping educate other investors. Ellis is also the author of the popular book Take Stock and its companion software, as well as the original developer of the Investor’s Toolkit line of legacy stock analysis desktop software programs. His company, Inve$tware Corp., merged with ICLUBcentral in 2003. ICLUBcentral’s online investing community at StockCentral.com features an online version of Ellis’ original Take Stock “Instant Stock Analysis” software. Now retired, Ellis lives with his wife in Davie, Florida and maintains an active speaking schedule and online education presence.

An Introduction to Take Stock
Take Stock is a software program that enables anyone, no matter how little investment experience he or she may have, to invest successfully using the fundamental investment principles introduced by George Nicholson, CFA. Nicholson’s methodology is deceptively simple to use, causing many to underestimate just how little or much “work” the software does during the instant it takes to produce a result. It is remarkably effective. Our challenge was to develop a product that was so simple to use that it would not require any previous investment education to use it. We wanted to create a program so innovative that it would effortlessly perform all of the steps required in our investment methodology as well as an educated user might. It would have to contain the educational content that would enable the user to learn the simple investing concepts behind the methodology, and to understand why this investment approach works. Most important to me was the goal of incorporating the necessary “intelligence” to automatically arrive at the same estimates and judgments that an experienced but cautious user would come up with, given the data that he or she had to work with.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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Meeting the Challenge
Our challenge: to come up with a program so simple anyone could use it, yet sophisticated enough to not only perform the mechanics of every step required by the methodology, but also automatically estimate and forecast—judgment tasks that heretofore had been the domain of only the experienced. The user interface — the “face” of the program the user must “talk to" for it to work — would be the key. The answer? What could be simpler than to ask the user to merely enter the name of the company she wants to study, or the ticker symbol, if she knows what it is?   But, another issue arose: comprehensive instructions were one thing, but being able to translate the results into a language anyone could understand was another. Were there not shades of gray? One company could be better than another, so it would not be enough to simply provide a pass/fail answer. There would have to be a way to easily quantify the different levels of "good" or "bad" if for no other reason than to permit investors to prioritize their selections — to have an educated preference for one over another.   There were two clearly determined goals of the process: the first was to determine whether the company was good enough to warrant investing in it. The second, strictly contingent upon the first, was to determine whether the price was reasonable. Indeed, those two items could be presented to the user all at once.   But if the user was to be empowered as any experienced investor was, she should be able to not only judge whether the company met the tests for quality, but, if it passes, also judge how well it passed. Ask any experienced investor how good a company is, and she'll have to go into a great deal of detail, explaining how each parameter meshed with the others to cause her to say, “very good,” “just okay,” or some other shade of grey. So we chose to use those parameters to “grade” the company on scale of 1 to 10. Any novice could understand that a 10 was better than a 9 or 8! Thus, the QI or Quality Index was developed.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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  Following the familiar methodology, we judge the quality of a company by two factors: growth and efficiency. Thus, we could create a GI or Growth Index, and an Efficiency Indicator, the combination of which would produce the Quality Index. The quality of growth would be measured by two attributes: •Strength - the stronger or more rapid the growth, the stronger or more rapid the return on an investment that grows along with the company •Stability - the more stable and steady historical growth, the more predictable it would be, and the better the odds that future growth would mirror the past. And, we were interested in grading relevant historical growth (over a ten year period) and recent growth (over the most recent twelve months), in both sales and earnings. For this we provided a table on front of the Technamental Stock Study Worksheet (TSSW) in which each of the most recent four quarters were matched with their previous counterparts so that a trend was visible; and, for the determination of recent growth, we matched the current trailing twelve months with the same period the year before.   Depending upon the size of a company (measured by annual revenue), the acceptable growth rate will vary from a low of 7 percent to as much as 20 percent. Growth of both sales and earnings must be in excess of 14.9 percent to be considered desirable.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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Eliminating Outliers
Someone doing a stock study by hand would look at the plotted points on a growth chart (semi-log graph) and arbitrarily place a ruler along those points to come up with the slope of a line that represented the rate of growth for all those data. Where the person with the ruler “eyeballs” the data and varies the position of that ruler to roughly compensate for the data that is irrelevant, the computer has the ability to calculate the slope of such a line instantly using the "least squares" formula and regression analysis. However, for the computer to take into account only data that is relevant, it must have some way of simulating what the human eye can do instinctively and remove irrelevant data from that calculation. Whether doing a study by hand or with a computer, this is the first point at which judgment must be applied: the elimination of irrelevant data, or "outliers." What is irrelevant data? It is data that makes no meaningful contribution to the task of estimating the future. Rapid growth early in a company's life cycle, for example, can hardly be relevant. As time goes on and the company increases its annual revenues, the growth rate naturally tends to slow; and it would be foolhardy to estimate future growth at a rate any higher than that of the most recent, slower years. The same would hold true of one or two years of poor performance, so long as that undesirable performance occurred early in the ten-year history. As a general rule, when viewing historical growth to help forecast future growth, it is best to eliminate outliers only when the deletion of that data would result in a lower value for the historical growth rate. That, therefore, became one of the guidelines the program applies when deciding which data to use in reporting relevant historical growth. (Incidentally, the chart on the front of the TSSW does not display the data as having been omitted, but it has been omitted from the calculations for purposes of reporting the historical growth and for estimating future growth.) To the mix, we added the stability of that growth. One of the by-products of regression analysis of the sales and earnings data is the calculation of the coefficient of determination (R-squared). [This is a measurement of
© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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the degree to which all plotted points in a sample fall on the line that lies closest to all the points. Thus, if all of the points fall on that straight line, R-squared would be 100 percent. If the points were all over the place and there were no discernible pattern or trend to them, the result would be zero.] This could also be expressed as a scale of from 1 to 10. A company whose R-squared is less than 95 percent will not be judged as desirable. If it's below 85 percent, it will not even qualify as acceptable.  Efficiency was not so easy to quantify. In fact, it was more of a pass/fail situation because declining profit margins were simply not acceptable (at least for the new investor) and return on equity (ROE), while sometimes interesting, was not sufficiently important to seriously affect a decision. In any case, the Efficiency Indicator will be red (unacceptable) only if profit margins are trending down. If ROE is greater than the TTM growth rate of earnings, it will be yellow (caution). For all other situations, it will be green. It will cause the QI to be in the red range (and prevent the program from calculating a buy price) only if the Efficiency Indicator is red. Using those attributes of the Efficiency Indicator and the Growth Index, along with some simple math, we were able to produce the Quality Index. Now anyone could judge the quality of a company, based entirely on the attributes we have been taught, on a simple scale of 1 to 10. For the first time, we would be able to say just how good a company was, based entirely on the principles Nicholson taught us. To make it even simpler, the grades have been broken down into thirds: “desirable,” “acceptable,” and “unacceptable,” and those levels are indicated in the program using green, yellow, and red, respectively. We also went a step further by determining how reasonable the stock’s price was. Rather than be content to just learn whether the stock would be a good investment at the current price — a determination of limited value — we determined just how high a price the user could pay and still realize a return of the desired 15 percent, while suffering a risk of only 25 percent (equivalent to the familiar 3 to 1 upside/downside ratio). Called the Buy Price, we would display it only if the company was of sufficiently good quality to be considered for purchase. (If the company was not that good, it would be overpriced at any price!)

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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And, if the current price was below that Buy Price, it would be framed in green. If the current price was above the Buy Price, a red frame would indicate that it was not currently selling at a reasonable price. From the user’s point of view, being able to type in a name and hit the Enter key satisfied our desire to make using the program simple enough. But what made the product simple and user-friendly was the novice’s ability to read a single statement in plain English that summarized the result, combined with the Quality Index to tell her “how good,” and the Buy Price to show whether or not the price was right. ICLUBcentral has produced an online version of Take Stock, which is available to anyone who visits StockCentral.com under the “Tools” tab. It is similar to the original desktop version, using a facsimile of the TSSW to display the complete stock study. Take Stock Online will be the focus of my workshop.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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A Look Under the Hood
Let’s take a look "under the hood" and see what actually happens when you enter a ticker and hit Enter or click Go.

Armed with the company's symbol, the program accesses a proprietary database which is updated on a weekly basis (although most company data is updated only four times each year). It processes 107 items of the company's data, including up to ten years of sales, earnings, pre-tax profit, return on equity, dividends, shares of stock outstanding, high and low stock prices, some significant dates, some identification information, and more. It eliminates irrelevant data from the sales, earnings, and pre-tax data, performs a regression analysis on the remaining data, and calculates the relevant historical growth rate and the R-squared for sales and earnings. From the relevant data, it estimates the future growth of sales and earnings, tempering the forecast according to the stability of the historical data (the less stable the historical plots are, the lower the forecast growth rate), capping it at no more than 20 percent. It calculates the Growth Index and decides what color to display. (For the QI to be "desirable” -- above 6.7 -- the historical and recent growth of sales and earnings must both be above 14.9%, the R-squared at or above 95%, and the Efficiency Indicator Green. If any of the historical growth values fall below the lowest required for the size of the company, the R-squared is below 85 percent, or the Efficiency Indicator is red, the QI will be "Unacceptable" -- at or below 3.3, -- its indicator will be red, and no Buy Price will be calculated. Between is acceptable, though less than desirable. (Companies in this category might be held if owned, but probably not purchased.) It calculates the value of sales and earnings five years in future, based on their estimated future growth.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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It does an alternative calculation of future earnings based upon forecast sales, multiplied by the average pre-tax profit margin, deducting estimated income taxes and other expenses, and dividing the result by the number of shares outstanding. Then it selects the lower of the two estimates. (This is another improvement over past products which offer the “preferred procedure” only as an afterthought.) It analyzes the ten years of profit margins and returns on equity and sets the Efficiency Indicator accordingly. Using the Efficiency Indicator and Growth Index, it then calculates the Quality Index. It analyzes historical PEs, high and low. Calculates the median, and uses that for the Signature PE. It calculates the current PE and, with the Signature PE, calculates the Historical Value Ratio (HVR) -the ten-year version of Relative Value. Then it offers that result as the Mood Indicator to inform you how the current PE compares with the historical PE. This tells you whether the stock is "Hot" or "Cold" or about right in view of its "usual" selling point. When “cold,” it cautions the user not to buy it until checking out why “the herd” is selling instead of buying. It averages the lowest half or majority of the historical high PEs and low PEs to provide a reasonable estimate of the high PE and low PE five years out. If the result is above that sustainable rate, the program caps it at 30. It then forecasts the high price in five years using the product of the forecast earnings and the High PE. Using the product of the earnings of the last twelve months, and the forecast low PE, it conservatively calculates the estimated low price in five years. It calculates the potential annual price appreciation using the current price and the forecast high price over the next five years. Using the current price and dividend, it calculates the current yield.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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It adds the potential appreciation and the yield together to calculate the potential annual return from the investment, should it be purchased at the current price. It calculates the Risk Index by dividing the potential loss (the difference between the current price and the low price) by the price range (the difference between the forecast high and low prices). It then calculates the highest price the stock could sell for and still produce a hypothetical return of 14.9 percent. It calculates the highest price the stock could sell for and still produce a Risk Index of 25 percent. It selects the lower of the two and displays it as the Buy Price. It compares the Buy Price with the current price and indicates whether the stock is currently selling at a price that will provide for the desired return and risk. It selects and displays the appropriate textual statements to best describe the Quality, the mood of the "herd," and the reasonableness of the price. It prepares a completed TSSW to display and print. This is a comprehensive report of the result. Finally, it prepares a Summary to display and print, which offers a plain-language interpretation of the Reasons to Buy and Items to Check.

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And it does all of this in less than one second! I'll just bet that many who have merely put a ticker into Take Stock and produced a result think that's all there is to the program. Not so! While there will be many who are content to do just that, taking for granted that there's some validity to the methodology even though they don't know why, there will certainly be others who want more. And, trust me, Take Stock has much more.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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But first, let me dispel some criticism we have had because someone can do just that: take the program at its word, without questioning, and use it mindlessly to invest. Those who methodically use Take Stock to choose stocks without understanding why may become as successful as those who just as mindlessly bought the stocks that turned up a Buy in their manual calculations. In fact, those who cling to Take Stock will likely be more successful than those who went through the classes and came out with less than a full understanding of the method. Why? Because Take Stock applies that method faithfully, conservatively, and with very few mistakes. If you want some evidence of that, you can look at the ICLWager Portfolio, mechanically managed by Lowell Herr. It's been running now for three years and, with the buy and sell decisions being virtually made for him, the portfolio soars well above the S&P 500 and the market as a whole — performance that eludes most professionals. Here's an example. You're a new investor and you have heard that ACME Inc. is a great company. Would it be a good investment? Ask Take Stock. Whoa! That's a kick in the head! And I thought it was a good company.   • WHY does it say it "doesn't meet your standards for quality at this time?" • WHY does it say "the fundamentals don't justify a purchase at this time? • WHY... etc.?   The average user is not going to be content with what he or she sees there. They click on the Buy Price or Quality Index to learn more, and now they are on their on the way to a better understanding of investing. This is called drilling down, and each time they do it, they are led to ask yet another question and look for the answer. It's only natural to want to explore. And the average user comes away from each experience with a little more understanding — all the time being able to put these principles to work without yet knowing all that much about them.
© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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Portfolio Management Tasks
As you move from novice to experienced user, you will acquire a portfolio; and it's as important to know when to sell your holdings as it is to know when to buy them. Those tasks are conveniently divided into two familiar disciplines:
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Defensive tasks (knowing when to sell companies that no longer meet the quality benchmarks of growth and efficiency), and Offensive tasks (replacing companies whose stocks are selling at a price that is so high that their potential return is no longer suitable)

Defensive management will consist of ranking your companies by the Quality Index and updating the data for them all. By simply watching the color of the indicators to see which of them turn yellow or red, you can select those whose fundamentals have slipped, and then make the decision to hold, sell, or buy more. This makes the task both simple and fun — almost like watching a colorful pinball machine. Offensive management will also be a piece of cake: ranking your holdings by "Mood," with the "hot" stocks first, and then going down the list to see whether the return on each is adequate. In either case, replacing the stocks becomes a simple matter of ranking your stocks by Quality and, starting from the top of the list, finding those that are selling at the right price and picking the one that suits your diversification needs. You'll have more convenient access to the Web to do your research, being able to click on a variety of URLs that provide you with the information you seek, and avoiding the inconvenience of having to enter the ticker symbols and click extra times to access the company-specific pages and sites. All of these features are now available to those using the desktop versions of Take Stock. But, they are not yet available in the online version. However, during the upcoming months, they will be available to users of Take Stock Online at StockCentral.com.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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Pedagogy
Successful teaching has two components: the first is, of course, the imparting of knowledge. Most teachers are pretty good at that. The second is the stimulation of curiosity, and that is one facet of teaching that escapes many, if not most. If a teacher completes a class leaving the students eager to hear what comes next, or to learn how to apply the theory to practical use, or to find out more about the topic on his or her own, then that teacher has been truly successful. We have approached Take Stock with that in mind, and we like to think of it as a teaching “wolf” in non-threatening clothing. We've tried very hard to present a program that not only gives answers but stimulates the natural curiosity as well. On the left side of the screen there is a hierarchical list of items. This operates as did the navigation map in the desktop versions. Clicking on an item enables the user to navigate from one part of the program to another after he or she has become familiar with what's contained in each "compartment." Click on the Help Menu link beneath that list. When you do, you will see Take Stock Concepts halfway down the page. Select the section that matches where you are in the program and find, in very easy-tounderstand language, the concepts behind that aspect of the methodology. There is enough educational material available in this program to give any investor a fantastic start to becoming well enough educated to pick quality growth stocks as well, or better than, the pros.

© Ellis Traub 2007. Reproduced with permission and distributed by StockCentral.com

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