The fall is fast disappearing and I think winter is almost here but the weather today was amazing so here is a shot I took for you while walking my doggy in Queen’s Park Toronto.
If you have been investing your own (specifically picking your own stocks) for a while then you should know what CAGR is by now.
Let me be kind and tell you here… CAGR is Compound Annual Growth Rate.
Just highlighting the names would bore many of the readers here but I am hoping that you are a little more educated and serious about getting into the next level. I hope that this helps you a bit when you make your most important decision of your life- picking companies that will make you richer.
CAGR analysis probably is one of the most important metrics I use next to 3 steps Dupont analysis, when I try to pick my long term picks.
Peter Lynch’s CAGR testing or let’s call it ‘GARP Rate’
Basically this will tell you growth rates of companies and Peter Lynch often used it to analyze one of key fundamentals of the company. Peter Lynch tested
if CAGR/ P/E multiple is higher than 1 then you could see the stock as undervalued and lower than 1 then it could be seen as overvalued from a growth perspective.
The number could vary depending on when you invest (especially bull markets like this) but that’s one of my quick checklist to quickly calculate before digging further to see whether I am paying fairly for the growth of the stocks that I am interested in buying.
If you are growth investors or balanced growth oriented GARP investors like me, then you must test this before pulling the trigger because there are only 15-20 slots of stocks you should buy. Remember this, if you have a full time job and do investing as a side kick like me, then you should only have around 15 stocks (20-25 at the maximum) at all times. If you have more than that then you would be sacrificing lots of your family and your time as it takes real dedication to follow more than 20 stocks. I have seen only few who can do well on more than 20 stocks.
The formula is quite simple.
CAGR= ( (Ending value/ Beginning value) ^ (1/ #of years) ) -1
Let me give you an example of one of my favorite stocks, MTY food group here.
CAGR in Revenue for last 10 years= ( (287/ 31) ^ (1-10 years) ) -1 = 24.9%
CAGR in Net income for last 10 years = ((61/ 9) ^ (1-10 years) ) -1 = 21.1%
CAGR in Free cash flows for last 10 years= ((77/ 12) ^ (1-10 years) ) -1 = 20.4%
CAGR in Share counts for last 10 years= ((21/ 19) ^ (1-10 years) ) -1 = 1%
Basically this tells me that MTY food group has grown by 20-25% in average for last 10 years while only increasing share count by 1% per year.
Currently its P/E is like 18-20 or Free cash flow multiple is like around 15 so Peter Lynch would have liked this company from a growth fundamental standpoint.
Since 10 years is a long time you can shorten it to calculate 5 years or even 3 years.
By using 5 years, MTY’s revenue, net income and free cash flow grew around 23% while share count has increased by 2% annually. That’s a pretty good deal to me.
3 Things to watch out on CAGR
- Depends on what period you decide to use, it can easily throw off numbers. For example, I may get significantly higher CAGR if my beginning numbers showed poor numbers (e.g. 2008 financial crisis) so normalize (i.e. pick other year) accordingly.
- Past performance is not indicative of future results – Any fundamental metrics you use, they are mostly historical basis. But do not forget that good consistent historical performance often indicates persistent performance going forward. I am just saying good historical performance is still better than nothing and you should constantly monitor the stocks carefully.
- It ignores volatility as it calculates average growth over certain period assuming the growth was steady. Don’t forget company never grows consistently year after year. There may be a time that growth does not perform as expected and the stock price may decrease at certain time.
CAGR on my major holdings- Lassonde, Google, Enghouse, Constellation Software, Stella Jones
Let’s talk about other companies that I own to see whether they are doing alright.
- Lassonde gives me about 17% of 10 years CAGR and 8% of 5 years CAGR which isn’t super growth but I still great. GARP rate of around 1 if I use free cash flow multiple.
- Google gives me 20% of 10 years CAGR and 15% of 5 years CAGR which again isn’t super high growth but still amazing enough. GARP rate of around 0.7-0.5 which is ok but keep in mind Google has its huge moats that won’t be taken away anytime soon.
- Enghouse gives me around 20% of last 10 and 5 years CAGR which is fantastic. GARP rate is around 0.9 so pretty awesome in this bull markets.
- Constellation Software gives me around 30% of 10 years CAGR and 22% of 5 years CAGR. GARP rate (on free cash flows) is 0.9-0.7 which isn’t too bad. Mark Leonard is one of the best capital allocator so I think this still is bargain.
- Stella Jones gives me around 25% on 10 years CAGR and 37% on 5 years CAGR. GARP rate is around 1.6 and 2.4 (on free cash flows). Stella Jones had pretty awesome quarters lately in terms of its cash flows so again, volatility often throw off numbers whether higher or lower…
Well… It seems that all my major holdings show pretty good growth rates from at least CAGR perspective.
Don’t forget this isn’t only fundamental metric you should be looking at because good investing is really combination of science, art with hard work (i.e. homework)
Investing is Art, Science and Your Own Homework
Well many legendary investors said investing is ‘Science’ because you should apply fundamentals and performances of companies into investing and they also said investing is ‘Art’ because you should be good at controlling what you can control such as your emotions- fear, greed etc…
A well known finance columnist Morgan Housel said
Investing is maybe 60% science, the rest art. Yes, it has numbers and formulas and rules. But the soft stuff you can’t measure or hardly even describe – the art of the business – makes all the difference in the world.
- Building a valuation model is a science. Calibrating it to reflect the psychology of uncertainty is an art.
- Gathering information is a science. Filtering out noise is an art.
- Net present value is a science. Identifying the trust and passion of a CEO is an art.
- Measuring what worked in the past is a science. Understanding why things are different now is an art.
My Investing Formula
Art 30% + Science 35% +Your own Homework 35%
I said your own homework because I was burned once when I listened to one of quite well known fund managers (you probably know who I am talking about. The person’s first name starts with J 🙂 ) The mistake was my own fault and I cannot blame him because I did not do my own homework. I did not understand what my investing style was at that time and just blindly followed the tip hoping that the stock he recommended would fly. That experience made me humble and no matter what happens, I will trust my instinct followed by thorough analysis done by myself.
Don’t listen to anyone no matter how knowledgeable and intelligent he/she may look (that includes me as well 🙂 ). Just use their tips as a reference and do your own home work. Art is important and Science is even more important and your own homework is the most important if you are a Do It Yourself investor. Trust me, don’t make costly mistake and do your own homework. Picking right stocks carefully while understanding that you are given a ticket with only 20 slots in it and you have only 20 punches is the biggest favour you will do for yourself and your family who will be in forever in your debt because of your intelligent hardworking investing decisions you made.
Warrent Buffett’s 20 Slot Rule
Warren Buffet preaches that he could:
Improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches–representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all … Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.
Ok I started talking about CAGR, GARP then Investing is art, science and your own homework thing and then Warren Buffett. How irony no matter what I write, I often ends my writing with Warren Buffett… No matter how many times I want to deny but it is really hard to hide my respect towards the one single ordinary richest old man in the world. Great job Buffett.. you among other legends are best teachers of my life and many others…
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Great post. You should start a hedge fund and manage my $$$
I will contact you If I start my hedge funds 🙂 You will be my first client Andrew!
Another informative writing. what is your third important financial metric? booya besmartrich!
Hm. I cannot pick all the important metrics I use but if I have to pick three then that should be GARP rate, Dupont and Free cash flow.
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