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Chuck Carnevale is one of the most popular authors on Seeking Alpha. He has contributed more than 200 articles and garnered almost 10,000 followers. Chuck is a sought-after public speaker who is passionate about spreading the critical message of prudence in money management. He has been working in the securities industry since 1970 and is the co-founder of EDMP, Inc., an investment management firm headquartered near Tampa, Florida.

One of the most popular features of Chuck’s articles are his F.A.S.T. Graphs™. “F.A.S.T.” stands for Fundamentals Analyzer Software Tool, and in the interview these will be referred to more simply as FAST graphs. Chuck recently introduced the graphs as a separate subscription product, which is the reason for this interview as many readers have expressed interest in them.

Dave Van Knapp: I sometimes call you “Mr. Valuation,” because you focus on valuation a lot. Why?

Chuck Carnevale: The straightforward answer to your question is because valuation is the second most important component of long-term return. The rate of change of earnings growth is actually the most important, as long as sound valuation is in alignment. However, if you paid too much for even the best company, and it gives you all the earnings growth and superb business results that you expect, or even more than you expect, you can still lose money.

But to truly understand my focus on valuation, you need to understand my definition of valuation. To me, sound valuation exists when the expected cash flows and earnings represent a calculated rate of return that is greater than what you can expect from less risky investments such as Treasury Bonds.

Therefore, irrespective of future price volatility, your investment has a solid base of potential cash flows underneath it that provide real value. It's like The Three Little Pigs fairy tale. Instead of your portfolio being built out of straws or sticks, when you get valuation right, you are building your portfolio house of bricks. In my experience, this is the only basis where buy-and-hold is a sensible and profitable strategy.

Ironically, from overvaluation you can also lose money by taking greater risk than you should. Of course, this is the exact opposite result of the theoretical risk-reward equation. In theory, you should expect greater results by taking on more risk. But overpaying for a great business, even one with an excellent dividend record, can turn an otherwise safe and sound investment into a high risk one.

Looking at valuation from the other side, low or undervaluation can significantly lower your risk while simultaneously dramatically increasing your rate of return. I think this is the situation we find today with many blue-chip “Dividend Champions.” Since many of these blue chips are trading at historically low valuations, they are offering an entry-level dividend yield that is in some cases a multiple of what you would normally expect to be able to get from these stocks. Therefore, the lower price (valuation) is mitigating risk and providing a higher yield while increasing the long-term capital appreciation component at the same time.

But here is the most important reason why I focus so much on valuation. After more than four decades of looking at thousands of companies through the lens of FAST Graphs, I can state the following with absolute confidence: Stock markets will from time to time miss-price common stocks, over or under. This is the principle that Ben Graham was articulating with his metaphor that "in the short run the market is a voting machine." However, the price of a common stock will inevitably move to reflect its intrinsic value based on earnings and cash flow. This is the "in the long run the market is a weighing machine" part of Ben Graham's metaphor.

Clearly, it's the growth rate of earnings that determines an investor’s long-term rate of return. However, valuation will have a major impact on both return and the risk taken to achieve it. If the company grows earnings by 5%, then investors should also expect a capital appreciation opportunity of 5%, assuming they purchased at sound valuation. If they overpay, their return will be less and vice versa. For stocks that pay a dividend, the dividend income and any growth in dividends represents a nice "kicker" to the total return.

DVK: In your experience, what are the top two or three mistakes that individual investors make? How do FAST Graphs help them avoid these mistakes?

CC: First and foremost, I believe they tend to focus way too much on price and way too little on the intrinsic value of their holdings. Consequently, they tend to have a penchant of wanting to sell when they should be buying and vice versa. In my experience, stock price volatility is not only unpredictable and therefore unreliable; it's also a tremendous generator of emotional extremes.

Of course, I am referring to fear or greed. Although I feel that fear can be the most dangerous emotional response, greed is not too far behind. Naturally, emotions tend to lead to activity. And as Warren Buffett once so eloquently put it: "Inactivity strikes us as intelligent behavior."

True investors need to keep in mind that they own real businesses, and that the operating success of those businesses is what matters most. Since FAST Graphs illuminates fair valuation based on fundamental values derived from earnings and cash flows, users can clearly see if a stock is overvalued or undervalued or fairly valued. Therefore, sound and intelligent decisions devoid of the emotional response can be made.

Here’s an example that illustrates the point for Oracle (NYSE:ORCL). On the following graph:
  • The orange earnings-justified valuation line was drawn based on applying a PE ratio that was derived from algorithms that we have developed for sensible PE ratios for each company. This line represents what we consider to be the fair value for each company, what many would call its intrinsic value.
  • The blue line represents the value of the company based on its historically normal PE ratio. Note that both lines convey a relationship between earnings and price, the only difference being how much the earnings are considered “worth.”
  • The black line represents the stock’s actual price. Note how ORCL’s price departed markedly from either the orange-line or blue-line measures of true value in the period of irrational exuberance of 1998-2000, then plunged back down in the tech bubble’s crash from 2000-2002.
  • The green dots are a representative client’s buys, the red dots are sells and the yellow line illustrates current cost basis. This graph represents pretty good decisions in every case. Note that it's not just the price where the company is bought or sold, it is how those buys and sells related to fundamental value that's most revealing.

click on all charts to enlarge

DVK: How do you personally use FAST Graphs? How many companies per day (on average) do you check out?

CC: Let me start by answering this question this way: Hi, my name is Chuck and I am a FAST Graphs-aholic. Although I say this somewhat tongue-in-cheek, the real truth is that I've literally become addicted to this research tool. So much so that I couldn't even imagine running a portfolio for myself or anyone else without the tremendous advantages and perspectives that FAST Graphs provides. For example, if I read an article or even a news item on any company, the first thing I do is generate a FAST Graph. What I find is an instantaneous evaluation of the recommendation, the business behind the company and its valuation.

Since I do this for a living, I draw somewhere between 75 and 100 graphs or more per day. Also, the tool has a function by which you can create portfolio lists that summarize the important attributes of a company on up to 17 different metrics. These portfolio lists can be sorted in many different ways that can alert the user to the risks and rewards of owning any company they are invested in or contemplating investing in. One example would be when a certain stock’s price is dangerously above its earnings justified valuation, the PE ratio will be written in red ink, implying danger.

DVK: What's the best way for an individual investor to use FAST Graphs?

CC: On the thesis that knowledge is power, I believe that providing individual investors the opportunity to review essential fundamentals at a glance is quite empowering. When markets are turbulent, as they often are, it's easy and understandable that investors can become confused. However, thanks to the factual perspective based on fundamentals that FAST Graphs provide, they empower the skillful user to think rationally about what they own.

For example, if the market is undervaluing a common stock that I own to an extreme level, let's say 50% below intrinsic value, instead of becoming frightened my reaction is typically less emotional and more learned. The graph for the stock allows me to see the undervaluation and take the position that I am simply not willing to sell my valuable asset for half what it's worth. The inverse is also true with the company that becomes extremely overvalued. Consequently, I feel that it's harder for the markets to take advantage of my emotions. Therefore, I am more capable of making sound long-term decisions.

There are numerous other ways that I believe FAST Graphs can benefit the individual subscriber. The opportunity to mark all buy and sell transactions is incredibly helpful, in my opinion. This premium feature provides a level of transparency into portfolio management that simply cannot be duplicated anywhere else. An additional benefit for the premium subscriber is the screening tool. This allows the investor to input various metrics that they desire in a stock and then screen the entire database of over 17,000 symbols to find the ones that are most appropriate to their needs and goals.

Any subscriber can benefit by drawing a graph on any company that comes to their attention. For example, let's say you come across an article listing the top five companies for any category. You can easily cut and paste or type in the symbols and immediately determine whether these recommendations make sense or not. Personally, this is one of my favorite ways to use FAST Graphs.

DVK: Give an example of an actual buying decision that was primarily influenced by FAST Graphs and tell why.

CC: Medtronic Inc. (NYSE:MDT) is a company that I've admired for a long time based on its superb operating history. This quality healthcare company has increased earnings at an average compounded rate of 16.7% a year over two decades like clockwork. Unfortunately, this excellent record did not go unnoticed by the stock market and the stock had been significantly overpriced in my opinion since 1995. However, the great recession brought a slowdown in earnings growth, but not an interruption. Nevertheless, the price fell precipitously, and for the first time since 1995, Medtronic could be purchased at a discount to its earnings justified valuation (the orange line). The FAST Graph for Medtronic provided a clear visual of this long-term opportunity, which allowed me to start building a position for the first time in over two decades.

DVK: Using FAST Graphs as examples, are there any stocks that you think look like "screaming buys" right now for the individual investor?

CC: With the market prices for what I would call the bluest of the large-cap dividend growth blue chips trading at low valuations not seen in several decades, it's hard to choose just a few. You can just about take your pick amongst names like Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Abbott Labs (NYSE:ABT) and on and on. Then there's the tech sector with names like Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT), and others too numerous to mention.

However, because its consistent long-term record of earnings growth I would pick Abbott Labs (ABT). This A++ diversified health-care company has not only achieved the most consistent record of double-digit earnings growth of any company I follow, since calendar year 2007 the rate of change of earnings growth has accelerated to 12.8% versus their historical average of about 10%. This company that has normally traded at around 20 times earnings can be bought today at a PE ratio of under 12, and a dividend yield greater than interest you can earn on the 30-year treasury bond.

Final Note: For more information on FAST Graphs, including a free trial of this “tool to think with,” please click here.
Source: Interview With Chuck Carnevale: Why Valuation Matters For Buy And Hold Dividend Investors