This post contains the main ideas I learnt from reading the book “Purple Chips by John Schwinghamer”
1. The Purple Chips methodology is based on finding good-quality companies, buying them when they are inexpensive and selling them when they are expensive.
2. The three main criteria for a company to qualify as a purple chip are:
1. a minimum seven years of positive and growing EPS
2. Smooth and predictable growth in EPS and not volatile earnings that are erratic and unpredictable
3. a minimum market capitalization of $ 1 billion.
3. Most purple chips are dividend paying companies
4. The purple chips will also be companies that have very good financial health as defined by the following three criteria:
5 year return on equity: Greater than 10%
5 year return on assets: Greater than 10%
5 year net profit margin( average): Higher than the industry average
5. The EPS line:The EPS line is shown above. The EPS line when it is constructed in such a way that the last price of the stock and the EPS end at the same point. The EPS is the trailing twelve months EPS.( TTM EPS) The lower the slope of the EPS line, the lower the valuation.
6. Valuation resets happen when the P/E changes. A higher P/E means a positive valuation reset: the market decides to pay more for the same earnings and a lower P/E means a negative valuation reset: the market decides to pay less for the same earnings.
7. The change in the long term EPS trend is significant is it is characterised by any of the following:
1. earnings per share that have declined by an abnormal amount in one quarter.
2. earnings per share that have declined for three consecutive quarters.
8. Value traps can be avoided by strictly following the Purple Chips criteria and the EPS trend criteria
9. The valuation trend(P/E ratio of the market and the individual stock), the PEG ratio(P/E divided by the growth rate) also have to be considered.
10. Diversify your portfolio by placing less than or equal to 15% in one sector and less than or equal to 5% in one stock and less than or equal to 3% for non-dividend paying stocks.
11. The actual process of creating these purple charts is difficult. To do this One can simply calculate the highest P/E achieved in the last 18 months and the lowest P/E achieved in the last 18 months and multiply by current EPS to get the valuation range in terms of price for the stock.
Highest P/E= 20
Current EPS= 10
High end of valuation =200
Low end of valuation=150
12. Before buying or selling consider the following as well:
- If P/E is greater than 15, then PEG ratio should be less than 1.
- If P/E is less than 15, then PEG ratio should be less than 1.3
- What is the trend in EPS likely to be? higher or lower
- How is the market? bull or bear
13. It may be worthwhile to buy if the stock price is below the high end of valuation by a certain percentage and sell above the the high end of valuation by a certain percentage. For actual buy and sell ranges one has to make the charts and form the high and low end valuations by following the curve of the EPS line to the highest and lowest values as shown below:
14. A stock market correction affects all stocks and can create once in a lifetime buying opportunities. Using trend in earnings as a reference point, investors can profit from price aberrations that are caused by fear and greed.
15. Buying and holding purple chips stocks without considering valuation ranges without buying and selling can be a simple way to outperform the market over the long run(multidecades).
For a list of current purple chips stocks, go to the purplechips website.