Posts Tagged ‘earnings’

Quantitaive demonstration of the effects of price inflation on your investment

Thursday, March 12th, 2009

For the hypothetical business in our previous article, Revealed: The error in the Buffett logic, we will show you how earnings are valued (using the discounted cash-flow method) and the effects inflation with a table:

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Here are the explanations for the columns on the table:

  1. Year – The table shows the year-by-year outcome in a 20-year period. This column denotes the year.
  2. Earnings – It shows the earnings of a business. You can see, at the end of the first year, the business will generate $100 of earnings. Earnings will grow at a rate denoted by the corresponding entry on the 6th column (Earnings Growth). In this example, earnings are growing at a rate of 25% per year. You can see, at the end of the 20th year, that business will earn $6938.89.
  3. PV of Earnings – This is the present value of earnings earned at the end of the year. The discount rate used in the present value calculation is 30%, which is defined in the 7th column of the table. As you can see, the present value of the 20th year of earnings ($6938.89) is only $36.51. As you can see, if you add up first 10 figures of that column, you will get $648.87, which is the number we gave in the previous article.
  4. Total PV – This is the sum total of the previous column. This is also the valuation of 20 years worth of earnings at the discount rate of 30%.
  5. Accumulated Re-invested Earnings – What happens if you re-invest all the earnings at an investment return rate that is the same as the discount rate (30%)? Each row of this column will show you what your total accumulation of that business’s earnings. As you can see, at the end of year 20, you will have accumulated $206,626.93.
  6. Inflation Rate – This column define the price inflation rate.
  7. FV of Total PV Due to Inflation – What if inflation is allowed to do its work to devalue your cash? In this column, it shows how much $1,087.23 (the valuation of 20 years worth of earnings) at the beginning of the first year will have to be in order to maintain the purchasing power at the end of the year. As you can see,  $94,301.83  at the end of the 20th year can only buy as much as $1,087.23 at the beginning of the first year, given price inflation of 25% for every year.

As this table shows, as long as you can re-invest the earnings of the business at a compounded return equivalent to the discount rate (30%), which is higher than the price inflation rate (25%), you will beat inflation. That is, your wealth in real terms will rise. But if you decide to stuff your earnings as unproductive cash under the bed, you will lose out to inflation. That is, at the end of the 20th year, you will have accumulated $34,294.47 in cash but price inflation will mean your original $1,087.23 investment have to grow to $94,301.83 in order to preserve its purchasing power.

If you apply a discount rate of only 10%, the valuation will balloon to $7,928.52, which is equivalent to  $687,689.46 in 20 years time due to inflation. But if you can only re-invest your earnings (which is growing at 25%- the same as inflation) at 10% (compounded), you will only accumulate $53,339.12, which means inflation will destroy your wealth in real terms.

Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses

Thursday, October 30th, 2008

Today, we will continue from our previous article, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses. After learning what type of businesses to avoid, you will now learn which type of businesses that makes ideal investment candidates.

The legendary investor, Warren Buffett favours businesses with durable competitive advantage. As The New Buffettology, explains, a business with

… durable competitive advantage typically sells a brand-name product or service that holds a privileged position in the stream of commerce that allows it to price its product or service as if it faces little or not competition, creating a kind of monopoly. If you want this particular product or service, you have to purchase it from one company and on one else. This gives the company the freedom to raise prices and produce higher earnings. These companies also have the greatest potential for long-term economic growth. They have fewer ups and downs and they posses the wherewithal to weather the storms that a short sighted market will overreact to.

As we mentioned before in Two uncertainties of valuing a business- risk & earnings,

To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates.

Therefore, businesses with durable competitive advantage are the ones that can be valued more accurately.

Before we go elaborate on durable competitive advantage, we need to devote a paragraph to explain how businesses make money. Businesses become successful in two ways: (1) having the highest profit margins and/or (2) selling the highest volume of goods/services. Ideally, the businesses that you invest in have both characteristics. If not, either one of them will do. But avoid those that have neither.

Businesses with durable competitive advantage are most likely to be the ones with high profit margins and inventory turnover. They have:

  1. Competitive advantage– they are the only ones producing a unique products/services. This means that unlike price-competitive businesses, price is not the most important consideration of their customers.
  2. Durable– Not only must they just have a competitive advantage, that advantage must be durable as well. That means they must be able to keep that advantage in the long term without needing to expend great amount of capital and energy to maintain it.

There are some businesses that have competitive advantage that are not durable. Consequently, vast sums of shareholder wealth have to be expended to maintain it instead of returning them back to the shareholders. Intel is an example of such business. No doubt it has a competitive advantage and a monopoly on computer chips in the market. But it has to spend billions of dollars in research and development and come up with new products continuously to maintain that monopoly.

In the next article, we will discuss how do we go in for the kill to invest in our chosen business.

Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses

Wednesday, October 15th, 2008

Yesterday, in Two uncertainties of valuing a business- risk & earnings, we mentioned that risk and earnings are the two uncertainties in valuing a business. As we said in that article,

However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates.

Today, we will start off with a mini-series about choosing businesses that have strong economics. Such businesses have relatively lower uncertainties regarding their earnings and are also much less risky. Businesses with weak economics are much more difficult to value because of their higher risks and earnings uncertainties. For today’s article, we will look at identifying such businesses to avoid.

First, what are businesses with poor economics? They are the ones in price-competitive industries. As this book, The New Buffettology explains,

A price-competitive type of business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Example of such business is steel making, agriculture and manufacturing of mass generic products like clothes hangers. If you see a businesses in which its customers’ strongest motivation to buy is price, then you know it has poor economics. For such businesses to survive and defeat their competitors, they have to beat their competitors in costs. To beat their competitors in costs, they have to continuously engage in ruthless cost-cutting measures and improvements in techniques to keep their businesses competitive. This often requires additional capital expenditures and energy to keep the wheels running non-stop, which translate to more long-term debt and less distribution of profits to shareholders. Often, cost-cutting measures and improvement techniques are easily replicated. Therefore, businesses in price-competitive industries end up under-cutting each other continuously, which erodes profit over time. For such businesses, good quality and intelligent management is crucial to keep the business profitable. Also, they are more prone to strokes of bad luck.

So, to be a successful investor, the first step is to avoid businesses with poor economics.

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

Two uncertainties of valuing a business- risk & earnings

Monday, September 29th, 2008

In our previous article, Measuring the value of an investment, we learnt about the theory and mathematics behind the valuation of a business under artificial conditions that are clearly defined. Under such conditions, we know exactly the business’s future earnings and its risk relative to government bonds. Therefore, valuing artificial businesses is easy and straightforward. But in the real world, earnings and risks are the very things that cannot be so easily and clearly defined and quantified. As we said in that article,

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ?art? of investing.

Thus, we should not be under the impression that the dollar number that is produced from the valuation of a real-world business is a scientifically precise number. Rather, no matter how precise that number is, it is just an estimate. And it is far more important for that number to be accurate than for it to be precise. If you are confused with what this means, we suggest that you read our previous article, Confusion between precision & accuracy and Example of precisely inaccurate information.

First, we will discuss the earnings of a business. Stock analysts spend a lot of effort trying to divine the future cash flows of the business that they are analysing. However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates. For some, they can even be unpredictable or volatile. To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates. We will explain the characteristics of businesses that favour accurate earnings estimates in future articles.

Next, we will discuss the risk of a business. The mainstream finance uses volatility of prices to define risk. As we said before in How do you define risk?,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time.

But we see risk differently. As we explained before in Measuring the value of an investment, the risk in value investing is a relative concept. The payments of government bonds are assumed to be completely risk-free whereas the earnings of a business are not so certain. Risk relates to how secure the future earnings of a business is. To illustrate this concept, let’s suppose there are two different businesses with identical earnings estimates. One is located in a geologically stable place (e.g. Singapore) while the other is located in an earthquake prone area (e.g. Tokyo). We can say that the latter one carries more risk because its earnings can be cut due to an earthquake. Therefore, it will carry a higher discount rate.

Between earnings and risk, the latter is the most subjective of all in the business’s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness. For earnings, all we have to do is to compare earnings estimates with the actual earnings to have a gauge of the estimate’s accuracy. But you cannot do so for the discount rate. Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts.

Bear that in mind when you look at analyst reports on the price targets of stocks.

Should value investors be ‘bullish’ in a bear market?

Tuesday, July 15th, 2008

Some of you may have subscribed to value-oriented stock research newsletter. One thing you may notice is that as the market enters deeper into the bear market, the number of “Buy” recommendation increases. From that perspective, these value-oriented stock research are ‘bullish.’

Before we comment on the wisdom of their recommendations, we will have to explain the philosophy of value-oriented stock research. As we explained to one of our reader’s comment in Confidence back? Beware of bear market rally,

… for long-term value investors, they follow the ?bottom-up? approach. That is, they (i.e. the value investor) invest in businesses based mainly on its individual merits (i.e. is it a good solid long-term safe businesses whose stock price is undervalued? Bear Stearns is definitely ruled out in this case) and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

Here, we see a potential trap for the unwary value investor. Back in February last year, as we explained in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom.

During the turning point of the business cycle, the P/E ratios of good quality companies in a bear market may look very enticingly cheap. But as we explained in Why accumulating stocks on the ?cheap? can be deadly to your wealth?, during such a time,

… a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Low P/E plus the “Buy” recommendations from the value-oriented stock research may make buying stocks of good quality companies look like astute contrarian moves.

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses. This news article, Bottom-up analysts ignore the big picture, sums it well:

“You have got a set of numbers that assumes some sort of recovery,” Macquarie’s equity strategist, Tanya Branwhite, said when releasing the report. “Unfortunately, that’s premised on the cycle we have seen in the last five to 10 years. What is facing the economy at the moment is nothing like we have seen in the last five to 10 years.”

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ‘typical’ bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current “Buy” recommendation will be very wrong.

To illustrate this point, we will give you two examples.

After the stock market crash of 1987, the world economy did not fall into a Depression as initially feared. By 1989, stock markets had more or less recovered. If you bought into the market after the crash, you would have profited greatly.

But what if you bought into the market after the stock market crash of 1929 (see The Great Crash of 1929)? Or you bought Japanese stocks just after the bursting of the bubble in the late 1980s? The outcome will be completely different if you had done so.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

Another sign of the business cycle top

Friday, February 23rd, 2007

In our previous article, Where are we in the business cycle?, we explained why we believe that Australia is probably at the peak of the business cycle. We also believe that the United States is also at the peak too. At the top of the business cycle, we will often be bombarded with reports about companies making record profits, even beyond analyst expectations. Consequently, share prices may rise as a result.

Do not be deceived.

In a business cycle peak, company profits as a whole are as good as it can get. If you expect the profit trend to continue and pay a premium price for stocks in anticipation for higher earnings next year, chances are, you will be disappointed.  It is now time to hunker down in your bunker in preparation for the economic downdraft. If you must stay invested in stocks, avoid outright cyclical stocks (see What to avoid at the peak of the business cycle?). Instead, choose companies whose earnings are more robust in the face of an economic slowdown and can survive through the tough times?even then, in such a pessimistic economic environment, even their stock prices will be depressed. Above all, avoid companies who are heavily laden with debt.

Already, we see another big warning sign: More US firms fail to meet Wall St’s earnings forecasts.