EXTRAPOLATING EARNINGS GROWTH — THE 1929 BULL MARKET

The year 1929 is etched in the mind of every stock market historian. The October 1929 Crash heralded the start of the worst bear market in US history. As already noted, by July 1932 the Dow was down a staggering 89 per cent from its September 1929 high. The crash triggered the worst depression in American history, sent thousands of banks to the wall, and bankrupted countless investors and businesses.

As with most ‘overcooked' markets, it's often asked why more investors didn't realise the 1929 Crash was coming. Problem was, like all bull markets, it wasn't obvious to them at the time. And, contrary to popular belief, not all stocks appeared to be overvalued to investors of the day.

Tables 26.1 and 26.2 show seven popular stocks both at the time of the Crash and in 1962. With the exception of General Electric their PEs weren't at stratospheric levels prior to the 1929 Crash. (Full acknowledgement for the information they include goes to Robert Sobel, who presented them in his book The Great Bull Market: Wall Street in the 1920s.¹³⁹)

It's interesting to note the staggering drop in the share prices of these companies from 1929 to 1962. The reason for this is the marked difference between what investors in 1929 expected regarding future earnings growth and what actually happened. Those investors who'd extrapolated the earnings growth rates that industrial stocks were delivering prior to the 1929 Crash would have been disappointed with their 1929 purchases for decades.

So, if extrapolation didn't work here, how does one select an appropriate earnings growth rate? Like the many examples given throughout this book, on every subject from the performance of the economy to the capital appreciation of real estate to share market returns, think ‘mean reversion'. In exuberant times, dial down the market's expectations of growth, and in depressed times dial them up. I know it's appealing to search exclusively for companies with the potential to deliver explosive growth, but the chances are you won't find them. Investing is about playing the odds, not buying winning lottery tickets. And the most likely odds are that companies, when considered as a group, will perform more in line with the long-term performance of the economy. You'll deliver more realistic valuations if you think earnings growth in the realm of low single digits.

I've previously described how a couple of great investors have dealt with the growth question. Ben Graham recommended that defensive investors seek companies that have demonstrated earnings growth over the previous 10 years of at least 33 per cent. That's an average geometric rate of just below 3 per cent per year. Graham proposed this for inclusion in a stock screen, but it also provides for the development of realistic assumptions. And, as I mentioned in chapter 22, I was told by a fund manager who worked with Warren Buffett for several years that ‘Buffett doesn't pay much for growth'.

Now I know that plenty of people can present real-life examples of companies that have delivered much higher earnings growth rates than I've mentioned here. But no company can do it forever, and of course these spurts of high growth are quoted after the event. To have gambled on them before they were delivered is an entirely different game, a high-stakes game. I'd liken it to spending your time chasing pots of gold at the end of rainbows. While you're off chasing them, you'll miss the more obvious opportunities that present themselves back at home from selecting undervalued companies you've identified using lower growth assumptions. If you approach things this way, any future surprises regarding rates of earnings growth actually delivered will more likely be pleasant ones. Again, we're working the odds in our favour. Edward Sherwood Mead and Julius Grodinsky, in their 1939 book The Ebb and Flow of Investment Values, made the powerful point that it's the natural course of events for corporate growth to slow. So paying a high price for a high rate of current growth means you're playing a game where the odds are stacked against you.

EXTRAPOLATING RETURN ON EQUITY

Closely tied to the concept of earnings growth is that of return on equity. Not surprising when you consider that:

Also not surprising when you consider that companies capable of maintaining a high ROE are more likely to demonstrate high rates of earnings growth.

Therefore I'll try not to repeat the discussion we've already had. But since many valuation formulae ask specifically for ROE as an input, I'd like to discuss it specifically. The question we must ask is: for those valuation formulae that demand ROE as an input, are we able to plug in historical figures for this metric?

Three researchers — Patricia Dechow, Amy Hutton and Richard Sloan — conducted a study that covered a large sample of company data from 1976 to 1995. They found that on average companies with initially high ROEs experienced a decay rate of 38 per cent per year in the margin between their ROE and their cost of equity. Assuming their typical company has a cost of equity of 10 per cent and an initial ROE of 40 per cent, this fall would be to less than 29 per cent in the first year and to 21 per cent in the second. This means they found a strong tendency for ROE to move over time towards the cost of equity, which would see the share price fall towards book value.¹⁴⁰

The 38 per cent decay rate quoted by these researchers is an average, and clearly it varies from company to company. And while an analyst might still choose to extrapolate high historical ROE figures, there must be justification that they will persist. It's useful to reflect on Graham's words regarding this: ‘There must be plausible grounds for believing that this average or this trend is a dependable guide to the future.'

Enter the concept of sustainable competitive advantage, or ‘moat'. It's why Buffett so dutifully searches moats out. This from his 2007 letter to Berkshire Hathaway shareholders: ‘A truly great business must have an enduring “moat” that protects excellent returns on invested capital.'

To assist in the selection of companies more likely to maintain a high ROE, look for factors that bestow an enduring competitive advantage — such as a strong market position, consumer brand loyalty coupled with the ability to maintain a price premium, an ability to maintain lower operating costs than competitors, or advantageous licensing agreements. Without one or more of these advantages the barrier is low for new competitors to enter that business space. It's likely new competitors will continue to be attracted as long as the anticipated ROE exceeds the return they demand. New entrants and the increased price competition they bring will see falling revenues, reduced profit margins and lower ROE for all businesses operating in that sector.

This should not be taken as an argument against investing in companies with high ROEs. On the contrary, these are the very companies that should be sought out. However, it is those characterised by enduring ROE and that can be purchased at either a fair or cheap price that will generate wealth for their shareholders.

Additionally, look for companies operating in a business sector, or sectors, less vulnerable to the march of technology. In the same PBS interview I quoted in chapter 24, Charlie Rose read aloud the following Buffett quote:

‘The Internet won't change chewing gum. When I look at the Internet I try to figure out how an industry or company can be hurt or changed by it and then I avoid it. Take Wrigleys. I don't think the Internet is going to change the way people chew gum.'

A CASE STUDY: FORGE GROUP

Now to a case study that was unravelling as I was writing this chapter. Forge Group is an Australian mining services company that rode high on the world mining boom fuelled by China's apparently insatiable appetite for iron ore and energy in the early 21st century. Forge's share price rose from a low of 15 cents in 2009 to a high of $7.06 in 2011, and over the following two years it hovered around the $5 to $7 mark. That represented a near 50-fold increase in its share price based on a fivefold increase in earnings.

The reason for the significant re-rating of its share price was that analysts had started to extrapolate the company's rapid change in fortune, and they were doing it in what they felt was a fairly conservative manner. The company was starting to deliver a new and consistently high return on equity of around 30 per cent. Annualised earnings had grown at an average rate of 37 per cent for a four-year period and the balance sheet appeared to be strong — there was a virtual absence of debt. What's more, there appeared to be plenty of new contracts in the pipeline for the company. And on a PE of less than seven times, even the most value-conscious of investors didn't appear to be going overboard on the share price. Certainly, based on historical metrics alone, this stock looked cheap.

Sailing along with its rosy metrics intact, the company requested a trading halt on 4 November 2013. Twenty-four days later the voluntary trading halt was lifted, and when trade recommenced Forge opened 91 per cent lower than its closing price before the halt. What happened?

The company had disclosed a $127 million profit write-down associated with two projects that seemed to be threatening the viability of the company. However, the bad news was closely followed by two positive announcements regarding new favourable future work contracts. Five weeks on and the share price was up 400 per cent from its November low.

But the renewed enthusiasm was short-lived. By February administrators were appointed and soon after the company was suspended from official quotation. Unlike the example of the Durant-Dort Carriage Company, the sector hadn't died, just the company. And what a roller-coaster it was for shareholders over the several months before it did.

To repeat Graham's words, for one to rely on historical metrics, ‘There must be plausible grounds for believing that this average or this trend is a dependable guide to the future.'

How you best arrive at plausible grounds for this belief is up to you. For me it starts with companies that possess:

• a solid history of positive earnings
• earnings growth that is consistent rather than erratic
• revenue streams that don't rely on just a few customers
• products that are relatively immune to the economic cycle
• products that are more attractive than those offered by competitors, enabling favourable pricing.

I expect this is why Buffett is so attracted to consumer staple stocks such as Coke and Gillette — they tick every one of these five boxes. It's probably also why research undertaken by Wharton professor Jeremy Siegel demonstrates that the best returns have been delivered by companies possessing strong brand names, particularly in the consumer staples and pharmaceutical industries.¹⁴¹

In your search for numerical constants look for stable, class-leading companies in stable industries. Look for relative rather than absolute constants. Mean revert. Think long term, not short. And don't be influenced by current opinion or sentiment in your determination of what those constants should be.