Newsletter December 26, 2013
InvestorsFriend Inc. Newsletter December 26, 2013
Company Earnings and returns Versus Investor Returns
Most mature Companies on the stock market tend to make profits almost every year. And some companies show earnings that advance fairly steadily without great volatility. Investors in such companies however tend to see returns that lurch around violently.
Even a very broad index like the S&P 500, since the year 2000, has seen “gains” as low as minus 38% (2008) and as high as 28% (this year). In these 14 years, four years have been negative and ten positive. The index gained only 19% in that entire time (about 1.25% per year). In only one year out of the past 14 was the gain on the S&P 500 index relatively close to its long term average.
Meanwhile the S&P 500 earnings, though they were volatile, were positive each and every year. The S&P 500 earnings are up 97% or 5.0% per year.
So the companies in the S&P 500 did well. They grew their earnings at a decent rate. But investors, on average, did not do well. This was because the P/E ratio fell 38% from a bloated and bubbly 30.5 at the start of the year 2000 to about 19 today.
The fact that investor gains and losses in the S&P 500 were hugely volatile in the past fourteen years while the earnings on the index were far less volatile (and never negative) may see strange. But it’s actually pretty normal.
Stock prices and the stock index levels are, in theory, the market’s best estimate of value of the expected future earnings of the company or the group of companies in the index. When estimates of the growth in earnings change moderately, this can have a fairly dramatic impact on valuation. And when the market’s consensus view of the required return on the index (which directly affects the P/E ratio) then changes in valuation can also be dramatic.
And while the valuation and returns on a broad index like the S&P 500 can be highly volatile even while the earnings are much more stable, the situation for an individual stock is far more dramatic. For a given company estimates of future earnings can change quite quickly and dramatically. Given dramatic changes in earnings estimates and changes in the required return (affected by interest rates and risk perceptions), the changes in a stocks value can be very dramatic indeed.
Therefore we arrive at a confusing situation whereby companies can make money while investors lose money. Or the opposite. There is nothing unusual about that. But that’s in the short term. Over the life of a company investors will ultimately make returns that are highly correlated to the actual earnings of individual companies and of the group of companies in stock indexes.
This being the case, it makes sense to focus investments on companies that are making good profit levels. (As opposed to focusing our investments on guessing which way the stock price will move in the short term). The following article addresses how companies make money.
The Dupont ROE Formula and How Companies Make Money For Investors
If you want to make money, go where the money is!1
In the stock market it is possible to make money by buying a stock in a company that is not making any money and that will never make any money. If you buy the stock at one price and are able to sell it at a higher price, you can make money no matter that the company is losing money. But that’s a dangerous and risky strategy.
A far more reliable way to make money in the stock market is to buy (reasonably priced) shares in a profitable company and to benefit as the company continues to make profits over the years.
Investors should understand how companies make money.
This article will review the basics of a balance sheet and income statement and will out components that illustrate how companies can make attractive returns for their owners.
It occurs to me that most stock market advice is not all that independent. Certainly some of it is but much advice is not independent.
A great deal of stock market research is supplied by large investment banks. Here are some of the ways that independence of that advice is compromised:
- The companies being rated are often (though not always) clients of the bank both as commercial banking customers and as investment bank clients (the bank raises debt and equity capital for these companies).
- The analysts rely on having good relations with the company so that they can be kept apprised of certain developments at the company. These analysts often forecast the earnings of companies. I suspect that this is usually done with some assistance from the companies. It’s hard expect such assistance if an analyst is critical of management and/or suggests that the stock is over-valued.
- Analysts working for big firms cannot safely depart from conventional methods of analysis. If an analyst gets something wrong while following the same procedures as others, there is little risk. But woe betide to the analyst with an unconventional approach or conclusion that ends up wrong.
- Analysts working for big firms will usually have their work second-guessed by supervisors, therefore the result will trend towards average thinking and away from truly independent thinking.
With respect, it’s my conclusion that my work at InvestorsFriend is unusually independent. That is not to say that my work is unbiased. Everyone has their biases. But I believe it is fair to say that the stock picks at InvestorsFriend Inc. are based on highly independent research. I developed my own unique approach to stock research. I borrowed ideas from here there and everywhere. But I did the math and the thinking to convince myself of the merits of all of the various parts of the analysis.
Shawn Allen, President
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