In part one of this two-part series on the importance of earnings I focused on the historical relationship between earnings and market price utilizing cyclical companies to illustrate the validity of my thesis. In this part two, I am going to focus on how since we learned from the past how important and highly correlated the earnings and price relationship is, that it only logically follows that future results will also be a function of future earnings achievements. Therefore, I confidently state that forecasting future earnings is the key to long-term investing success.
Furthermore, I want to acknowledge that I believe that investors cannot escape the obligation to forecast–our results depend upon it. However, we should not just guess, nor should we merely play hunches. Forecasting should be approached as analytically and even as scientifically as possible. Our goal is to calculate reasonable probabilities based on all factual information that we can assemble. We should then apply analytical methods that are employed based upon our underlying earnings-driven rationale. The endgame is providing us reasons to believe that the relationships producing earnings growth in the past will persist in the future. Maybe not at the precise historical rate, but at least at a rate that should compensate us for the risk we are assuming.
I believe the best way to accomplish a forecast that is reasonable within an acceptable range of probabilities is by applying both a macro and micro analysis. However, by macro I am not implying attempting to forecast the economy or political events. Instead, I believe that investors should focus on the major macroeconomic trends that identify the possibilities of major future investment opportunities. There are two that quickly come to mind, analyzing and monitoring demographics, and focusing on the potential of technological advancement.
The Macro Approach
Regarding demographics, perhaps the most important factor to recognize is what I like to call our population’s current bimodal distribution, namely, the graying of America and the baby boomer generation. Both of these powerful demographic forces are currently merging to create a powerful demographic associated with the aging of our population. By understanding the consumption tendencies of these and other demographic segments will allow us to make informed forecasts on the future health of several industries that will serve these large and growing markets. Of course, two obvious industries would be healthcare and financial services associated with retirement planning.
Regarding technological enhancements, there are just too many to single out. I believe the best way to learn more about this is to buy the New York Times best-selling book, Abundance: The Future is Better Than You Think, by Peter H. Diamandis and Steven Kotler. The book is just out, and the following are just a sampling of the many excellent reviews pouring in:
“A manifesto for the future that is grounded in practical solutions addressing the world’s most pressing concerns: overpopulation, food, water, energy, education, health care and freedom.”
– The Wall Street Journal
“…a godsend for those who suffer from Armageddon fatigue!”
– The Economist Magazine
“This is a vital book. Diamandis and Kotler give us a blinding glimpse of the innovations that are coming our way—and that they are helping to create.”
– Matt Ridley, Author of The Rational Optimist
I would like to add that there are unbelievably exciting opportunities described in this, what I believe, is a groundbreaking book. However, I would also add that there are some very frightening possibilities that the book also points out. Nevertheless, the book is about the exponential growth potential from new ideas that are capable of changing our entire economic paradigm. But most importantly, many of these game changing technology advancements are already available. In my opinion, the ideas in the book are mostly for the better, but there are also issues that will need to be dealt with. To my way of thinking, anyone that has investment capital at risk should get a copy of this book.
The Micro Approach
From the macro, the individual investor needs to move to the micro because ultimately, it is the individual security, or stock selection that produces long-term returns. As I’ve previously discussed in part one, long-term returns are a function of earnings past, present and future. And, I believe there’s no better way to come up with a reasonable forecast of future earnings than by conducting a thorough and comprehensive fundamental analysis on every company under consideration. However, the focus should be on attempting to determine whether said company possesses the future earnings power to provide you the returns required that are commensurate to the amount of risk you are taking to achieve them.
As serendipity would have it, I received a communiqué from MorningStar promoting a new growth stock product they are offering. Keep in mind that they are specifically speaking about growth stocks; however, I believe the underlying principles apply to all stock investing. There are two excerpts from their promotion that I thought succinctly spoke to what I’m discussing in this article, the first is as follows:
“The central question for successful growth investing, as we see it, is this: how long can above-average growth continue? Answer this question correctly, and you can make a lot of money, no matter how much you pay for a company’s stock. Compounding growth is a powerful force. “
The second excerpt talks about companies sustaining and building their moats:
“How can investors spot growth that’s unlikely to fizzle out?
Our answer: focus on the economic moat trend. A company’s ability to shield its business franchise not only protects its current profits, but also its growth prospects. Rather than simply focusing on companies already benefiting from strong competitive advantages–or focusing on companies that already have wide economic moats–we look at companies still building and growing their economic moats. We believe this brand of growth investing leads to high-quality companies that can consistently compound their intrinsic values year after year.
In other words, we buy not only growing companies, but also sustainably growing companies.”
To my way of thinking, MorningStar’s above advice is extremely important when trying to determine the future growth potential of any company you are analyzing. On the other hand, it’s often easier said than done. Recognizing and correctly evaluating a company’s strategic advantage is a difficult task indeed. Furthermore, this is a process and not a one-time act. In other words, it’s imperative that the investor/owner continues to monitor, check and recheck a company’s strategic advantage on a continuous basis. Due diligence must be ongoing. Perhaps the good news is the company’s prospects usually don’t change overnight or in the blink of an eye. Therefore, the diligent investor would have ample time to reevaluate each company’s prospects.
A Quick Review of History-Learning from the Past
In part one of this two-part series we used four examples of cyclical companies that illustrated the undeniable earnings and price relationship and correlation. Although this, part two, is essentially focused on the future, there is much that can be learned from the past. So before we move on to a closer examination of the future, let’s review the past by including one of our example cyclical companies from part one, and compare it to a company with a stronger history of earnings growth. For perspective, we’re going to add a plotting