Investing in anything comes with a degree of uncertainty because all investing returns happen in the future. And even though the future is unpredictable, the future is what everyone that invests is investing for. These realities present important challenges that every investor must face and deal with in order to succeed.
But even though we cannot predict the future with perfect precision, there are prudent and rational actions that investors can take that can bring an element of certainty into an uncertain process. This article will review 2 key strategies that investors can implement to improve their odds of successfully investing in common stocks in an uncertain world.
The Two Keys to Investment Success: Fair Valuation and Earnings Growth
The 1st Key: Assessing Fair or Sound Valuation
[drizzle]The first major key to successful long-term investing in stocks is to get valuation right on the buy side. I’ve written extensively on fair valuation in my last article found here.
One of the primary points made in the above article about valuation is that it is a measure of soundness and not an indicator of potential future return. I also pointed out that one of the key points about paying attention to fair value is that it positions you as an investor to achieve results commensurate with what the company is capable of generating as a business. This represents the essence of soundness.
This is critically important and worthy of repeating. Fair valuation empowers the investor to receive the full complement of what the business invested in is capable of producing earnings-wise. In other words, when you are disciplined enough to only invest when fair valuation is present, you position yourself to earn returns that are consistent with what the underlying business earns. However, it’s important to recognize that this means getting the good and/or the bad depending on the individual company. The following excerpt from my previous article elaborates on this point:
“Just because you buy a stock at value doesn't necessarily mean that you will receive a high return. This is because value, although important, is only one component of future return. The other important component is the earnings growth rate of the business.
To clarify, you can buy a slow-growing company at sound valuation and even at the same valuation as a faster growing company, while still earning only a modest rate of return. In fact, it could be argued that only being willing to invest at sound valuation is more critical for a slow grower than it is for a faster grower.”
At this point I will also add that it is also possible to buy a company at fair value based on current earnings and lose money if future earnings fall dramatically. This is where forecasting future earnings in addition to assessing fair current valuation comes into play.
The 2nd Key: Estimating Future Earnings Growth
Estimating future earnings growth is the second major key to successful long-term stock investing. This is especially relevant to the business perspective investor because you are actually investing in the business, not the stock. Consequently, the success of the business that you invest in is going to be the primary determinant of how much money you can expect to earn on that investment. Stated more directly; when you invest in a business, you are buying its future earnings potential.
The only logical reason I would ever want to invest in a business is because I believe the company is a profitable enterprise. Like all business owners, I recognize that my reward can only come from the future profits the business can generate on my behalf as an owner. Moreover, the growth of those profits will represent the primary source of the future total return I can expect to receive from investing in it. In the long run, the market will capitalize future earnings growth (apply a reasonable P/E ratio) which will generate my potential capital appreciation, and dividends, if any, will also come from future profitability. Of course, this only applies if I originally invested in the business at fair value.
Therefore, I believe as investors, we cannot escape the obligation to forecast future earnings, because our results depend on it. Furthermore, we should not guess, nor should we simply play hunches. Instead, we must attempt to calculate reasonable probabilities based on all the factual information that we can assemble. Then we should apply analytical methods based upon our earnings-driven rationale that provide us reasons to believe that the relationships producing earnings growth will persist in the future. In other words, we must strive to forecast future earnings as accurately as we possibly can. On the other hand, we should simultaneously realize that perfection is not to be expected.
As an aside, there are many who criticize or even claim that we should avoid utilizing forward earnings forecasts when trying to determine fair value, or even when trying to decide what stock to own. I find these positions rather bizarre. I cannot think of any logical reason why anyone would invest in a business, unless they had a reasonable expectation of that business's ability to generate future profits. Since I am confident that both capital appreciation and dividend income will be a function of the company's future earnings power, estimating future earnings must be an essential element of long-term success.
Consensus Earnings Estimates Accuracy
Looking for attractive dividend-paying stocks to add to your retirement portfolio? You might want to try trusting analysts' estimates to aid in your selection process. I cannot tell you the exact number of times that people have commented on how inaccurate analyst estimates are in my articles over the years. However, I can confidently state that there have been many.
Nevertheless, I have always found those comments rather strange. It seems to me that rational people would recognize that forecasting the future of anything can never be perfectly precise. In other words, how high of a standard should we hold analyst earnings estimates to? I will add my personal view a little later in the article. But before I do, I would like to call attention to what I consider excellent work on the subject by highly respected fellow Seeking Alpha author Jeff Miller.
Interestingly, both articles were written in 2010; however, I consider the content just as relevant today as it was back then. One of the primary points that Jeff expressed in these articles is that the perception that analyst estimates are unreliable was based on studies that evaluated long-term earnings growth rate forecasts. However, Jeff pointed out that analyst forecasts over shorter periods of time tend to be more accurate, and for the most part, conservative. For those not interested in reading both articles in their entirety, I include the following two excerpts that I consider irrelevant to this article:
“Analysts' forward earnings estimates are very good for a one-year time frame.
To emphasize, in the forward earnings series I am taking this one step at a time.
- Earnings are important. Eventually, stock prices reflect the fundamentals. If you do not understand this, you should read some of the work from Chuck Carnevale, whom I have cited on several occasions.
- If you have a better estimate of next