February 4, 2011

There are several concepts associated with value investing: margin of safety, hunting for low Price-to-Earnings (PER) and Price-to-Book ratios, being contrarian. Another point, one that we feel is underappreciated, is avoiding peak earnings.

The PER has been the mainstay of investors ever since Benjamin Graham. Whilst the volatility of stock prices (the “P”) gets a lot of publicity, we are surprised at how little press is given to the risk associated with the “E”. If the earnings aren’t sustainable, then trading on a low multiple of those earnings is not an indication of value. So earnings, and their sustainability, are just as important as the PER. How does the industry test the resilience of earnings? Far too frequently analysts are seduced into the trap of extrapolating the recent past. “It’s what management are saying, it’s been true recently, everything seems fine”. A company’s earnings will grow at 10% because they have done so recently.

There are many reasons why relying on this extrapolation of the recent past is a bad idea, and the most obvious is that forecasters are terrible at predicting reverses in trends. Companies don’t grow strongly, consistently and without interruption. Look back at history. The markets are riddled with companies that have grown earnings for several years in a row; those that have done it consistently for 10 or even 20 are extremely rare.

In almost every case, economies and corporate profits have proved to be cyclical over time. They don’t go from high to higher for eternity. Most often corporate profits and returns on capital fade from peaks back down to more modest levels.

The fundamental reason for profits reverting to a mean is that excess returns attract increased competition. Whenever a company comes out with a very profitable product, competitors immediately attempt to “invent” a similar product. Competition is drawn to a fat profit margin as bees are to honey. Very few products are so distinct as to avoid losing their edge in the longer run (this is what makes the Apple iPhone, Google web searches and Louis Vuitton handbags so exceptional. But no one knows which one of those will be de-throned or when). For almost all other products, competition wears down profit margins eventually.

Because it is so attractive to extrapolate short term trends (both profits and price, i.e. momentum investing), companies experiencing peak earnings are often the most popular, and trade on the highest PERs. This doubles up on the risks associated with earnings reverting to mean.

At the other end of the spectrum, there are opportunities: companies that are trading on low PERs with trough earnings. Industries that are in a tough period where returns are low are likely to see the weakest players leave the industry. This retraction of supply allows the remaining players some level of increased pricing power when (if) demand increases. The combination of some growth in these earnings aligned with a re-rating by the market can make for a very attractive return.

We at Kennox think that, of all the aspects of value investing, margin of safety is the most important. This means buying an asset that is significantly cheaper than a conservative estimate of its intrinsic value. “Conservative” is a key word there – we feel that conservative means that you have to look very sceptically on peak earnings.

Next time someone says to you that a particular company is on a low PER, don’t forget to check how high the earnings are. If they’re at a peak level, realise that the risk is higher than it first appears.

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