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When Using a Trend, Tread with Caution

Alex Morris

Alex Morris

36 followers
When I’m using my favorite methodology for valuation (reverse DCF), I spend a fair amount of time looking at past growth rates and earnings trends when evaluating a security. As noted by Ben Graham in Security Analysis, “The trend of earnings is a key factor in current analysis and appraisal of common stocks.” However, this strategy must be used with extreme caution: As noted by Graham, “The analyst must be fully aware of the implications of extrapolating a trend line.”

First off, the time period chosen must be deciphered as an adequate representation of the firm and its movements throughout a full business cycle; choosing a cyclical business and focusing on only half of the cycle will certainly lead to inaccurate conclusions. For this exercise, I’m most comfortable taking no less than ten years worth of data, while consciously considering the time frame in question and how developments during which have adversely or positively impacted the company. A great example would be Lululemon (LULU); in my mind, to grab the last five years of data and simply extrapolate into the future would be a grave miscalculation that fails to account for a fad which will face increased competition and compressed margins due to the lack of any real competitive advantage for the incumbent. Without any barriers to entry, Lululemon will not be able to continue to generate outsized gross margins (56%, compared to 40%, 37%, and 44% for other retailers, such as The Gap (GPS), Aeropostale (ARO), and The Buckle (BKE), respectively), and will revert to the mean as new entrants chip away at excess returns. As Graham noted, “The analyst’s primary role is to anticipate change when others are extrapolating the past.”

Another important concept is the ability to step back from the research, and not to become enamored by the numbers. Academic finance has fallen victim to this desire for precision (but certainly not accuracy), with an emphasis on metrics like WACC, cost of equity, and beta. As Graham notes, “It [the trend projection] should only be used as a rough index of what might be expected from the future.”

As always, the intelligent investor demands a margin of safety, and would not make an investment on the hope that extraordinary growth rates continue to materialize. As James Montier calculated in “Value Investing: Tools and Techniques for Intelligent Investment,” staying away from expectations of high double digit growth would be well advised: From 1951-1998 in the United States, only stocks in the 90th percentile and above were able to achieve growth in operating income (before depreciation) of 15%-plus over a ten-year period.

As expected, trend extrapolations are most reliable and useful for companies with a long history of consistent (hopefully increasing) cash flow generation. Unlike the speculator, who is guessing about the future without a reasonable guide from the past, the investor must “treat the future as a hazard which their expectations must encounter and attempt to guard against.” This explains why someone like Warren Buffett of Berkshire Hathaway (BRK.A, BRK.B) buys companies with sustainable competitive advantages and relatively static business models that won’t look much different 10, 20 and 50 years from now.

Many of the growth stocks that are loved by investors today (like Salesforce.com (CRM), for example), simply do not meet the safety requirements (especially at these prices) for sound investment: “The security analyst is on safest ground when favorable expectations are treated as an added reason for a purchase which would not be unsound if based entirely on the past record and the present situation.” Salesforce.com, at $136 per share, is the antithesis of this idea: Nobody in their right mind would consider paying even half of today’s market price based on the historical record and present economic situation.

People interested in investing rather than speculating should heed the words of Ben Graham and James Montier, and flock to stocks with consistent (proven) earnings power rather than wildly optimistic expectations for future growth; for the intelligent investor, this means treading with caution when implementing trend line extrapolation in security valuation.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 4.1/5 (7 votes)

Comments

Adib Motiwala
Adib Motiwala - 3 years ago
Alex. Keep up the good work. I am sure you will find some suitable employment :)
Alex Morris
Alex Morris - 3 years ago
Adib, thanks for the kind words. Officially a college graduate and unemployed! Not too angry though, keep on writing articles and reading books for a bit until someone gives me a shot to prove myself :)
Adib Motiwala
Adib Motiwala - 3 years ago
Send me an email. Lets talk.
Alex Morris
Alex Morris - 3 years ago
Adib,

What is your email? You can contact me at alexmorrisinvesting@gmail.com if that is better for you. Thanks
ashrafwagdy
Ashrafwagdy - 3 years ago




I have the pleasure to brief you on our Data Visualization software

"Trend Compass".



TC is a new concept in viewing statistics and trends in an animated

way by displaying in one chart 5 axis (X, Y, Time, Bubble size &

Bubble color) instead of just the traditional X and Y axis. Discover

trends hidden in spreadsheets. It could be used in analysis,

research, presentation etc. In different business sectors, to name a

few we have Deutsche Bank, NBC Universal, RIM, Vanguard

Institutional Investor, Ipsos, Princeton University as our clients.



NBC presentation on TED using Trend Compass exported Videos. Now on

CNN Money / Fortune (Dec 21st,2010):

http://tech.fortune.cnn.com/2010/12/21/from-laughing-to-judging-in-fifty-years-the-evolution-of-televised-emotion/



The
following link is for our new Geographical Trend Compass

(Earthquake in Japan - Mag vs Depth vs Time):

http://www.epicsyst.com/test/v2/japan-earthquake



Link
on Ads Monitoring on TV Satellite Channels. Pick Duration (Ads

daily duration) vs Repeat (Ads repetition per day).

http://www.epicsyst.com/test/v2/tv-monitor/



Link
showing drilling feature (Parent/Child) - Just double-click on any

bubble:

http://www.epicsyst.com/test/v2/drilling/



Link
on UK Master Card vs Visa performance :

http://www.epicsyst.com/test/v2/mastercard_vs_visa/



Links
on Funds:

http://www.epicsyst.com/test/v2/best_exchange_traded_funds/

http://www.epicsyst.com/test/v2/us_insurance_funds/

http://www.epicsyst.com/test/v2/aaim_fund_performance/



Link
on other KPIs :

http://www.epicsyst.com/test/v2/hospital_performance/

http://www.epicsyst.com/test/v2/international_insurance/



Link
on Chile's Earthquake (Feb 27th 2010):

http://www.epicsyst.com/test/v2/EarthQuakeinChile/



This
a link on weather data :

http://www.epicsyst.com/test/v2/aims/



This
is a bank link to compare Deposits, Withdrawals and numbers of

Customers for different branches over time ( all in 1 Chart) :

http://www.epicsyst.com/test/v2/bank-trx/



Misc
Examples :

http://www.epicsyst.com/test/v2/airline/

http://www.epicsyst.com/test/v2/stockmarket1/

http://www.epicsyst.com/test/v2/football/

http://www.epicsyst.com/test/v2/swinefludaily/

http://www.epicsyst.com/test/v2/babyboomers/



This
is a project we did with Princeton University on US unemployment :

http://www.epicsyst.com/main3.swf



A
3 minutes video presentation of above by Professor Alan Krueger

Bendheim Professor of Economics and Public Affairs at Princeton

University and currently Chief Economist at the US Treasury using

Trend Compass :

http://epicsyst.com/trendcompass/princeton.aspx?home=1



You
can download a trial version. It has a feature to export

EXE,PPS,HTML and AVI files. The most impressive is the AVI since you

can record Audio/Video for the charts you create.



http://epicsyst.com/trendcompass/FreeVersion/TrendCompassv1.2_DotNet.zip



All the best.



ashrafwagdy

Trend Compass Team

Epic Systems

www.epicsyst.com





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