With that aside, it is sometimes necessary to bring things down to the “elementary” or uncomplicated talk — plain language if you will, so that we all can easily understand. Too often, we investors tend to make things rather complicated. While they often are, sometimes we complicate things on our own. It’s good to return to the basics and remind ourselves of some very important principles that some of the great investors have laid down for us.
In an attempt to simplify or clarify some of our methodologies during tough times, and somewhat in the same vein of Bruce Berkowitz’s attempting to "kill the stock,” I want to Lynch them — Peter Lynch, that is. Rather than attempting to kill the stock, Lynch gave us a different perspective in evaluating earnings that bears repeating and that investors need to implement in their examination of any stock being analyzed.
Peter Lynch managed the now famous Fidelity Investments’ Magellan Fund, thereby placing himself among the greatest of investors. The fund, at times, consisted of nearly 1,400 stocks at any one time. During his tenure, the Magellan Fund returned approximately 29 percent annually, almost doubling the return of the S&P during that 13-year run. At the genesis of the fund, Lynch had only $20 million to manage and was able to transform that amount into $14 billion during those 13 years. The author of such books as “Beating the Street,” “One Up on Wall Street” and “Learn to Earn,” Lynch remains a favorite of many (both value investors and growth investors), since walking away from his position as vice chairman of Fidelity’s Management and Research Company and finally retiring in 2007.
“Invest in simple companies that appear dull, mundane, out of favour, and haven’t caught the fancy of Wall Street.” — Peter Lynch
Lynch doubted the ability of individual investors or of analysts to predict the future when it came to earnings, even those as early as the next quarter’s. He was always cynical of the earnings estimates that investors seemingly waited for each quarter as if the company’s entire future rested on the outcome. No better example of the truth of this skepticism can be portrayed as well as James Montier is his book, “The Little Book of Behavior Investing.” Montier explains that the analysts are no better than the average investor and that’s not good: “Their forecasting record is simply dreadful on both short- and long-term issues. When an analyst first makes a forecast for a company’s earnings two years prior to the actual event, they are on average wrong by a staggering 94 percent (emphasis mine). Even at a 12-month time horizon, they are wrong by around 45 percent! To put it mildly, analysts don’t have a clue about future earnings”. He goes on to point out that their accuracy is basically the same as a flip of a coin.
So what are investors to do when it comes to earnings? Consider the earnings of General Electric (NYSE:GE) over the last 10 years:
2003: $ 1.49
2004: $ 1.59
2005: $ 1.54
2006: $ 2.00
2007: $ 2.17
2008: $ 1.72
2009: $ 1.01
2010: $ 1.06
2011: $ 1.23
2012: $ 1.29
Depending on one’s outlook or search for confirmation bias, what would you expect next year’s earnings to be? $1.40? More? Less? Five-year and 10 year averages for GE indicate a negative earnings growth percentage. Only in the last three years has some consistency been shown, but earnings for 2010, 2011 and 2012 are still less than the earnings of 2003, 2004 and 2005.
The following numbers are from Yahoo Finance, and are the projected earnings for GE for the years 2013 and 2014. It is difficult to know what this is based upon, other than they are projecting 2013 earnings to be 25% higher than 2012’s. The first quarter for GE disappointed the analysts already and it appears that the numbers are already too optimistic.
Several large investors have purchased General Electric (NYSE:GE) recently, yet the average investor is stymied because they see no earnings growth, no free cash flow growth, little revenue growth, negative EBITDA growth and a discounted cash flow analysis that indicates the stock is worth less than the current price. They try other methods of valuation to try and determine the company’s true value, but the Lynch number or Graham number does not help confirm what they are hoping for. You continue until you either discover a valuation method that indicates the value you are hoping for or you decide to stay away from a stock that very well may have lots of potential your just aren’t seeing.
What does Peter Lynch suggest? Instead of looking at the “future” or “projected” earnings, Lynch wants you to fully comprehend the business model and recognize that management has five primary options for increasing earnings. Once you understand their options, you know what to look for. Follow management’s guidelines for the future and see how they follow through. Their options are limited for earnings growth:
1. Reduce the company’s costs.
2. Raise all or a portion of the company’s prices.
3. Expand the company by entering new markets (Russia, India, Brazil, etc.).
4. Increase sales or revenues in existing markets.
5. Close or sell a portion of the business that is not adding value.
They also have a choice of manipulating depreciating expenses, as an example, giving them a short term boost to earnings, only to be followed up by worse earnings down the road. Not the best road for a CEO to take, but it happens too often and you need to be able to recognize it when it occurs.
Earlier this year Jeff Immelt, General Electric’s CEO, announced the acquisition of Lufkin Industries. What the investor needs to determine is whether the acquisition may be accretive to shareholders, that is, is it adding value? While it remains to be seen, those are the considerations you need to make next to the company's stagnant earnings, cash flow, etc.
Immelt also announced the intention of several spin-offs. For a large conglomerate like General Electric, this very well could be a catalyst for a more efficient and growing company. Will that add value? How much? Don’t just look at the numbers; understand the business and the potential for Immelt’s program for growing earnings.
Projecting yourself into management’s position is also a wise move. How would you deal with the economic headwinds, recessionary, deflationary or competitive problems that your company is faced with? You could opt to do nothing and let the earnings report disappoint and let the market react accordingly. Sometimes this can be a brutal option, and depending on your compensation arrangement, may not be the best choice. You can try to cut costs, but even those can create new problems. Eliminating or decreasing promotional budgets may perhaps make up for the earnings shortage, but they may also decrease potential revenues. Another alternative is to create some promotional incentives that might increase revenue prior to the quarter’s end.
But Lynch wants you to think as the business owner. What else do I have here that increases or indicates value? Okay, maybe the spin-offs will be the catalyst for future growth, but what else can I rely on? Consider two Lynch favorites:
Look at the debt ratios. Peter Lynch did not like companies that had lots of debt, especially during troubled economic times. According to Lynch and common sense, “Companies that have no debt can’t go bankrupt.” This screams value.
Look at net cash per share. It’s calculated by taking cash and cash equivalents, subtracting long-term debt and dividing by the number of shares. High level numbers of this ratio indicate financial strength or removal of potential risk. Lynch considered it a bonus when the number exceeded 30%. General Electric’s net cash per share currently is 31%.
Ultimately, Lynch knew the story behind the companies he invested in and knew the various ways to discover value that was hidden from many investors. When you think like the owner, things become much more elementary and straightforward.
Disclosure: No position