By Dr. Sheldon Shi
Wouldn't it be nice if a company's business is completely predictable,
just like a model train? Once wound-up, you know exactly where and how
fast it is going to be. Unfortunately in the real world there is no
such thing as a total predictability. But if you observe long enough,
you will find out some companies are more predictable than others.
Predictability is a loathed word in the financial world. Nobody wants to make a prediction and appears stupid when the numbers don't match. People like to use the word "forecast" instead. Just like a weather forecast, it is somehow "acceptible" and less stupid to be wrong and if it happens, we just joke about it. But in the end, they are the same thing. No matter whether we predict, forecast, project or extrapolate, predictability measures how well a company's past and present can be projected into the future, and how little or no surprises it usually gives along the way.
A prediction is different from a guess. A prediction is based on a calculated process where chances are to be minimized. A guess involves numbers mainly backed by chances not thoughts. The difference is as big as that between investors and gamblers.
There are reasons why predictability is loathed when it comes to the financial world, because chances are if one makes a prediction, it is going to be wrong. And even if it is right one may not know why it's right. (Sounds like the "high-school sex" joke?)
Predictability is lacking because:
- The real business world is full of random events. Whether by nature or man-made, "shit happens". There is no way to tell when a mad cow desease breaks out, or a tornado hits. This is the randomness factor.
- Even if in some place at some time "shit" didn't happen, we most likely do not know all the factors involved to make a deterministic judgement. When a drug company develops a new drug, it simply does not have information about its long-term side-effect. This lack of knowledge will certainly make the prediction on the future of the company on an incomplete footing.
- Even if we know all the factors involved, we still cannot make a good prediction because we can't measure these factors precisely enough. This is summed up in the "butterfly effect": a butterfly flaps its wings in one part of the world may cause a storm in another. We know all the laws of Physics to determine how the butterfly's wing flaps change the atmosphere, but in practice we can't know the wing flaps precisely enough to make a good prediction of whether, when, and where there will be a storm as a result. This is the "chaos" factor, where the result is too sensitive to the initial conditions, such that a small modification of the initial conditions may yield a completely different outcome. Even a simple system like three pendulums linked together will exhibit chaotic behavior, much less a real business situation which is infinitely more complex.
But luckily predictability to a long term investor doesn't have to be a precise science. If you predicted a $100M profit for a company based on the best information you had, but it made $105M profit, was your prediction right or wrong? If the difference of $5M was not enough to impact whatever decision you were going to make based on your prediction, I'd say your prediction was fairly right, and the company exhibited a fairly high degree of predictability. Remember Warren Buffett's words? "It is better to be approximately right than precisely wrong".
But of course, if a company repeatedly came up with numbers that were far off from your best-effort predictions so as to impact your decisions, it became rather unpredictable, at least to you. The reason might simply be you: your best effort was not good enough. But what does that help you? You'd better stay away from the company as an investment.
There are multiple reasons why some companies have more predictability than others:
- The business these companies conduct may be more stable, with fewer uncertain, disruptive forces. For example, the distribution and logistics business is more stable than high-tech network equipment business. That explains why Sysco is more predictable than Cisco.
- Some companies may be financially stronger to weather ups and downs of economic cycles. A company with no debt and a hefty cash reserve, will certainly fair much better in difficult times than a company whose cash flow barely covers interests.
- The management of some companies may be more experienced than others to steer their companies on steady courses. One can never overstate the importance of a good management team. Whether it is good time or bad time, a good management team makes the right strategic moves, and is responsive to operational errors. Companies under good management can constantly re-inventing themselves to survive in the changing world. IBM has been around for close to a century, and is still going strong. Who would think Nokia started out making rubber boots for the forest industry?
- Some companies may be in leading positions of their industries so that they are less subjective to competitions and pricing pressures. Intel, for example, have always been able to flex their marketing and financial muscle to keep AMD at bay, even if sometimes they are falling behind technologically. AMD, on the other hand, has had wild swings in profitability.
- Some companies use their cash more prudently, paying down debt, buying back stocks, instead of spending on empire-building acquisitions. Mergers and Acquisitions always introduce uncertainties and degrade predictability. If Company A is highly predictable, and Company B is not, the combination of A+B will at most have Company B's predictability, often worse. There are no shortage of exmaples of mergers and acquisitions turning bad, AOL and Time Warner was a prime example. Of course sometimes M&As do turned out ok, but they are the exceptions. Even in those exceptional cases, predictibility nevertheless decreases.
One thing I'd like to note is that I am not in favor of companies that don't change over time. Absolutely not. In fact, if a company never changes, its business eventually suffers. Predictibility does not stem from lack of changes, rather it stems from a constant adaption to changes. Only a steady stream keeps running forever; a standing pool will soon be full of algae and foul smells.
Although the reasons behind predictability are often consistent, the measurement of predictability itself is very subjective. If Company A made $100M profit in year 1, $110M in year 2, merged with another company and made $120M in year 3, is it more predictable than company B who made $100M profit in year 1, $110M in year 2 and $115M in year 3 without any M&A activity? I would think Company B is more predictable than Company A, because M&A activities introduce uncertainties, even though the end number (in this case the profit) happened to fall on the right line in statistical terms. Fortunately these subjectivities can be at least partially quantified. For example, I bet if you measure the number of diluted shares, you will see that Company B has a better predictibility than Company A.
To give some definitive measures of companies' predictivity, I devised the following subjective criteria:
- Consistency of revenues within the last 5 years
- Consistency of owner's earnings within the last 5 years
- Consistency of operating margins within the last 5 years
- Low debt to equity ratio and/or high debt coverage (owner's earning to debt ratio) during the last fiscal year
- high current ratio during the last fiscal year
- Consistent share growth, or even better, negative share growth within the last 5 years
I also excluded the entire financial sector. The financial sector is very different from the other sectors. Debt, for example, means a totally different thing to a bank. I haven't figured out an automated, meaningful and consistent way to measure predictability of banks, insurance companies and so on. I may revisit this sector later on.
Out of 4400 stocks that I track, 1675 of them appeared in my rankings. They have positive owner's earnings, positive book values, and have more complete financial data available to the public. As an sample of the ranking, the following table shows the top 100 S&P 500 members in terms of predictability (out of 292 ranked). The financial data shown in the table are snapshots of the companies' most recent fiscal year. Interestingly but not surprisingly, two of the top three of the S&P 500 ranking are among Buffett's holdings. A complete ranking (by sectors) of the 1675 companies are available as an Excel attachment to paid subscribers.
|Rank||Ticker||Name||D/E Ratio (a)||OE/Debt (a),(b),(c)||Op. Margin (a)||Current Ratio
|5-yr Average Share Growth||Market
Cap. ($M) (d)
|5-Year Return (d)|
|1||BUD||Anheuser-Busch Companies Inc.||4.32||0.11||22.50%||0.92||-3.86%||33,180||10.36||8.45%|
|5||TJX||TJX Companies Inc.||0.73||0.43||7.41%||1.31||-4.25%||9,640||7.56||85.02%|
|8||HCR||Manor Care Inc.||0.96||0.14||9.12%||1.34||-5.42%||2,930||9.15||143.03%|
|10||HD||Home Depot Inc.||0.17||0.38||10.84%||1.34||-0.89%||84,990||9.59||9.61%|
|12||FD||Federated Department Stores In||0.71||0.20||8.95%||1.74||-4.89%||10,890||6.73||124.26%|
|16||AVP||Avon Products Inc.||1.75||0.40||15.82%||1.643||-0.26%||12,680||9.97||34.29%|
|17||PG||Procter & Gamble Co.||1.08||0.33||19.25%||0.81||-1.2%||137,460||11.71||71.78%|
|18||PHM||Pulte Homes Inc.||0.67||0.31||13.15%||2.73||7.13%||9,790||7.90||399.45%|
|19||BBBY||Bed Bath & Beyond Inc.||0.055||3.38||15.39%||2.40||0.71%||11,570||12.86||79.48%|
|20||CAG||ConAgra Foods Inc.||1.14||0.097||8.69%||1.89||-1.03%||12,420||10.97||43.66%|
|21||PBG||Pepsi Bottling Group Inc.||3.49||0.034||8.94%||1.28||-4.05%||6,650||8.38||78.978%|
|22||NEM||Newmont Mining Corp.||0.37||0.14||26.88%||2.47||15.73%||19,680||11.40||213.44%|
|24||DGX||Quest Diagnostics Inc.||0.38||0.56||17.58%||0.89||1.66%||9,760||9.86||63.61%|
|25||FPL||FPL Group Inc.||2.19||0.036||14.75%||0.59||1.56%||17,010||11.90||58.48%|
|27||BBY||Best Buy Co. Inc.||0.19||1.06||5.25%||1.39||1.16%||21,270||11.40||110.45%|
|28||STJ||St. Jude Medical Inc.||0.12||0.53||25.54%||3.07||0.90%||17,500||25.45||276.00%|
|29||DHI||DR Horton Inc.||0.88||0.27||14.42%||5.21||7.29%||9,950||7.98||538.77%|
|30||RBK||Reebok International Ltd.||0.30||-0.05||7.77%||2.30||0.66%||3,000||8.41||255.15%|
|31||ADP||Automatic Data Processing Inc.||3.29||0.044||15.13%||1.58||-2.19%||24,980||26.12||-27.8%|
|32||FO||Fortune Brands Inc.||0.70||0.32||16.41%||1.29||-1.39%||11,180||9.66||252.88%|
|33||NWS-A||News Corp. Ltd.||0.62||0.10||14.93%||1.92||4.90%||48,800||14.03||-18.6%|
|34||JCP||JC Penney Co. Inc.||1.19||0.082||7.12%||2.44||0.95%||12,870||8.33||433.43%|
|36||SBC||SBC Communications Inc.||1.21||0.16||14.46%||0.45||-0.91%||73,000||9.05||-45.0%|
|37||ERTS||Electronic Arts Inc.||0.009||11.27||21.86%||4.47||2.27%||16,690||20.35||116.24%|
|38||BCR||CR Bard Inc.||0.17||0.90||21.931%||2.70||0.43%||6,720||15.36||233.12%|
|39||DRI||Darden Restaurants Inc.||0.48||0.29||8.93%||0.38||-3.69%||4,700||7.58||127.01%|
|40||BNI||Burlington Northern Santa Fe C||1.81||0.016||15.40%||0.59||-1.18%||21,820||14.23||189.17%|
|41||GILD||Gilead Sciences Inc.||0.016||13.62||47.68%||7.29||4.13%||20,900||31.47||295.49%|
|44||HRB||H&R Block Inc.||0.68||0.48||20.21%||1.39||-2.62%||7,680||7.07||197.58%|
|45||PBI||Pitney Bowes Inc.||3.81||0.008||21.08%||0.81||-2.04%||9,600||10.50||70.39%|
|48||WMT||Wal-Mart Stores Inc.||0.53||0.066||5.02%||0.89||-1.89%||190,320||11.28||3.92%|
|50||CSCO||Cisco Systems Inc.||0.051||4.33||30.00%||1.37||-4.06%||108,680||12.43||-69.1%|
|52||JNJ||Johnson & Johnson||0.23||1.03||27.16%||1.96||1.31%||190,950||12.63||44.31%|
|53||LOW||Lowe's Companies Inc.||0.34||0.042||10.17%||1.21||0.33%||48,600||11.20||219.46%|
|56||AVY||Avery Dennison Corp.||0.94||0.18||8.74%||1.11||-0.50%||5,770||10.90||31.39%|
|57||MHP||McGraw-Hill Companies Inc.||0.30||0.77||22.37%||1.24||-0.62%||17,760||11.47||67.73%|
|60||AW||Allied Waste Industries Inc.||3.50||0.001||16.53%||0.52||11.42%||2,660||8.07||-0.12%|
|61||WWY||William Wrigley Jr. Co.||0.12||0.55||19.73%||2.09||-0.06%||15,990||18.13||108.25%|
|62||LIZ||Liz Claiborne Inc.||0.31||0.17||11.06%||2.36||1.54%||4,060||6.74||119.01%|
|66||JCI||Johnson Controls Inc.||0.57||0.050||4.89%||0.96||2.23%||12,830||8.17||158.95%|
|67||ACS||Affiliated Computer Services I||0.41||-0.18||15.04%||1.48||3.29%||6,030||7.90||98.13%|
|68||LH||Laboratory Corp. of America Ho||0.65||0.28||19.36%||2.46||-0.31%||6,810||10.76||59.08%|
|69||NSC||Norfolk Southern Corp.||1.82||0.033||23.27%||0.89||0.95%||16,120||13.02||238.21%|
|70||NOC||Northrop Grumman Corp.||0.60||0.11||6.71%||1.10||14.36%||19,440||10.39||25.64%|
|72||TMO||Thermo Electron Corp.||0.12||0.70||11.48%||2.53||-3.45%||4,880||15.29||33.39%|
|73||CAH||Cardinal Health Inc.||0.39||0.18||2.86%||1.33||-1.46%||27,300||11.44||7.81%|
|74||FDO||Family Dollar Stores Inc.||0.068||1.53||7.84%||1.71||-0.42%||3,630||6.97||34.59%|
|76||IGT||International Game Technology||0.67||0.23||33.50%||2.69||4.62%||9,080||9.82||222.45%|
|79||APOL||Apollo Group Inc.||0.030||7.37||24.36%||1.83||2.90%||10,700||21.50||281.44%|
|80||APD||Air Products & Chemicals Inc.||0.83||0.14||11.30%||1.41||-0.78%||11,920||9.97||66.25%|
|81||FRX||Forest Laboratories Inc.||0.002||100.8||36.57%||4.80||-0.00%||12,030||9.09||32.23%|
|82||BR||Burlington Resources Inc.||1.01||0.14||46.60%||2.16||-2.40%||25,830||8.19||250.29%|
|83||COST||Costco Wholesale Corp.||0.16||0.49||2.88%||1.17||0.87%||23,080||11.76||46.74%|
|87||ESRX||Express Scripts Inc.||0.49||-0.03||3.26%||0.79||-1.04%||9,410||17.10||225.83%|
|91||BMY||Bristol-Myers Squibb Co.||1.01||0.23||23.03%||1.50||-1.06%||42,850||9.22||-51.5%|
|92||AHC||Amerada Hess Corp.||1.07||0.070||8.40%||0.92||0.77%||11,060||6.81||93.90%|
|93||BMS||Bemis Co. Inc.||0.61||0.18||10.22%||2.32||0.36%||2,570||7.78||73.52%|
|95||BAX||Baxter International Inc.||1.66||0.066||12.08%||1.40||1.22%||23,720||16.43||-3.33%|
|96||TYC||Tyco International Ltd.||0.73||0.17||14.39%||1.66||3.39%||52,440||8.75||-47.1%|
|97||CTXS||Citrix Systems, Inc.||0.020||-0.00||24.02%||1.24||-2.91%||4,440||20.71||33.53%|
|98||BDX||Becton Dickinson & Co.||0.53||0.32||17.98%||2.51||-0.65%||12,950||11.13||86.57%|
|99||BOL||Bausch & Lomb Inc.||0.52||0.21||12.52%||1.65||-1.77%||3,950||10.36||120.13%|
(b) OE: Owner's earning = net earning + (depreciation & amortization) - capital expenditure
(c) OE/Debt: Assuming a 5% interest rate, a OE/Debt ratio of 0.15 implies that the owner's earning can cover 3 times the interest payment - a debt interest coverage of 3.
(d) As of 10/14/2005.
(e) Enterprise Value = Market Capitalization + Debt - Cash. Enterprise Value to EBITDA ratio is often used to crudely measure the attractiveness of a company as an acquisition target.
Are more predictable companies truly better investment? To answer the question, I divide the ranked companies into four quartiles. Interesting enough, the stocks of the top quartile of the 292 S&P 500 members ranked returned an average of 132% over the last five years, while the lowest quartile only 54%. The 5-yr average return positively correlates with the quartile of the ranking:
|Ranking Out of 292 S&P 500 Members||5-yr Average Return|
The same theme is also present in the ranking of 1675 companies. In
every sector, the top half statistically returns more than the bottom
half over the last five years. Clearly, at least from a statistical
point of view, the factors that caused companies to be more predictable
were most likely the same factors that drove better returns for
One word of caution before anyone goes out and just puts money on the top ranking companies though, the ranking is based on historical data and any conclusion based on it is both subjective and statistical. The big question is, will top ranking companies continue to be more predictable, and continue to deliver better returns? As an intelligent investors, you definitely have to do your own homeworks to find out. And please remember the No. 1 principal of value investing: Margin of Safety. Don't overpay for stocks, no matter how high they rank on any list!
Sheldon Shi, Ph.D., editor of Buffetteer.com, a site for intelligent investors.