Among Ben Graham’s many warnings of folly in Security Analysis and The Intelligent Investor, the one I have found most difficult to heed in recent years has been and continues to be his warning about earnings extrapolation. There are two simple explanations for this:
1. Coming from the Buffett stable earnings school that, far more often than not, shuns wildly cyclical earnings, I expect earnings of my companies to increase year in and year out and, in those rare instances when they do not, I expect the decreases to be minor
2. An entire generation of investment history, call it 1982 to 2006, has just passed when stable company earnings did, in fact, increase year in and year out, nearly without fail (as proof, call up the Valuelines for ADP, KO, CTAS, WMT, GIS to name but a handful)
It now appears that, with regard to #2 above, times may be changing, and this makes Mr. Graham’s warning all the more critical. I still believe in the stable earnings thesis of #1 above; its rebuttal is the Great Depression II scenario of deflation and, by extension, severely reduced profitability for nearly all companies. What is difficult, however, is accurately identifying which companies really are the stable earners and/or which companies will ¬inexorably be making more money after one or two slightly down years in earnings (again, presuming no GD, II). I offer two follies I have made in the past couple of years, in sequence, to demonstrate both Mr. Graham’s warning and the challenge we face looking ahead:
1.Home Depot (HD, Financial): a wonderful earnings growth story since its founding in 1978, I, along with many value investing gurus, started to like the price in 2006. The business is the industry leader, the industry is not going away, and – here was the folly – extrapolating 7-8% earnings growth on a base of $2.72 (2005 earnings) for 3-5 years produced a decent profit when termed at 16-17x earnings. Well, we all know what happened. 2006’s EPS of $2.79 is turning into 2009’s $1.50. I do believe it will come back, as HD is in a powerful competitive position in a necessary industry. Nevertheless, it was a mistake to shun Mr. Graham’s advice and fully capitalize (16-17x) earnings based on extrapolations from record highs.
2. Best Buy (BBY, Financial): very similar story to the above (and, yes, we do own businesses outside of retail!), the difference is that the earnings turndown has occurred approximately 18 months after HD’s. To detail the folly, the record earnings year for BBY was 2007 when it registered EPS of $3.12; extrapolating this forward 3-5 years at a seemingly conservative 7-8% growth rate yielded a nice profit when termed at 16-17x for purchases made in the low $40 per share range. And, like HD, it is critical to note that BBY was (and is, even moreso now) the industry leader which lended confidence to this projection. Alas, the earnings have turned and this simple model has been annihilated, as Mr. Graham cautioned.
Looking at the investment landscape currently, I would offer that this peak-earnings extrapolation folly could be looming for a different investment sector – the industrials. It is hard not to be an admirer of such powerhouse companies as United Technologies, Boeing, and 3M. They, not unlike HD and BBY, are leaders in their fields; the products and services they sell are long-run necessary for a reasonable quality of life. Lovefesting aside, I sense that their earnings are turning. Retrenchment is the state of affairs currently, and, if history is somewhat of an accurate guide, capital spending will be significantly reduced on the margin, which will, in turn, significantly reduce the heavily operating-leveraged profits for the sellers of capital goods. It becomes dangerous in my estimate, therefore, to conclude that because UTX earned in the ballpark of $4.90 for 2008 (a record), by 2010 it will be earning $5.50 (an earnings retreat in 2009 is overwhelmingly predicted at this point). I do not believe Mr. Graham would approve of this forecast or 16-17x earnings capitalizations made from it.
Eric Houssell
www.housselscapital.com
1. Coming from the Buffett stable earnings school that, far more often than not, shuns wildly cyclical earnings, I expect earnings of my companies to increase year in and year out and, in those rare instances when they do not, I expect the decreases to be minor
2. An entire generation of investment history, call it 1982 to 2006, has just passed when stable company earnings did, in fact, increase year in and year out, nearly without fail (as proof, call up the Valuelines for ADP, KO, CTAS, WMT, GIS to name but a handful)
It now appears that, with regard to #2 above, times may be changing, and this makes Mr. Graham’s warning all the more critical. I still believe in the stable earnings thesis of #1 above; its rebuttal is the Great Depression II scenario of deflation and, by extension, severely reduced profitability for nearly all companies. What is difficult, however, is accurately identifying which companies really are the stable earners and/or which companies will ¬inexorably be making more money after one or two slightly down years in earnings (again, presuming no GD, II). I offer two follies I have made in the past couple of years, in sequence, to demonstrate both Mr. Graham’s warning and the challenge we face looking ahead:
1.Home Depot (HD, Financial): a wonderful earnings growth story since its founding in 1978, I, along with many value investing gurus, started to like the price in 2006. The business is the industry leader, the industry is not going away, and – here was the folly – extrapolating 7-8% earnings growth on a base of $2.72 (2005 earnings) for 3-5 years produced a decent profit when termed at 16-17x earnings. Well, we all know what happened. 2006’s EPS of $2.79 is turning into 2009’s $1.50. I do believe it will come back, as HD is in a powerful competitive position in a necessary industry. Nevertheless, it was a mistake to shun Mr. Graham’s advice and fully capitalize (16-17x) earnings based on extrapolations from record highs.
2. Best Buy (BBY, Financial): very similar story to the above (and, yes, we do own businesses outside of retail!), the difference is that the earnings turndown has occurred approximately 18 months after HD’s. To detail the folly, the record earnings year for BBY was 2007 when it registered EPS of $3.12; extrapolating this forward 3-5 years at a seemingly conservative 7-8% growth rate yielded a nice profit when termed at 16-17x for purchases made in the low $40 per share range. And, like HD, it is critical to note that BBY was (and is, even moreso now) the industry leader which lended confidence to this projection. Alas, the earnings have turned and this simple model has been annihilated, as Mr. Graham cautioned.
Looking at the investment landscape currently, I would offer that this peak-earnings extrapolation folly could be looming for a different investment sector – the industrials. It is hard not to be an admirer of such powerhouse companies as United Technologies, Boeing, and 3M. They, not unlike HD and BBY, are leaders in their fields; the products and services they sell are long-run necessary for a reasonable quality of life. Lovefesting aside, I sense that their earnings are turning. Retrenchment is the state of affairs currently, and, if history is somewhat of an accurate guide, capital spending will be significantly reduced on the margin, which will, in turn, significantly reduce the heavily operating-leveraged profits for the sellers of capital goods. It becomes dangerous in my estimate, therefore, to conclude that because UTX earned in the ballpark of $4.90 for 2008 (a record), by 2010 it will be earning $5.50 (an earnings retreat in 2009 is overwhelmingly predicted at this point). I do not believe Mr. Graham would approve of this forecast or 16-17x earnings capitalizations made from it.
Eric Houssell
www.housselscapital.com
