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Chapter 37: Significance of the Earnings Record

Business Aspect: Indications Regarding Future Earnings Power

The accounting aspect was devoted to the critical examination of the income account to arrive at fair and informing income statement of the results for the period covered. The second main question is concerned with the utility of this past record as an indicator of future earnings. This is the most important and also the least satisfactory aspect of security analysis. It is important because the sole practical value of a laborious study of the past lies in the clue it may offer to the future; it is least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless. These shortcomings detract seriously from the value of the analyst’s work but they do not destroy it. The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.

·         Concept of Earning Power: The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years.

A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal”, in the sense that the annual results show a definite tendency to approximate the average. For an average calculated from wildly differing earnings numbers, there is no convincing reason to believe that the future earnings would bear any recognizable relationship to this average.

·         Quantitative Analysis Should be Supplemented by Qualitative Considerations: An important principle of security analysis is: Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.

In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent permanence of earning power.

Graham compares Studebaker and US Steel and notes that even though Studebaker showed greater stability, the average US Steel earnings of $8 has far more significance as a guide to the future than Studebaker’s $6.75. This greater dependability arises from the entrenched position of US Steel in its industry and also from the relatively narrow fluctuations in both the annual output and the profit per ton over most of this period. Graham first estimates a normal annual steel output and a normal profit per ton to estimate the average earnings for US Steel. Although a substantial margin of error must be allowed for in such a computation, it at least  supplies a starting point for an intelligent estimate of future probabilities.

·         Current Earnings Should not be the Primary Basis of Appraisal: The market level of common stocks is governed more by their current earnings than by their long term average. This fact accounts in good part for the wide fluctuations in common stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad. Because the speculative public is clearly wrong in its attitude on this point, it would seem that its errors should afford profitable opportunities to the more logically minded to buy common stocks at the low prices occasioned by temporarily reduced earnings and to sell them at inflated levels created by abnormal prosperity.

This is the classical formula for beating the stock market. Obviously it requires strength of character in order to think and to act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart. In actual practice the selection of suitable buying and selling levels become a difficult matter. Taking the long market cycle of 1921-1933, an investor might well have sold out at the end of 1925 and remained out of market in 1926-1930 and bought again in the depression year 1931.

Graham notes that some stocks that sold at generous price may later so improve their position as to justify a still higher price. Such situations occur frequently, but the mistake of the market lies in its assumption that in every case changes of this sort are likely to go further whereas experience suggests such developments are exceptional and probabilities favor a swing of the pendulum in the opposite direction.

An investor may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.

·         Average vs. Trend Earnings: In addition to emphasizing strongly the current showing of a company, the stock market attaches great weight to the indicated trend of earnings. Two problems with magnification of trend – tend might prove deceptive and valuations based on trend obey no arithmetical rules and therefore may be too easily exaggerated.

Is not the trend at least as significant for the future as the average? Favorable trend must certainly be taken into account, but not by mere automatic projection of the line of growth into the distant future. Automatic or normal economic forces militate against the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc, are a powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favorable trend for granted – as the stock market is wont to do – the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacles in the way of continued growth.

Attitude of Analyst Where the Trend is Upward – if a qualitative study leads to a favorable verdict – as frequently it should – the investment valuation should be based on an assumed earning power no larger than the company has already achieved in a period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis. This assumed earning power may be properly capitalized more liberally when the prospects appear excellent than in the ordinary case, but would suggest that the maximum multiplier be held to a conservative figure (say 20, under the conditions of 1940). This would mean that price levels for “good stocks” under normal market conditions are likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right. He would call a substantial part of the price a “speculative component” in the sense that it is paid not for demonstrated performance but for expected results.

Attitude of Analyst Where the Trend is Downward – When the trend has been definitely downward, the analyst will assign great weight to this unfavorable factor. He will not assume that the downcurve must presently turn upward, nor can he accept the past average – which is much higher than the current figure – as normal index of future earnings. But he will be chary about any hasty conclusions to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely and that the stock is therefore without merit or value. A qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.

·         Deficits a Qualitative, Not a Quantitative Factor: Graham notes that when an average of earnings is taken over a period that includes a number of deficits, some question must arise as to whether or not the resultant figure is really indicative of the earning power.

The deficit figure when taken by themselves have no quantitative significance and that their value in forming an average may often be open to serious question.

·         Intuition Not a Part of the Analyst’s Stock in Trade: In the absence of indications to the contrary we accept the past record as a basis for judging the future. But the analyst must be on the lookout for any such indications to the contrary. Here we must distinguish between vision or intuition on the one hand, and ordinary sound reasoning on the other. The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade. (If he had it, he could dispense with analysis.) He can be asked to show only that moderate degree of foresight which springs from logic and from experience intelligently pondered. Analysis of the future should be penetrating rather than prophetic.

Example – Intertype Corporation, selling at $8, is an established company and one of the leaders in the relatively small industry of line-casting machines. Its recent earnings are not favorable and there does not seem any reason to be optimistic as to the near term outlook. The balance sheet is strong with net current assets equaling $20. The essential question for an investor is whether the company can be counted to remain in business and participate about as before in good times and bad. The company’s strong position in the industry and strong financial position suggest an affirmative answer. If this were granted the investor would then point out that the shares could be bought for $8 with very small chance of ultimate loss and with every indication that under the next set of favorable conditions the value of the stock would double.

This type of reasoning lays emphasis not upon an accurate prediction of future trends but rather on reaching the general conclusion that the company will continue to do business pretty much as before. Wall street is inclined to doubt that any such presumption may be applied to companies with an irregular trend, and to consider that it is just as difficult and hazardous to reach a conclusion of this kind as to determine that a growing company will continue to grow. However there are two advantages to Intertype form of reasoning over the customary attitude which would prefer Coca Cola at 22 times recent earnings because of its virtually uninterrupted expansion of its profits for more than 15 years: (1) Private business is conducted and investments made on the same kind of assumptions that we have made with respect with Intertype (2) This type of investment can be conservative in that it allows for a liberal margin of safety in case of error or disappointment. It runs considerable less risk of confusion between “confidence in the future” and mere speculative enthusiasm.

·         Large Profits Frequently Transitory: Graham cautions against assuming that large profits would continue in future. Provides three examples of companies where profits proved temporary – J W Watson which manufactured a single type of automotive accessory. Success of such a gadget is normally short lived, competition and changes in the art being a threat to the stability of earning power; Coty Inc, which depended on the popularity of trademarked line of cosmetics. Variable tastes of women could readily destroy profits; Brewery stocks in 1933 where a flood of capital poured into the new industry resulting in overcapacity and competition.

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