I have excerpted the conclusion of a Tweedy Browne research study on A Great 10-Year Track Record; Great Future Performance Right? because it illustrates the importance of assessing the qualitative information that drives financial numbers. If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich. …..And that, folks, is why we will spend time on studying franchises and their competitive advantages.
Interesting investment research articles on Value Investing from Tweedy Browne: http://www.tweedy.com/research/papers_speeches.php
Research paper on the predictability of long-term earnings and intrinsic value growth: Great 10-Year Record = Great Future, Right?
The conclusion of this study explains why an investor must focus on the qualitative aspects of a business–what drives the financial performance?
The easy-to-calculate Implied Growth Rate (i.e., return on equity times the percentage of earnings that is reinvested in the business and not paid out to stockholders as a dividend) did not predict future earnings growth, on average, for companies that had been highly profitable over the last ten years. Return on equity for these companies, as a group, tended to decline over the next seven years. Financial pasts were not related to financial futures for the companies as a group.
Similarly, companies that experienced the highest growth in e.p.s. over the 12/31/90–12/31/97 seven-year period had prior 10-year average profitability, as measured by average return on equity, that ranged all over the map. The pattern looked random to us. The financial future, as measured by seven-year e.p.s. growth, was unrelated to the financial past. Many companies with poor return on equity track records perked up and produced significant earnings increases, and many companies with excellent return on equity track records stumbled and experienced a large decline in earnings.
The previously described study by Patricia Dechow and Richard Sloan suggests that when the average company experiences a growth spurt in sales per share over a five-year period, the growth in sales per share over the next five years will tend to revert to about the mean average for most companies. Similarly, the Dechow and Sloan study suggests that the average company that has had five years of exceptional earnings per share growth will tend to have e.p.s. growth over the next five years that is about equal to the average for all companies.
The drivers of growth in intrinsic value (as measured by 10x EBIT (i.e., earnings before deducting interest and taxes), plus cash, minus debt and preferred stock, divided by shares outstanding) are growth in EBIT and cash generation (that results in an increase in cash or a decrease in debt). Aside from increases in EBIT that can be generated by price increases or cost cuts, which are often one-time turnaround type changes, the engine that drives EBIT growth over the long-term is sales growth. And more sales generally require more operating assets such as inventory and property, plant and equipment. A company that experiences significant growth in unleveraged intrinsic value of, say, 18% per year, over a long period of time, such as 10–20 years, has to have a high return on the capital that is being reinvested in the business to support the 18% growth rate. Just look at Walmart’s or Coca-Cola’s long-term record as examples of sustained high returns on equity and high reinvestment in the business. Companies that grow a lot over a long, long period of time, have to have sufficient opportunities to reinvest earnings at high rates of return in order to generate more sales and earnings. The math is easy.
Not only do investors have to understand growth but also what the expectations of growth imply for future returns.
This is an important article for understanding how to invest in growth companies and franchises. One conclusion of the research is financial numbers. Isn’t it a paradox that most of what is written about investment analysis in textbooks and journals is about quantitative information, and so little is written about digging up and analyzing the qualitative information that ultimately drives the financial numbers? Customers drive sales, sales drive profits and, ultimately, a company’s competitive standing, or advantage, its “franchise”, determines the sustainability of sales and profits. If long-term growth can be predicted at all, it would appear that the prediction must rely upon insights relating to qualitative information that has been used to assess the sustainability of a competitive edge. When Warren Buffett is considering an investment, he doesn’t just study the company that he is considering. He studies the company’s competitors as well. Historical financial numbers alone do not predict growth. If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.
In recent years, Warren Buffett has said that you shouldn’t consider buying an interest in a business unless you are willing to own it for at least ten years. He and Charles Munger have also mentioned that the futures (and future growth) of very, very few businesses are predictable with certainty. As a corollary, they believe that the competitive landscape in ten years can only be predicted with certainty for a few businesses. They like a business that they can “understand”, and they don’t like a lot of change in a business. Warren Buffett and Charles Munger classify Coca-Cola as an “inevitable” that they believe is certain to grow. As a corollary, they must believe that Pepsi Cola, Cott, Virgin Cola and other competitors’ future actions and responses over the next ten years will not impair Coca-Cola’s future profitability or dent its 15%+ growth prospects, and that customers’ choices among many competing beverages will continue to favor Coca-Cola’s offerings. Similarly, in emphasizing the rareness of businesses that are “certain” to grow at 15%+ rates over a long period of time, Warren Buffett and Charles Munger describe having an opportunity ticket that may only be punched ten or fewer times in a lifetime. Because there are so few businesses that are certain to grow at high rates that are also available at an attractive price, Warren Buffett and Charles Munger believe that you should load up and concentrate your portfolio on that “opportunity of a lifetime” when you find it. How many businesses are you certain about ten years from now?