Q2. Will the company be prosperous?
Posted on February 2, 2009 by Richard Beddard
Filed Under Investing |
It’s cheap! It’s cheap! But is it nasty too?
This is part three of a three-part mini-series. In part one I said there are only three questions that count. In part two, I explained how I decide a company is cheap (question 1). In this part I’ll explain how I decide it will be prosperous (question 2)1.
If the shares are cheap and the company will prosper, there’s every chance investors will profit.
The difficulty is, seeing the future. We’re not very good at it, even City analysts can’t forecast. Look at this chart from SG behavioural investing guru James Montier:
Earnings versus forecasts
Montier says:
…the chart… shows that analysts are exceptionally good at one thing, and possibly one thing alone – telling you what has just happened.
The black line, the earnings forecasts lags the red line, actual earnings. It’s supposed to be the other way around. The forecasts are supposed to predict the earnings. Our inability to forecast, Montier explains, is partly because of a psychological trait called anchoring, or only changing your mind once it’s obvious you are wrong. I think there are also too many variables, the future is simply incalculable.
Unless we develop a way of seeing the future, it’s better to focus on what we know about the present.
One way is to reduce our expectations, or buy shares at a price that will give a reasonable return even if, in an average year in the future it makes no more profit than it did in an average year in the past (that’s the point of question 1). That way we can switch our attention from fancy calculations guessing at future growth to something more realistic, business as usual.
Statistically, Joseph Piotroski demonstrated financially strong companies are more likely to survive, and earn higher returns than companies with growing debt, diminishing working capital and falling profitability.
Calculating a company’s financial strength doesn’t involve forecasts, or projections, it means checking it’s healthy. Piotroski measured nine variables in his F_Score, but I tend to rule out companies with large amounts of debt and companies with apparently doomed business models too.
Newspapers may be an example. As our attention moves online, they’re facing competition for readers from sites often started for fun, Google News is skimming off headlines, and eBay’s nicking advertisers. Meanwhile they must invest in new technology and keep the old presses running. Once virtual monopolies, newspaper companies can’t maintain the profits they made in the past.
That explains why the share prices of Johnston Press, Trinity Mirror and DMGT (or Gannett and the New York Times for that matter) have fallen so far. Even though they might make good investments now, they’re different companies, operating in a different environment. DMGT makes more money from business information and exhibitions than it does from newspapers.
It seems like permanent change, not a temporary lull in trading, so the assumption that newspapers will be as profitable in five years time as they were five years ago is an uncertain one.
My three questions focus on profitable companies (question one and two) in stable businesses (question two) at low prices (question one again). Question three is a ‘yes or no’ question requiring the investor to confirm she understands how the business makes money.
If she’s checked it’s healthy and signed off its business model, but still doesn’t understand how it makes money, she needs to do more work on questions one and two.
Footnotes:
- Buying good companies cheaply. Although I’ve stuck to the general principal for a decade, I’m much more strict about it now than I used to be. Must be a sign of the times…
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