Forum Archive Index - February 2003

["tennyson@caverock.net.nz" <tennyson@caverock.net.nz>]

Hi Morgy,

> 
> 
>Travis Morien wrote:
>>"As a value investor I seek to predict the future
>>return from owning a business, using mathematics
>>identical to that used to value a bond."  
> 
> 
>Here is what Benjamin Graham has to say about your method, 
> 
>The problem with forecasted earnings is that they are highly
>unreliable and subject to constant change. The father of securities
>analysis, Benjamin Graham, did not believe in predicting earnings
>for stocks. 
>
>Graham wrote,
>"In forty-four years of Wall Street experience and study I have
>never seen dependable calculations made about common-stock values,
>or related investment policies that went beyond simple arithmetic or
>the most elementary algebra. Whenever calculus is brought in, or
>higher algebra, you could take it as a warning signal that the
>operator was trying to substitute theory for experience, and usually
>also to give to speculation the deceptive guise of investment."
> 
>I came across the above passage while reading the associated article
>(the article not being relevant to your thread in any way) and
>having read your email from earlier today and being highly amused at
>your ability to "predict"  future value based on "assumptions" of
>future profits it sort of jumped out at me. There are a lot of
>unemployed analysts around at the moment who also assumed future
>profits based on there predicative assumptions.
> 
>

At last, another person on this forum that can think for themselves!

Excellent response Morgy.  You just nailed Travis.  Or did you?  I 
hope Travis will excuse me for butting in at this point, but I think 
Morgy, you haven't quite got the point that Travis was trying to make 
(probably due to Travis not presenting his argument clearly enough 
for you). 

First up, I have no argument with any of your quotes.  Trying to 
predict earnings one year out is a minefield, two years out is 
incredibly difficult and ten years out is practically insane.

However, there is one special class of company where, as strange as 
it may seem, insanity can prevail.   This is the so called 'consumer 
monopoly' as described in 'the Buffettology Workbook', and all those 
other Buffettology books.   A consumer monopoly is a company that is 
a well established leader in its chosen market, with a history of 
profit growth.  It will generally also show a healthy return on 
shareholders funds and be almost immune from competition being able 
to devastate its profit margins.   There aren't many companies that 
can satisfy these very strict criteria.   A failure at any of the 
qualifying hurdles means any ten year earnings prediction is 
nonsense.  But find the select few companies that clear those 
hurdles, and it can work.  This is what Buffett does, but how to find 
these companies?   It takes hard work, but this is the mission of the 
'Focus Investment Group' (one of the 'sharechat message boards').    
Welcome aboard, if you would like to help us.

There is one more point about predicting future earnings that needs 
to be made clear.  When Travis says he is predicting future earnings 
he does *not* mean he is trying to pin down earnings figures five, 
six or seven years hence.  What Travis is plotting here are *future 
earnings trends*.  An actual result for a particular year *may* be 
right on the trend line.  But the result may also be significantly 
above or significantly below it.   This sort of thing does not 
invalidate his analysis.  Why not?

There exists in business a phenomenon known as 'regression to the 
mean'.  Put simply this means businesses have good and bad years and 
although some of these good/bad fluctuations are quite unpredictable, 
they tend to average out in the end.  

The secret to running a successful business lies in hiring the right 
people, getting the management structure right and understanding your 
market.   Get these basics right and the single year earnings 
forecasting blips pale into insignificance.   Bad years are balanced 
out by good years and looking back over several years of trading 
history the upward trend in earnings will still be apparent.  

Reduced to this level you can see that what Travis is saying is that: 
if you have 

i/the right people 
ii/doing the right things 
iii/ in the right market, 

and 

iv/ this combination has been proven to work in the past, 

THEN

it is reasonable to conclude that the business will continue to grow 
in the future.

To anyone who has run a business this is just common sense.  Travis 
is *not* predicting that such a business will grow a predictable 
amount every year without fail.  Travis is predicting the longer the 
ingredients of a successful business are there, the better the chances 
are it will be recognized by the market - eventually.  And as a long 
term investor Travis is patient, able to bide his time waiting for 
that 'eventually' to really happen.

SNOOPY



PS  You should also know that the mathematics needed to carry out 
this analysis *can* be carried out on a simple four function 
calculator.   OK, I'll admit that a business or scientific calculator 
might have you pushing less buttons.  But nothing anywhere as complex 
as calculus or heavy algebra is needed to solve these 'valuing as a 
bond' problems.



---------------------------------
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