Monday, January 9, 2012

Great 10-Year Record = Great Future, Right?

Interesting PDF by Tweedy, Brown Company. They posed the question "How well did companies with great 10-year records as of December 31, 1990 perform in the next 7 years? A study of the predictability of long-term earnings and intrinsic value growth".

Page 2 explains the basic setup: 71 high ROE companies had an average ROE of 28.9% over the decade to 31-Dec-1990. They had an average 18.8% CAGR in EPS.

What they found: Over the next 7 years, 33% of the companies reported lower EPS in 1997 than in 1990. 26% had 7% CAGR in EPS or less. 22% had 8.5%-14.7% CAGR in EPS. Only 19% had a growth rates of at least 15%.

A similar pattern was noted in "intrinsic value", defined as 10X EBIT + net cash. Despite 7 years of cash generation, IV was lower in 1997 than in 1990 for 28% of the companies. Only 15% were able to increase IV at a rate of 15% or more.

Basic conclusion: consistently high past ROEs  does not indicate future ones.

On page 5, they did their own estimates and concluded:
In Schedule IV, the author’s “best guess” estimated growth rate for sales and EBIT over the next seven-year 1990–1997 period can be compared to the actual growth rate in intrinsic value (10x EBIT value) and e.p.s. that occurred over the 1990–1997 period. The author’s best guess about future growth, which was based solely upon examination and extrapolation of historical financial information (and without any qualitative information), was an extremely inaccurate predictor of the actual growth that subsequently occurred over the seven-year 1990–1997 period.
 Page 11:
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.
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. The hard part is unearthing, sifting, weighing and assessing the qualitative information that drives 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?


John Kingham said...

Excellent points Mark. That's partly why I'm upping diversification from 20 to 30 positions, because picking winners is virtually impossible.

I do think that there's a positive correlation though to average long term past performance and average future performance. A good history doesn't mean a good future, but on average I think it means a better than average medium term future. As for the long term, who knows!

Richard Beddard said...

Good find. According to Dylan Gryce/Soc Gen ROE asymptotes (tends) towards the median (but don't actually get there). So high ROE companies tend to remain above average, but less so. Low ROE companies tend to improve but not to the median. You'd expect this, perhaps, if you accept that competition erodes competitive advantages and hard times reduces competition in highly competitive industries. So I conclude that you can try and pick those companies likely to sustain high ROE (bit of a black art) and/or stick to those companies likely to improve (i.e. low ROE).


That seems to be the conclusion of the Tweedy Browne document too. It's very interesting.

Philip Stive said...

I think it's interesting that you and Tweedy Brown seem to be assuming that you are paying for growth. IMHO the key is to not pay for growth with these kind of companies. It should be OK if they don't increase their earnings, keep distributing a good part of their profit to shareholders via dividends and share buy backs. This in itself should provide adequate safety of principal and even provide some upside. If they can increase their earnings that's a nice added bonus.

Looking at the numbers it looks like 2/3 of the companies indeed increased their earnings over the next 7 years, some with quite a bit. I think these are good odds.

Richard Beddard said...

Hi Philip, I agree and missed that option out! If you can buy high ROE cheaply that's your margin of safety. You're fishing in a smaller pond but it compliments bargain hunting nicely.