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Monday, June 27, 2016

Investing is about the future, not the past, stupid! kcchongnz

Investing is about the future, not the past, stupid! kcchongnz
Author: kcchongnz | Publish date: Mon, 27 Jun 2016, 12:48 AM

I have just read an interesting article titled "It is the future earning that matters, stupid" by my friend Icon8888 here:

I would rate this as a great article as many can learn something from it, unlike many just touting certain stocks for you to chase when their share prices have increased a lot, and as a result, I believe many retail investors have lost a bundle due to their own greed following those tips in the last half a year.

Furthermore, my name was mentioned and there was a write-up on me which I highly appreciated, although I may not agree with some of it, which I will elaborate later. Thanks for the publicity, I really do.

Icon8888 further reinforced that "the best predictor of share price is earning growth".

I agree with his statement except that to me, it is just half the story, or may be just a quarter only of the story, in my opinion, which I will elaborate later too.

First of all, we should agree that we are discussing about investing, and not trading. Stock market is dominated by institutional investors, fund managers, syndicates etc who have all the resources. It is a highly uneven playfield, if you play on other's field by engaging in a zero-sum game of trading, very few retail investors can be a winner, unless you are very lucky.

What do some super investors say about investing?

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Benjamin Graham

“Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.” Buffett

Predicting the future earnings

let see how do these people following this "the best predictor of share price is earning growth" principle predicts their future earnings or earnings growth. I will use this argument given by Icon8888 himself that,

Quote [“What caused you to lose money is the PLC that you invest in DIDN'T DELIVER STRONG PROFIT AS EXPECTED".

If you compared the earnings table and the chart above, Canone share price experienced strong run around November 2015, after releasing two consecutive quarters of strong results - June 2015 quarter's strong profit caused certain people to start accumulating. September 2015 quarter's strong profit "confirm a trend", resulting in massive buying by the investing public.

However, after a good run, Canone share price started declining in February 2016. That was actually due to the release of December 2015 quarterly result, which was below everybody's expectation. Share price declined further in May 2016 after the release of another quarter (March 2016) of depressing results.

See the correlation? Strong earnings caused share price to go up, weak earnings caused share price to go down.] Unquote

The total market capitalization of Canone at RM2.50 was only about RM380m. Assuming there is 30% free float, there was only about RM100m worth of shares of Canone in the market to “play” about. Sure, if someone who has a lot of money and he saw the high profit growth in the quarter, he used RM50m of his own money and borrowed another RM50m to “play” the stock using a certain golden rule strategy, and at the same time touting this stock everywhere in seminars, in the internet, and with friendly bloggers, you can imagine how high the share price of Canone can go up to, can’t you? More so if as a big shareholder now, he goes into the AGM and demands for bonus issues, share splits and “free” warrants in the name of liquidity, and the management works hand-in-hand with him, and assuming with some help from the syndicates, the sky is the limit for its share price. These people would have the insider information way before the good quarterly results were announced and have bought loads of them before the announcements. Some naïve retail investors will follow suit to chase the stock after the announcements of good results.

What happened when the next quarter results turned bad? I am sure insiders would have seen it coming way before the announcement of the bad quarterly reports and have exited way before that. Those who suffered the steep price drop of 37% just 5 months ago from RM5.10 to RM3.22 now are the poor retail investors. You can see the outcome now following the strategy of "the best predictor of share price is earning growth" for Canone.

How well have been the predictions of future earnings growth

The case of Canone mentioned above appear to me it is using the quarterly announced reports and made “predictions” that the growth in future profit.

Aren’t quarterly results historical too? And what does research shows regarding forecasting of future earnings predictions?

The forecasting of future earnings and hence future growth in earnings is in the domain of professional analysts who are qualified, knowledgeable and with all the information at their disposal. We as retail investors have our own jobs and professions and have no match against them. Let’s see how well the professionals have done in forecasting of future earnings, and hence growth in earnings.

Figure 1 below shows the long-term growth, historic, forecast and out-turn (1985-2007) of futue earnings and hence growth in eranings from Dresdner Kleinwort Macro Research, a reputable research house.

There is statistically no difference between the actual out-turns of return on investment for those in the high-growth quintile which is based on the high earnings forecast, and those in the low growth quintile. For the high growth projection, the out-turn was way below the expectation. Investors who chased the high growth shares with high valuations, and hoping for further valuation expansion due to high growth expectation, lost a bundle.

What is the difference of the “earnings” you use and the earnings in my return on capitals, ROC, or return of equity, ROE? Aren’t they the same historical data?

Why do I think return on capital is more important than the future earnings or earnings growth?

Return on capital

Customarily, most investors measure annual company performance by looking at earnings per share (EPS). Did they increase over last year? Are they high enough to brag about? For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record earnings per share. There is nothing spectacular about a company that increases earnings per share by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way below its borrowing costs.

For example, a company borrows RM100 m and invest in a new project making RM2 m for the year. Its earnings would grow by RM2 m and EPS grows by 2% for the year. Is that a good move? Obviously not. How can making a 2% of an additional capital when the cost is much higher than that a good thing?

The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS.

If your rate of return is lower than the cost, the value of the company is being slowly destroyed. The higher the growth, the faster the value is being destroyed.

This is one of many of them.

There are many examples in the link below:

But let’s say the company has profit growth as well as earning high ROE, will that earnings growth just announced definitely increase the share price in the long run?

Price versus value

“The secret to successful investing is to figure out the value of something and then-pay a lot less” Joel Greenblatt

Would you offer RM10 to buy a beautifully renovated bungalow in a suburb with similar bungalows average price at RM1m? Maybe and maybe not, but you still need to make an assessment why that bungalow costs so much more before you buy, don’t you?

Why is value not in the equation of this statement below?

"the best predictor of share price is earning growth"

Or unless you think the stock market is efficient; that the price has incorporated all information and it is a fair price.

So which school of thought are you in; the efficient market, of inefficient market?

Let us look at a high earnings growth company in the United States, Microsoft Corporation. In December 2000, Microsoft was trading at around RM59.00, at a PE ratio of 84, with earnings per share (EPS) of 70 sen then. In the seven years leading to 1999, Microsoft’s EPS has grown by 775%, or a compounded annual growth rate (CAGR) of 34%. That high PE ratio for such a high growth company was logical, wasn’t it? Microsoft’s EPS was $2.63 for the last twelve months ending 30th September 2014, or an increase of 276% since 14 years ago. It is still a fantastic CAGR of 10%. I doubt you can find many companies like this with this type of CAGR. Microsoft was trading at $48.79 then. Its share price was still 17% below what it was 14 years earlier, despite its share price has risen by about 200% since the US sublime crisis 5 years ago.

The August 2000 issue of Fortune Magazine included an article titled “10 Stocks to Last the Decade” with expected high earnings growth. The recommended stocks (which were described as “Here’s a buy-and-forget portfolio” that would let you “Retire when ready”) suffered an average loss of 80% at the end of 2002. Some have gone into oblivion like Enron, Nokia, and none of them have recovered to their previous prices as at now. Sure, investors can retire when you are 80 years old, but eating Maggie mee every day.

The problem with forecasting future earnings is not only it is difficult to do it right consistently, even if you are right once in a while, because most people chase growth and pay too much for growth, the outcome of investment has not been satisfactory.

"The price you pay determines your return."

How about these comment of me?

"KC relies heavily on past performance of PLCs to guide his investment decisions".

"Contrary to his own belief that one should not invest based on prediction of future, KC subconsciously does so".

In other words, "prediction of future" does play a significant role in KC's stock picking.

In a nutshell, "KC relies heavily on past performance of PLCs to guide his investment decisions".

Thanks Icon8888 again for the kind words here, and also your encouragement for others to join my investment course.

Investing is about the future, not the past

I have been emphasizing the statement above to all my online course participants, again and again. However, I have been criticized again and again each time I talk about value investing using ROE. ROIC, PE, EV/Ebit, cash flows, free cash flows etc.

Who does investing for the past, and not the future, or rather the present, as the future is uncertain and unpredictable? Aren’t your earnings growth projection in Canone above also based on the present?

I certainly believe that a company with steady earnings, stable cash flows, high return on capitals over a long period of time must have shown that the business is likely to last a long time and the existing management must have done something right. This is in comparison with looking at a good earnings growth for a quarter or two and project the same high growth for the future. Haven’t we seen the research on predicting future earnings carried out by Dresdner Kleinwort Macro Research above?

Isn’t considering buying a good company with the good attributes above at low prices such as PE ratio, Enterprise value/Ebit, or whatever metrics plausible for good future returns, better than predicting from good results of a quarter or two?

In a stock pick article on Padini where I used dividend discount Model to get an estimate intrinsic value of Padini and compared with its share price to obtain the margin of safety below,

I was basing on its present dividend payment and project a conservative growth in dividends in the future. I have explained why future dividend is usually more predictable than the obscure earnings growth projection in the article. The past growth in dividend did show the steady and more predictable growth and there are plausible reasons why it should be in the future as explained in the article.

Valuation using dividend discount model, or free cash flows model in finance is forward looking. It may use the present as a guide, but is not about the past. All investment is about the future, not the past.


So which is a better predictor of future return, future earnings projection base on a quarter’s result, or return on capital and estimating of the intrinsic value of the stock and buys at a high margin of safety?

Everyone’s experience is different. I have shown predicting future earnings has not been proven dependable.

I have also shown in my previous article the evidence of the later, and also my own personal investing experience that the latter works very well as shown in the links below:

As suggested by Icon in his latest article, “Predicting future earnings”, if you are interested to learn about how to carry out thorough analysis for a predictable way of earnings reasonable returns with the safety of principal for a small fee, please contact me at

The course will start soon.

“If protecting and growing your assets is more urgent to you than ever, don’t settle for stories. Settle for hard analysis.”

KC Chong

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