Tuesday, March 15, 2016

Debunking the Growth Mantra and Getting Real

Roughly two years ago, I ran the following screening exercise on the ASX:

29 April 2014
10 to 15
5 to 10
0 to 5
10 years average Sales/Share growth
10 years average EPS growth
10 years average Book Value/share growth
10 years average DPS growth
10 years average Operating cashflow/share growth


Total population=2100 companies

Intersecting analysis:

Only 2 companies filled all 5 criteria above 20% per annum: MND, WOR on the back of the super resources boom.

5 companies filled all 5 criteria above 15% per annum: JBH, WOR, RCR, CTL, MND. 0.2%

13 companies achieved both sales and EPS growth above 20% pa for 10 years. 0.6%

28 companies achieved both sales and EPS growth above 15% pa for 10 years. 1.3%

68 companies achieved both sales and EPS growth above 10% pa for 10 years. 3.2%

145 companies achieved both sales and EPS growth above 5% pa for 10 years. 7%

220 companies achieved both sales and EPS growth above 0% pa for 10 years. 10%

(Notice the number roughly doubles as we go down the ranking. These sort of data series follows the power law. Don't ask- no one knows why as yet.)

How about companies able to grow EPS without corresponding growth in sales?

Of 93 companies with less than 5% pa average growth in sales, 38 companies (ie 40%) were able to grow EPS more than 5% pa average,  12 companies grew EPS by more than 10% pa, 9 companies grew by more than 15% pa, and only 3 companies by more than 20% pa.

Of 157 companies with less than 10% pa average growth in sales, 33 companies (21%) able to grow EPS more than 10% pa average,  18 companies grew EPS by more than 15% pa, 7 by more than 20% pa.

Of 219 companies with less than 15% pa average growth in sales, 30 companies (13.7%) able to grow EPS more than 15% pa average,  11 by more than 20% pa.

Higher growth rates in sales appear to reduce ability to increase margins.

204 companies trade above PE 20 as at 30 April 2014. PE 20 roughly implies a growth rate of at least 10% per annum for 10 years and 10x terminal.

The Siren Call of Growth

As of the time of writing in April 2014, I noted that FLN (Freelancer) is trading at a PE multiple of over 615, making it the most expensive stock on the ASX by the measure of price earnings multiple.  I will have to leave the dissection of the business prospects of FLN for another time.  My main objective is to briefly address the issue of “growth” and how it fits within our investing philosophy and framework.

1.       Less than 7% of companies on the ASX achieve compound annual growth in earnings per share of more than 10% per year over periods of 10 years or more. If you remove companies whose EPS figures are distorted by abnormal gains offsetting continual losses, or companies with no consistent earnings, the figure drops dramatically to less than 5%.

2.      However, close to 10% of companies on the ASX are priced for annual compound growth in earnings per share exceeding 10%.  This number does not include loss making companies, which makes up over 66% of the ASX. Clearly, there is presently a divergence between wishes (reflected in pricing) and reality (reflected in historical data).

3.       We need to keep in mind that this distribution is a normal functioning of the market, due to the mysterious workings of power laws.

4.       However, bearing in mind Rule Number 1, we are fearful of Siegling’s Paradox. Whilst sizzling growth rates are always used to justify lofty valuations, many forget that an initial gain of 50% or more is more than wiped out by subsequent losses of similar sizes. For example, you lose all your capital if you gain 100% in the first year, and losses 100% in the second year. You lose 25% of your capital if you gain 50% in the first year and losses 50% in the second year.  As evidenced by the Kelly criterion, bigger risk does not equate bigger gains if you have a scarcity of capital.

5.       Sustained growth is rare and difficult, it requires a confluence of factors- industry tailwinds driving revenue, costs being kept in control, competitors being kept at bay, management not making mistakes, no disruption by technology, no interference from government, no unforeseen events.

Edit: I need to insert a word of caution here on the common but nonsensical use of PEG ratios popularised by proponents of growth investing. The basic idea is to divide the PE ratio by the projected EPS growth to get the PEG ratio. Apparently, anything between 1 to 2 falls within the attractive range. A stock growing EPS at 20% per annum is justified by PE 20, since the PE falls rapidly. To take the logic even further, a stock growing EPS at 100% per annum is justified by PE 100, since 3 years of doubling will bring the PE back to a lowish 12.5. The problem is that the issue of risk is not addressed. A stock growing at more than 20% per annum (let alone 50% per annum) for an extended period of time is a rare beast, as the numbers I have shown above attest to. If I have two stocks, each with a PEG ratio of 1, the first stock at PE 20 projected to grow at 20%, and the second stock at PE 1 projected to grow at 1% per annum, the choice is an absolute no brainer. The absolute irony is that with the second stock, I am getting a 100% per annum yield, assuming all earnings are paid out.

Enjoy and Prosper
Yours One Legged 

Monday, March 14, 2016

Musings 15 March 2016

I came across a good book recently- Aurora by Kim Stanley Robinson. You can get a synopsis from various sources online including the link to Amazon. The author tends to get quite descriptive and it is a characteristic of this particular author that readers will have to come to terms with. The reason why I am always partial to this author is that he always presents big interesting thought stimulating ideas.  Aurora is a reminder that I should reread his previous books to refresh or gain new perspectives.

Before you read on further, just be aware that this blog post contains SPOILERS. To avoid ruining your enjoyment of the book, you should stop here and read the book first before reading on.

The main proposition from the book is that interstellar travel and colonisation are extremely difficult, and quite likely much more difficult than what we would like to believe at present. For various reasons, ranging from physics to chemistry to biology to psychology to sociology, such an undertaking may well be impossible. If so, it presents a very neat answer to the Fermi Paradox.

In respect of the Fermi Paradox, the lesson to be learned here is applicable to life and to investing. The weak assumptive link in the Fermi Paradox is the assertion of interstellar travel as a given. In Aurora, the author demonstrates to us the effect of being realistic and critical in a chain of reasoning. Asking the question why, and demanding an answer is imperative. And then tackling the question with multidisciplinary methods. As usual and often the case, these methods lead to fresh valuable insights.

In investing, constant stress test of the hypothesis is vital in order to avoid mistakes and the permanent loss of capital. Logically, our job would be much easier if we concentrate on a simple hypothesis, rather than one consisting of many moving parts whose cause and effect are unclear. This is one reason why I cannot do macro investing.

Stress testing of investing hypothesis has recently gotten us out of REF, although the final verdict on our decision remains unknown. The same exercise also got us out of PRG just in time before its implosion, and helped us steer clear of disasters such as VET and SGH. The absence of rigorous stress testing accounted for some of our losses, one of such being NWH, Stress testing continues to make us wary of XRO and MSB, although I could certainly see a bright future if things work out. Also very much of importance, continual stress testing of investment hypothesis has given us the confidence to stay with our winners, allowing us to reap the benefits of compounding a winning position.  Finally, stress testing of one investment hypothesis has also led us to better insights, resulting in a development of a much better, and currently profitable, hypothesis.

Another lesson from Aurora is the futility of detailed planning when one is dealing with complex and chaotic systems, and the serious importance of adaptability. From ship components breaking down due to physical stresses, the effect on biological cells due to changes in gravity, to the recycling of vital elements in a closed ecosystem, the ship engineer's continuing lament about the lack of foresight of the ship builders reminds me starkly of the futility of financial forecasting of complex economic systems. If we cannot be certain of the future, the best that we can do, and should do, is to prepare ourselves for a range of outcomes. This is where Graham's concept of Margin of Safety becomes relevant. The importance of adaptability is also a reason why we tend to focus on organisations that maintain maximum flexibility via low costs, low debt and high gross margins. Just have a look at the taxi industry in NSW, and the performance of CAB, for a bleak illustration of the consequence of a stubborn lack of adaptability.

Aurora also reminds us of what it means to be humans, literally speaking, and if you are metaphysically inclined, spiritually. As usual, parallels can be drawn with the investing world. Just as the existence of humans and the existence of Earth are arguably intrinsically inseparable, we would be ill-advised to view businesses in isolation from their ecosystems. Valuation from empirical data cannot be relied exclusively and separated from the business environment. A short cautionary note against blind and complete reliance on common metrics such as PE and PB.

Finally, the second level question: so what? Aurora deals with this admirably. Just as Charlie Munger wants to know where he will die, so that he never goes there, if we are being realistic and aware of the difficulties involve in interstellar travel and colonisation, we should be focusing more efforts on the difficulties rather than on the easy solutions such as physics and propulsion. It is certainly relevant in terms of Elon Musk's long term plans to colonise Mars.

Aurora attempts to bring us awarenesss of the possibility that interstellar travel and colonisation may well be an impossible undertaking. It points out that perhaps our existence as humans is inextricably linked to the existence and wellbeing of planet Earth. If this is so, it would be prudent on all of us to rethink our relationship with, and treatment of, what may well be our only home.

Enjoy and Prosper,
Yours One-Legged