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Shares: the importance of the 10-year record

Created:
29 September 2006
Written by:
Dan Oakey

There is a belief, going back at least as far as Benjamin Graham's 1949 classic book: The Intelligent Investor, that stock markets are inherently prone to silly spells. Shares can peak and trough wildly in the space of a few months, weeks or even hours - yet the day-to-day businesses of these companies can remain almost totally unchanged.

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Clearly, then, stock prices are more volatile than underlying business performance. In fact, if you were to personify the market, these days you would probably say it suffered from bipolar disorder - profoundly depressed one moment only to be convinced of its greatness the next.

One way of approaching stock-picking, therefore, is to make sure you know the real business merits of as many companies as you can and to wait for the market to have one of its turns. At that moment, you can buy a significant quantity of shares in the unjustly treated company and wait for the anomaly to pass. Conversely, if you hold shares, you should also be willing to take the market up on its offer, and sell, should it quote you a ridiculously high price.

But how do you spot the difference between a gem hidden in the gutter and all the rubbish that actually belongs there? In other words, what are the characteristics of quality?

The answer to this question, according to one branch of investing, lies in the business models of the individual companies.

Think about ideals. The perfect company would make objects or sell services that everyone needed and that could not be bought from anyone else. Because it had a monopoly, this company could charge whatever it liked. And, as it was perfect, no other company could ever replicate what it did, nor introduce the kind of competition that would drive down prices or hike costs.

You needn't waste much time looking for a stock like that since it obviously doesn't exist. Yet there are companies that resemble this ideal in certain ways.

Companies with strong brand names, such as Coca Cola or Nike, create high barriers to entry in the soft drinks or sportswear markets. Publishers of regional newspapers know that there is often only room for one successful title in each town. And Gillette can devote so much money to advertising, research and marketing that breaking into the razor market would be prohibitively expensive.

So, as a stock-picker, you can try to analyse each industry and type of company. The more experienced you are at running your own business, the more likely you are to spot where profit margins are high and defensible.

However, there is another way to identify companies with a durable competitive advantage, and this is to look at their 10-year records.

The theory behind this approach is simple. You want to avoid companies that lack pricing power. This sort of company is at the whim of forces it cannot control. Imagine that several new rivals all have the bright idea of entering this market at the same time. A glut of new capacity will send prices crashing down. Periodic collapses in profits will be the norm. To compete, the companies may have to invest in new plant, take on a lot of long-term debt or slash prices.

That's not the sort of share you want to fill your boots with. Instead, you want a share that can post consistent earnings on a steady upwards path. This is essential for two reasons.

First, consistency is a great indicator of durability. The only companies likely to show such durability are those with a real competitive advantage.

Second, the more stable a company's performance, the easier it is to make predictions about future earnings, and the simpler it is to tell whether you are over- or underpaying for the shares.

The 10-year record of earnings per share (EPS) should reveal what sort of company you are dealing with. Do the EPS figures rise more or less smoothly or do they form a jagged rollercoaster?

That's one simple way to weed out the inconsistent types. But it is only a first impression. US billionaire Warren Buffett is said to study the 10-year records of two more insightful performance measures: return on equity (defined as post-tax earnings divided by shareholders' equity) and return on total capital (defined as earnings before interest and tax, divided by shareholders' equity plus debt).

Companies with consistent 10-year records in these three categories are likely to have enduring competitive advantages. That is not to say that they will never mess up. In fact, that is what you want: a passing, solvable problem that causes a nasty dent to short-term performance and that prompts the market to overreact. Knowing that the long-term picture is far rosier, you can then pile in to buy quality at a discount.

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