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12 Aug 2022 6:54
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  •   Home > News > Business > Features

    When A Dog Becomes A Darling

    I have always been fascinated by the fragility - yet resilience - of humankind in the face of immensely powerful forces such as the weather, nature and, well, the universe in general.

    Investment Research Group
    Investment Research Group
    I love stories about man's inability to influence these forces - and arrogance in thinking that they can be tamed.

    One famous parable I like is about King Canute, an ancient king of England, who showed his courtiers the limits of his powers by commanding the tide not to come in, and of course utterly failing.

    Another is about King Solomon who commanded his wise men to find some words of wisdom that would never fade or cease to be relevant. After much deliberation, they came up with the phrase "this too shall pass".

    One of the secrets to picking shares is to look at long-term trends and to extrapolate these for an equal period in the future.

    This prevents us from falling into a trap that catches many investors, that is, assuming that current conditions will continue into the future indefinitely.

    Take for example a company that in the past three years has grown earnings by 20% a year. Many investors would happily pay a high price for this company on the assumption that it will continue to grow by this rate in the future.

    However, let's assume that these three years are particularly good ones for the company and that, over the past 10 years, it has had three exceptional years, a few ordinary ones and a few terrible ones. Given that, its long-term average growth rate may be only 10% a year rather than 20%.

    Knowing this, we would not recommend the company unless its price was much lower.

    Conversely, investing based on a 10% growth rate when everyone else is picking zero growth (based on recent evidence) can result in excellent profits for the patient investor.

    Let's take a real life example. Hands up who would have invested in a company that was in an out-of-favour sector where prices had been declining for years?

    It records a loss of $2.3b, compound a loss of $1.7b in the previous year. Senior managers are resigning or being sacked and analysts are asking whether the company can survive.

    The company? Resource giant BHP just nine years ago. Since then, of course, the company has performed spectacularly. However, those who are buying the company on the basis of its 76% average growth in net profit in the past four years may end up disappointed.

    Over 10 years, the rate is more like 23% and even this is cannot be relied upon as a full commodity cycle is typically 13 - 18 years. Our assumptions for the next 10 years are based on a sector-average annual growth rate of just 8% a year.

    Return on Equity is another measure that can excite investors. Forecasts for the 2009 financial year are for a ROE of 46% while the company's long-term average is a more reasonable 18%.

    We are not advocating that investors avoid or sell BHP - the commodity cycle still has several years to run.

    However, we do counsel against spending too much on a share whose earnings are growing very rapidly. We also advise against selling shares only because its earnings are declining or growing slowly.

    In both cases, it can be said with a high degree of confidence that this situation will change. Quite how things will change we can't say, just that they will.

    © 2022 David McEwen, NZCity

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