Quarter 2 - 2018

Does P/E Predict Stock Performance?

As we have ended the first quarter we begin to enter the media ritual of earnings season.  This is the time when corporations announce their first quarter earnings and revenue.  This time-honored tradition has been the source of countless hours of TV programming and print media focus with the intent of pushing the narrative that earnings and revenue are good indicators of stock performance.  There is considerable evidence in support of the contrary.

What is the problem with this metric?  Let’s look at an example.  ABC tech widget is preparing to announce earnings. Analysts from firms who have provided their underwriting have predicted they will earn 55 cents per share.  Unknown to the analyst ABC had an order cancel late in the quarter. The CFO, who in the past has been very liberal with earnings and revenue recognition has just realized they will be a considerably short of predictions.

What to do? “We have to do something, this is terrible” …

They go to work.  “You know that land we own in Texas? Let’s mark it up.” “That severance package for the old CEO? Let’s defer recognition until next year”.

Presto their earnings are now inline.

On the other hand, ZZZ tech widget, a competitor of ABC captured the cancelled order and got the new business.  This may appear to be great news.  The problem is they will now beat analysts’ projections substantially thereby embarrassing the same people who provided their underwriting and forcing them to continue to beat earnings in the coming quarters.

What to do? “We have to do something, this is terrible” …

They go to work.  “You know that land we own in Texas? Let’s mark it down.” “Let’s move ahead with the vesting schedule of our employees” …

Abracadabra their earnings are now inline.

All this is done in concert with their legal departments and under the guise of Generally Accepted Accounting Practices.  This not necessarily cooking the books just microwaving.

Any CFO worth his golden parachute has a treasure trove of contingencies for any occasion. All done with the intent to manipulate investors.

Setting aside the perverse incentives of corporations and analyst let’s examine the actual effectiveness of the price earnings ratio and why this factor can be so misleading.

In May of 2009 the S&P 500 was trading at a price earnings multiple of 123.  By historical standards this was the highest in recent history.  At this level relying on the richness of this number investors would have avoided the stock market and continued to wait for a much cheaper price.  The price of the S&P 500 on May 30, 2009 was 919.  The price of the S&P 500 at the end of 2009 was 1115.  The price today stands at 2671.  A 191% return since May 2009.

Let’s review an example of the consequences of using price earnings on an individual company.

Microsoft is arguably the 3rd or 4th largest company by market cap with 30 analysts covering their performance. Hardly anything they do can be kept a secret.  Microsoft closes its fiscal year each June.  From June of 1998 to June of 2000 Microsoft doubled its earnings from 42 cents a share to 85 cents a share.  The stock price went from 15.80 to 40 per share during this time.  A gain of 153%.  Compare this to the time period June of 2002 to June of 2005.  Their earnings went from 48 cents to $1.12 per share.  Again, more than doubling their earnings.  The difference was the price went from 36.50 to 24.84 per share. A loss of -32%.

Investment firms have long since relied on earnings predictions to market their expertise.  Their discounted cash flow models depend on you believing in this theory. They would have you believe their bloated research departments and personal relationships with the corporate management give them special expertise into understanding the stock performance of a company.  This is all part of their marketing program.  Evidence has shown otherwise.  This is a part of the reason 70 percent of fund managers have failed to outperform their passive indexes.

At Core Capital Management we rely on factors which have proven to have predictive results.  Storytelling and cozy relationships with corporate management are not effective investment strategies. Price earnings multiples may have a small influence of price performance, however history has proven it can be mis-leading and can result in investor losses.

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