Earnings Persistence Is Your Best Ally

The worst obstacle an investor must overcome is uncertainty. To make an investment decision, an investor needs to look at a company’s past, make some assumptions about the future, and come up with some trigger values that make it worth taking risks. But sometimes the past is confusing, made of inconsistent and volatile earnings and cash flows. Under such foggy conditions, it is very hard to employ a transparent and clear decision model. The quality of the inputs can be doubtful, making the investor pick stocks that are often overvalued and fall short of expectations.

The future is always uncertain, that’s the way life works! If there was no uncertainty about a company’s future, then risk would be non-existent and you would be remunerated with the risk-free rate, nothing more. However, risk exists, and a lot of the time you’re willing to take it in return for some profit. But if taking risks is a necessary condition to make a profit, it is not a sufficient one. Carefully avoid unnecessary risks and maximize the chances of getting a profit through a selective valuation process.

Successful investors, such as Warren Buffet, usually look at earnings consistency (or earnings persistency as it is often called) as an eliminatory condition when selecting stocks. A company showing consistent past earnings is usually in a better position to deliver a continuous stream of growing cash flows in the future. Consistent past earnings show the company is able to make a persistent profit over time and allow an investor to better predict its future. An investor will be more confident at estimating growth rates, and valuation will deliver higher quality results.

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When a company shows inconsistent earnings over time, most of its value comes only from speculation. Under such conditions it is very difficult to estimate future growth and come up with a fair price for the business. Most of the time, investors just end up paying too much. An example would be the 2000 tech bubble that culminated with the collapse of the stock market after March 2000. Investors were paying any price for dot com companies with uncertain cash flows and without a proven record of delivering a continuous profit; they were exposed to a market crash when everybody realized actual growth was much lower than first expected.

Look at the following example with Microsoft and 1-800-Flowers.

While Microsoft suffered its dips, which were related to the business cycle, 1-800 Flowers wasn’t able to show a consistent growth. It is not difficult to come up with an interval of expected future growth for Microsoft, which certainly isn’t the case for 1-800 Flowers. You can take a speculative bet on 1-800 flowers and end up winning it, but it is earnings persistence that drives long-term success.

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