Warren Buffett has been known to say that if past history was all there was to the game (of picking good investments) then the richest people would be librarians.
Buffett's musing highlights the difficulties investors face in extrapolating past performance into the future.
For example, a high growth stock such as SEEK Limited (ASX: SEK) might not have looked like much 10 years ago but just look at it today! For the year ending 30 June 2005 SEEK earned 6.9 cents per share (cps); for the current financial year one consensus estimate has the group earning 58.6 cps.
Conversely, a seemingly defensive and sturdy business such as Metcash Limited (ASX: MTS) which grew earnings for most of the past decade, reaching a high of 38.1 cps in 2012 is expected to earn just 21.6 cps in 2015.
Contradictory advice:
Despite Buffett's advice that you can't simply look in the rear view mirror to pick successful stocks; Buffett does appear to rely heavily on past performance to determine if a company has a sustainable comparative advantage as a basis for picking his investment opportunities.
Let's consider two widely owned blue-chips Woolworths Limited (ASX: WOW) and AMP Limited (ASX: AMP).
The bear case:
When it comes to Woolworths there are reasons to be cautious that the future will look like the past. Consider the past decade – Woolworths' earnings per share (EPS) in 2006 were 75.4 cps. By 2014, EPS has grown to 195.6 cps, a very solid achievement indeed.
The group looks to have a tough road ahead of itself however with the leading retailer facing increasingly stiff competition from competitors Aldi, Costco and a revitalised Coles, owned by Wesfarmers Ltd (ASX: WES). This competitive threat could lead to Woolworths' world-leading profit margin coming under pressure. Its earnings growth certainly might not be as strong in the next decade as it was in the last.
So while it is hard not to imagine Woolworths as a leading supermarket retailer with enviable store locations and a first class distribution system in ten years' time, its profitability may not be as impressive.
The bull case:
Unlike Woolworths which has enjoyed a stellar run for the last decade, AMP has been a serial disappointment for long-term shareholders. Earnings in 2005 were 86.6 cps but in 2014 they were just 29 cps.
Certainly past performance doesn't instil confidence but with the group exposed to the growing financial services sector and particularly the superannuation industry the future for AMP's business looks bright. While the share price has performed poorly both on a relative and absolute basis over the last 10 years, shareholders may be set to enjoy better returns over the next 10.