Why earnings growth is a rubbish way to judge a stock: report

Here’s another metric you should use to find companies that will explode in value over the long term.

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An equities fund has reminded punters that earnings growth should never be used to judge the worthiness of a share.

Sydney’s AIM fund has a motto of “Successful investing is done from the perspective of a business owner, not a stock speculator” in choosing which businesses to invest in.

The firm, led by chief investment officer Charlie Aitken, explained why in a whitepaper.

“Growth only creates value for owners if the capital that has been invested to generate it earns a return above the cost of said capital.”

What does ‘return on capital’ mean?

The paper took the example of a small cafe.

Say you were opening a coffee shop that took $100,000 to set up. After the first year of operation, the owner earns $10,000 after maintenance and inventory are taken into account.

During that second year, the first shop continues to return 10% – providing the owner $11,000. But the second cafe is less successful, only returning $5,000.

A 10% return, not bad at all.

This prompts you to open a second cafe in a different suburb for the start of the second year. The expansion store also costs $100,000 to establish.

That’s a total of $16,000 earnings for the second year, which is 60% growth. Sounds amazing!

But in terms of return on capital, year 2 was a dud. The owner ploughed $210,000 into the business and got $16,000 back. 

This is a 7.6% return, which is a lot lower than the 10% after year 1.

“As the example has demonstrated, it is quite possible to generate ‘growth’ without creating a single dollar of ownership value (or, in fact, destroying value),” AIM stated in the whitepaper.

“Investing like a business owner means thinking about the underlying economics and returns of the business, not the year-over-year growth rate that is generated.”

Jackpot: find a business with explosive return on capital

Charlie Munger, who is Warren Buffett’s longtime right-hand man and the vice chair of Berkshire Hathaway Inc (NYSE: BRK.A), agrees investors shouldn’t get seduced by earnings growth.

Munger said in his famous Art of Stock Picking speech that over a long period, it’s unlikely a stock will earn a better return than the earnings of the underlying business.

“If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount,” he said.

“Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

AIM’s whitepaper stated the critical part of this treasure hunt is that the returns on capital are sustainable.

“This means performing a qualitative assessment of the industry structure and competitive advantages of the business you are invested in.”

AIM plugged some numbers in to test Munger’s assertion. 

Say business A returned 6% of capital per annum for 40 years, and business B returned 18% per year for 20 years.

Even if you bought business A at 7.5 times price-to-earnings ratio and B at 15 times, the returns for the latter are far superior after 20 years.

Compound annual returns after ownership of…
  5 years 10 years 20 years 40 years
Business A 21.8% 13.6% 9.7% 9.7%
Business B 18% 18% 18% 18%
Source: AIM; table created by author

“The critical point when investing from a business ownership perspective – and to be clear, this is no small task – is to own businesses that generate sustainably high returns on capital over the very long term,” the AIM whitepaper read.

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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