The Most Feel-Good Way of Losing Money
It is a common view held by most fundamentally-oriented investors that investing in companies with high earnings growth is a good investment strategy. OmniView doesn’t agree with this simplistic notion which is currently held by a lot of prominent investors and fund managers. This might seem surprising to a lot of readers but it will get clearer.
Earnings growth is good, but first step is to establish that it is a sustainable, fundamentally-sound earnings growth.
For this, first of all, the debt position of the company needs to be analysed. Are the revenue and earnings growth of the company coming from debt-fuelled asset expansion? If that is the case, the earnings growth might not be sustainable at some point in the future. Even if debt is not the fuel, then is it financed by equity infusions? Even that is not sustainable unless there is a huge competitive advantage showing up in the form of higher margins and profitability as compared to competitors.
Second, is the earnings growth at the cost of profitability? If earnings are growing in absolute numbers but the profitability of the company is reducing then again it is a cause for further analysis.
Third, assuming there is genuine demand and there is some kind of a sustainable competitive edge, still there is a concern about the valuations. Now this is the main point where we diverge from other fundamentally-oriented investors. This is where we would like to point out the focus of our concerns.
A good fundamental analyst will be able to pin point that a company is enjoying earnings growth and is likely to continue doing so for several more quarters. A very good fundamental analyst will be able to pin point that a company not only enjoys strong earnings growth but that it also enjoys some kind of a competitive advantage which allows it to earn supernormal profits while maintaining the earnings growth. Only exceptional analysts can truly pin point that a company will be able to maintain a supernormal earnings growth while maintaining a supernormal competitive advantage; that is surely a supernormal company.
In fact, the problem of investing starts from here. Even though the exceptional analyst identified a company as supernormal, this fact tends to be disseminated fairly quickly throughout the market and the market starts pricing the company accordingly. The knowledge has been commoditised. What that means is that an investor now buying this company at its full price is going to be entitled to market returns at best over the long term.
There are two questions which are still unclear as a true value-oriented, fundamental analyst:
· How sustainable is the competitive advantage the company enjoys and how long will it last?
· Does the market price incorporate this information fully? Is the market overvaluing or undervaluing this company and is that significantly out of line?
The OmniView is that mostly the mistake of most pseudo-value investors is in assuming that what they have identified is a supernormal company which can sustain this competitive advantage nearly permanently. The pseudo-value investors then justify paying prices which are way above the actual economic values of these companies. And therein lies the folly. The OmniView is that this is the most feel-good way of losing money.
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