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…
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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The post Why earnings growth is a rubbish way to judge a stock: report appeared first on The Motley Fool Australia.