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The Quest for Railroad-Track Growth

Often a Sign of Good Management, Sometimes Too Good to Be True

Sustainable earnings growth is a Holy Grail sought by investors of all stripes. Value investing guru Benjamin Graham searched for it, choosing stocks based in part on a management team’s ability to generate an upward trend in earnings over many years. Graham was a bit accommodating with this requirement; he’d tolerate flat earnings for a year or two so long as it didn’t look as if earnings were about to break through the floor. He believed stock prices eventually would track growing earnings over time.

Growth investors expect more. BetterInvesting members look for companies that have a consistent history of producing better-than-average earnings growth. In innovation-based industries such as pharmaceuticals and technology, this can often mean double-digit earnings growth even as stocks in the broader market are buffeted by recession.
The managers of the U.S. Trust Focused Large-Cap Growth Fund explain the strategy this way: “Emphasis is placed on selecting high-quality companies having dominant industry positions, strong financials and consistently high earnings growth rates. Such companies tend to be brand name, globally dominant companies in open-ended growth industries such as devices/biotech/ genetics, information technology, global consumer brands and global financial companies.”
Consistent earnings growth implies that a company is in a position to maintain dominance and has the management team to do it. A good example is Johnson & Johnson. Its five-year earnings growth rate is 13.8 percent a year, creating enough steady increases to fund 14 percent growth in dividends over that time and more than 20 percent return on equity. J&J has a diversified product line across pharmaceuticals, home products and consumer goods. Its ability to distribute products around the world is difficult for competitors to match much less beat. This seems to be a company where the past growth is indicative of good management and a dominant market position. (Companies are mentioned in this article for educational purposes only. No investment recommendations are intended.)
Apple has grown earnings at well over 100 percent annually for the last five years, an amazing run as new products such as the iPod and iPhone were brought to market and then allowed to mature. These are widely acknowledged as the products of Steve Jobs’ genius, or at least of the culture of design he implemented and fostered during his tenure at the company. A lot of companies had MP3 players and smart phones before Apple, but only Apple made them cool.
But the Apple example brings us to the pitfall of this style of investing. Apple isn’t exactly like J&J. Apple has a good number of larger competitors (such as Sony and Microsoft) that can, and often do, undersell it. Also, fads change, so although Apple’s proven ability to remain in style is nice to know, investors can’t count on it. Look at what happened to The Gap, which was once a hot brand but hasn’t been in a decade.
Another concern is that consistent earnings growth is extremely hard to produce, so investors should try to learn more when seeing 15 percent growth year after year. Enron is among the most notorious examples of this principle. Between 1997 and 2000 the company’s management team somehow beat analysts’ earnings estimates more than three quarters of the time, an amazing feat we now know was made possible by accounting shenanigans that kept losses and liabilities out of the picture. Enron’s managers were also masters at inorganic growth — boosting earnings through acquisitions and asset sales rather than by improving fundamentals in its business.
Finally, watch out for “earnings smoothing,” the term academics and regulators use to describe cases in which company managers adhere strictly to the letter of generally accepted accounting principles, or GAAP, but not quite to the spirit of it. Some have charged that financial firms used loopholes and oversights in the complicated body of GAAP rules to consistently understate losses and potential losses they faced from subprime mortgage exposure early in the credit crisis. This explains why, as the crisis unfolded, there seemed to be so many new surprises from companies that had supposedly come clean.
One rule of thumb: If the earnings growth doesn’t have a simple explanation behind it, as in the case of, say, J&J, Wal-Mart or Apple, at the very least be skeptical.

BetterInvesting’s Online Tools

The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks with histories of sales and earnings growth. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.

Michael Maiello, who wrote "Fly With The Fundamentals" for the January 2006 issue, is author of Buy the Rumor, Sellthe Fact (McGraw-Hill, 2004).

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