The danger of getting obsessed about earnings per share
(Apr 23, 2015)
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In this issue:
» What's on the mind of this guru of emerging markets?
» FY16 disinvestment target looks steep yet again
» A round up on markets
» ...and more!
What do you think is common between Jaipur and Oakland? Well, forget the commonality, most of you may not have even heard of Oakland. At least this is the case with us. We are only faintly aware that it might be some western city.
However, a gentleman who answers to the name of Billy Beane should take some credit for putting Oakland on the world map. Well, if not on the world map then at least on the sporting map.
Turns out, his is a typical David versus Goliath story. The biblical David in this case being a small, non-descript baseball team called the Oakland Athletics that Billy Beane was in charge of. His 'slaying the Goliath' moment came back in the years 2002 and 2003 where armed with nothing more than a puny budget; he and his team managed to sweep the competition aside and reach the final rounds of the intensely competitive Major League Baseball.
Exactly how puny? Well, at US$ 44 m, its payroll was amongst the lowest. Absolutely paling in comparison to the US$ 125 m that behemoths like New York Yankees shelled out. Where it starts to get really interesting is how exactly Billy Beane managed to put together a winning outfit despite the yawning gap in money available for spending.
Make no mistake. Everyone enters a competition with the objective of winning. However, what really differentiates the winner from the loser is what statistics one relies on while forging a team. And this is where Billy Beane and his management team really stole a march over rivals. They literally turned the conventional wisdom on its head in trying to achieve their objective. They very well knew that they stood no chance in recruiting superstar players with the budget they had. And therefore, did not take the traditional route of recruiting players. So tossed away was the reliance on baseball insiders like talent scouts, coaches, managers etc for recruiting players. Mind you this was the norm at the time and perhaps still is.
They instead took the help of cold, hard facts. In other words, rigorous statistical analysis. It is here that they came across a rather interesting looking anomaly. They observed that better indicators of success are not the ones that most of the other teams were relying on. Instead, they were a set of qualities that practically no-one was looking at. What more, they were also relatively quite cheap to obtain from the market. And it was relying on these qualities and hiring the players best equipped with them that they started running circles around other teams in the competition. Mind you, all of these at a fraction of the cost of the so called Goliaths.
Interestingly, this very same strategy has travelled all the way across the Atlantic and the Arabian Sea. And has landed right here on Indian shores. And if you are tracking the performance of Rajasthan Royals in the current IPL and the previous couple of seasons, the similarities with the Oakland Athletics is hard to miss.
Notice carefully how Rajasthan Royals do not have an army of cricketing superstars; players who can singlehandedly win them matches. What they do have are lesser known but equally effective players who can clearly punch above their weights whenever the situation calls for it. Little wonder, they are the team to beat this season despite being extremely frugal with their spending on players.
So, what's the key big picture takeaway from these examples? Well, if the famous author Michael Mauboussin is to be believed, while trying to achieve something, it is absolutely imperative to look at the right statistic. And a lot of times, even the conventional wisdom could be wrong on what the right metric or statistic is.
At least this is true of investing we reckon. Majority of times in trying to find the next big winner, investors ended up measuring only the growth in earnings per share. However, is this right thing to do? Certainly not. Growth in earnings helps create shareholder value only if the firm under consideration earns more than the cost of capital.
In cases where the return on capital is poor and lower than the cost of capital, growth in EPS actually ends up destroying shareholder value. In other words, obsession with EPS and EPS alone can end up causing way more damage than one thinks possible.
Therefore, even before looking at the growth in earnings per share number, it will help to check the company's track record on the return on capital front and the sustainability of it. Absent this, your results could be similar to those of other teams in the leagues. In the sense that your portfolio could be loaded with expensive looking high growth stocks. But it may not produce the desired results over the long term.
Do you think relying on growth in earnings per share alone is a huge mistake? Let us know your comments or share your views in the Equitymaster Club.
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Coming out with aggressive targets is not just a corporate phenomenon. Even government departments are prone to this syndrome. As today's chart of the day depicts, in the last 5 fiscal years the government has not met its disinvestment target even once. In fact, in every year except for FY13, the actual figures have been way of the target.
Is FY16 disinvestment target achievable?
For FY16, the government has set a target for Rs 410 bn. This excludes a sum of Rs 285 bn set for strategic disinvestment which may include sale of residual stakes in Hindustan Zinc, BALCO and some other PSUs. If we include this sum then the target for FY16 is staggering at Rs 695 bn, highest over the last 5 years!
Only time will tell if the government is able to meet the target this time around. However, the fact that many PSU stocks are beaten down currently suggests that government will have to wait for an opportune time before offloading them. Apart from current prices, imbroglio on the subsidy sharing mechanism is another factor that may hamper the stake sale in oil PSUs. Not to mention the litigation issues that has delayed the stake sale in private companies like Hindustan Zinc. Considering these multiple deadlocks, it appears that FY16 would be another year where meeting the disinvestment target could be a big challenge.
Emerging markets have long been a favourite of fund managers across globe. However, ever since the news of US economic recovery gained prominence there was a capital flight. Nonetheless, if Mark Mobius is to be believed then this capital flight should be temporary in nature. He reckons that the US stocks are pricey at this juncture and one should consider gravitating towards emerging market stocks.
Poor earnings performance so far is one of the reasons why valuations for the US stocks appear to be out of sync. And in future too the earnings are not likely to be strong considering the headwinds that the economy is facing. Thus, there are much better opportunities outside of the US particularly in emerging markets. And when it comes to emerging markets, India has always been a favourite. With the Modi government seemingly being willing to bite the bullet, it seems that achhe din are not far away as far as attracting foreign capital is concerned.
The Indian stock markets were trading in the red at the time of writing. While the BSE-Sensex was down by 199 points, NSE-Nifty was down by 46 points. Most Asian markets were trading mixed at the time of writing. European stock markets, however, opened in the red.
"If a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result" - Charlie Munger
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|This edition of The 5 Minute WrapUp is authored by Rahul Shah and Jinesh Joshi.
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