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Earnings Power: The Key to Outstanding Investments
Apr 6, 2016

What are the key variables you look at when you want to invest in a company?

Did I hear you say revenues, profits, market share, and margins?

'You see, but you do not observe.' That's what Sherlock Holmes would say if he knew how most investors go about analysing a business.

Earnings power is the key to profitable investments.

Earnings are simply the reported profits. It matters not how they are obtained. Perhaps they came from a sudden non-recurring surge in demand...or a change in accounting practices.

So the question is investors must ask is three-fold. Are the earnings...

  1. Real
  2. Here to stay
  3. Going to improve

Scrutinise earnings thoroughly. Look out for what Phil Fisher calls 'certain inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future'.

Those characteristics are the earnings power of the company. Earnings power is competitive strength. It's the ability of the business to repeatedly earn above average rates of return on invested capital over a long periods of time.

Consider Eicher Motors. On one end, the company sells an aspirational product - a high end motorcycle. On the other, it has a strong presence in the commercial vehicles segment.

Here's Eicher Motors managing director Siddhartha Lal on the demand for his company's products:

  • We are still a discretionary product and our buyers are an upgrading audience. Our intention is not to be a niche player, but we want to be a leader in our category. Our bottom line is perhaps the best in the world at around 24%

We're talking about a business with industry-leading margins and excellent return ratios on invested capital. The average five-year ROE is 27%.

Competitors find this profitability hard to match; they do not even try to compete with Eicher's level of quality.

What works for the firm is its ability to convert commodities into an aspirational brand. They know how to tap into that little space in our brains that compels us to buy a product without regard to price.

Eicher's earnings aren't a one-off, and they don't need accounting tricks. The company is a success because of its ability to generate repeatedly high returns on its capital and its ability to nurture and grow its brand. In other words, its earning power.

In your search for outstanding investments, if you find yourself wanting to buy a company that has reported a couple of years of good earnings, I would urge you to look closer at the true earnings of the company before you decide to buy.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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