Don’t like the real data? Just pretend!

If you are reaching an important investment decision, I have a suggestion for you:

Insist on data — accept nothing less!

Investors should monitor diverse sources of investment information to avoid confirmation bias.  If you want to succeed, you still need to engage in critical thinking.  Some are in complete denial about progress.  There is a simple solution if you do not like the reality of strong corporate earnings:

Talk about "normalized earnings."

This has a wonderful scientific feel to it, lending an air of credibility to those who have not studied the subject.  After all, don't we want our estimates to be "normal?"

If the current strong earnings reports do not fit your forecast, you can just say that you want to "normalize" earnings without offering any clue about your method or how it has worked in the past.

Background

When the recession hit, there were many observers who felt that even the finest companies would be crushed by the economic collapse.  They expected that revenues would fall, expenses would increase, and profit margins would collapse.

Some of us thought that the best companies — not all — would learn to get "lean and mean" and would increase earnings rapidly during the rebound.  We were right, and we have profited from this investment.

The increased earnings had a downside, since it often came at the expense of workforce reductions, with remaining workers asked to do more.

The Recovery

During the recovery period, the companies with enhanced productivity have blossomed — better earnings and better cash flows.  There is a clear lesson:

Profit margins went higher as pricing power and employment went lower.

I disagree with some observers (sometimes accused of being perma-bulls) who think that profit margins have achieved a permanently higher level.  My own conclusions are more nuanced.  I fully expect profit margins to decline, and I am interested in two questions:

  1. When?
  2. How far?

We should all be open-minded about the eventual profit margin level, which is a function of (primarily) new competitive entrants. When it comes to a topic like — for example — unemployment — the bearish pundits are eager to embrace the idea that there have been structural changes.  OK — and what about the many companies that are protecting their profit margins?

More importantly, I agree with the general concept that profit margins will decline.  At the same time this "mean reversion" occurs I expect  all of the things we associate with a strong recovery:   Better employment, better pricing power, and more aggressive competition from new companies.

There is nothing surprising about any of this, since it reflects a typical business cycle.

Time to call "FOUL!"

There is a group that I'll call Pundits in Denial.  They engage in static analysis, expecting profit margins to decline while nothing else changes.  As a result of this misguided analysis they help to scare the daylights out of the average investor by stating that if earnings were "normalized"  —what a wonderful word!!  — then the market is massively overvalued.

How to Normalize

When I am analyzing a stock with cyclical properties, I definitely consider the earnings at peaks and troughs of the business cycle.  This is one of the key elements of my edge, so most people have no idea about how to do this.  If you are at a business cycle trough, you must be willing to buy cyclical stocks at a high P/E multiple  — and vice versa.

To do this correctly you need to have a good theory of the business cycle and where we are right now.

You cannot just take a meat cleaver to earnings, saying that you reject the data because of profit margins.

Investment Conclusion

If you want to gain an investment edge you have to find something that most people are doing wrong.  Investing in cyclical stocks combines common errors on profit margins, economic strength, and where we are in the business cycle.

I have a current emphasis on this theme, but today presents an outstanding candidate in Caterpillar (CAT). I had several stocks in mind for this article, but CAT is the most timely.  I am choosing it as the worst-performing (and therefore the best opportunity) of stock fitting this theme, since the stock sold off today despite a good report.  Here is the long-term earnings picture (from the excellent fastgraphs source) before today's report:

CAT

Any investor who looks at this chart for a minute or so will be far ahead of most of the people they see in TV!  You can see for yourself the worst case of earnings during recessions, the general growth rate, the ability of the company to deal with recessions, and the current potential.

Nothing in today's report upset this story, so you get a chance to buy a terrific stock at a discount.

Once again, I abbreviated this story to cite the stock with the best current opportunity.  Another candidate to feature in this story was Apple, but that would have been a layup!  I hope readers understand that there are many, many stocks like this.

To repeat the main point — "normalizing" profits is not as obvious as it first seems…..

More to come.

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4 comments

  • jd April 26, 2012  

    Thanks Jeff,
    This is all extremely helpful.

  • Paul Nunes April 26, 2012  

    Timely article and an enjoyable read Jeff.

  • Scott April 28, 2012  

    While CAT’s growth is undeniable (even in Asia at 33% this quarter!), the balance sheet isn’t the best I’ve seen. Strip out the intangibles and goodwill and you have tangible equity of about $2B with a market cap of $68B. Not good. The debt to cash is over 10x, and the haven’t been a cash generator for a long time. In their defense, a lot of that debt is CAT financial, the lending arm, so they are a small bank to customers in essence as well.
    So if you are a value investor, you don’t have a margin of safety and probably want to wait for better prices. IMHO.

  • High School Diploma May 21, 2012  

    I appreciate your help. You really helped me.