The Effect of Complexity

Adding complexity to a story adds "spin potential."  It is great for media and pundits.  It is a disaster for investors.

[Warning:  I am writing this under duress.  I am supposed to be on vacation.  Since we are at the five-year anniversary for "A Dash" there might be some updates or historical posts from my team.  I am supposed to ignore this while taking some time away from writing, but of course, not from the markets.  The portfolio manager is never really on vacation.]

The Genius Manager

I do not know if anyone could have been this smart, but let us suppose the following about a company:

  • Anticipated lower sales and cut costs;
  • Adjusted inventory to meet expectations;
  • Accelerated purchases as demand increased;
  • Stayed "lean and mean" on inventory to enhance returns;
  • Prepared to cut pricing, if that would lead to long-term growth;
  • Ready to hire if indicated.

This would be a great management team.  In fact, no one is using these criteria as a scorecard.  Why not?

The Simple View — and the Long-Term Winner

Those who seek long-term investment success need to focus on individual stocks:   earnings, earnings growth, and the current price.  We are trying to buy strong companies with great potential.  You should be doing the same.

I am monitoring, with great interest, the approach of Chuck Carnevale.  He has a vision that I share.  He takes a very long-term view to corporate earnings.  He is aligned with Warren Buffett:

Time is the friend of the wonderful company, the enemy of the mediocre.


Here is an example of Carnevale's analysis, taken from April.  He shows a price based upon long-term earnings trends.  It is worth considering.  It is beyond my current scope to consider the balance sheet components (all of which are very important)  but the information is all there.  The key point of his thesis — and a good one — is that the market eventually returns to the earnings story.



Dealing with Complexity

Since we are investing in interesting times, we are challenged with complex stories.  A few weeks ago I wrote that earnings would be strong, but that the market response might not be as expected.  Now we see why — there is always something to criticize.

As you consider this list, please keep in mind the example of what strong management might have done.

No longer is there a single bar.  Were earnings strong?  Or even a second bar.  How was revenue?

Instead, there is a long laundry list of tests:

  • Earnings — comps from last year.
  • Earnings — meeting expectations.
  • Earnings — meeting the "whisper number."
  • Revenues — should meet all of the above.  The market is very skeptical of earnings from cost-cutting, even though that shows smart management and can easily be reversed.  It is a clear-cut bias.
  • Gross margins falling — another thing that can be wrong.  Even though it might be correct to compete by cutting margins, the pundits will pounce.
  • Gross margins rising –  evidence of unsustainable earnings on a long-term basis.
  • Foreign sales — another no-win area for management.  If you suggest that sales were lower, then pundits will infer Europe weakness.  If you try to cite currency changes, you get the opposite spin.
  • Ignore current earnings.  Look backward.
  • Ignore forward earnings.  Look backward.
  • Ignore strong earnings.  Look at multiple year growth estimates.
  • Ignore long-term growth estimates.  Those are too bullish.

The added complexity of the earnings story is not helpful to the investor.  For consideration by investors who want to look more deeply into this process, I now posit "The Miller Rule."

The more variables, the more spin potential.

This is the investment corollary of Occam's razor, which emphasizes simple explanations.

Investment Implications

The Miller Rule is simple and powerful.  It shows how to take a good earnings story and find something wrong with it.  If you make the story complicated enough, you can find something to criticize.  It makes for great ratings and page views.  It helps to explain the behavior of financial television, MSM, and blogs.

Meanwhile, investors with a long-term horizon,  and who have a laser-like focus on actual earnings potential, have a great opportunity.

[No IBM position – but taking a close look]

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  • Paul Nunes in kansas City July 20, 2010  

    This was very helpful. Enjoy your time off Jeff! I give Chuck kudos for his effort; it provides a good framework to look at individual stocks.

  • JL July 20, 2010  

    Great post!!!
    How about this spin on financials:
    2008: Banks increase loan loss reserves — omg this is the end of the world. sell
    2010: Banks decrease loan loss reserves — omg banks are using accounting tricks, sell
    In both cases, the LLR represents unrealized losses

  • Mike C July 20, 2010  

    [No IBM position – but taking a close look]
    Please do a blog post on this.
    The Most Remarkably Mispriced Name in the Market
    That’s the way legendary investor Bill Miller described IBM (NYSE: IBM) in an interview at the 2010 Morningstar Investment Conference at the end of June, adding that the stock is “30%-50% underpriced, yet no-one seems to care about it.”