Wednesday, April 28, 2010

Earnings Persistence

Value investors love finding stocks trading at low P/E values, as this means the price that must be paid for the stock is low relative to the company's earnings. But the investor cannot assume that current or recent earnings will persist forever, as this could result in an overpayment for a stock. One warning sign in particular that may indicate that earnings may not persist are abnormally high returns on equity.

The same feature of capitalism that has provided continuous improvements in productivity and our standards of living will also erode the earnings of investors who do not pay attention to its power: competition. When firms are able to generate abnormally high returns, a plethora of copy-cats will attempt to replicate its success.

Consider Cambrex Corporation (CBM), maker of active ingredients for pharmaceutical products. In 2009, the company generated operating income of $26 million against a market cap of just $128 million. But can it keep those levels of earnings going? That depends on whether the company has any advantages that the competition cannot erode. As a producer of commodity products, the company has at least 25 competitors in Western Europe and the United States, and many more in low-cost regions such as Asia and Eastern Europe.

It's important to note that every company will claim to have a competitive advantage. In the case of Cambrex, it has patents covering various processes and claims to have superior manufacturing know-how. However, only someone who understands the industry and the companies within it quite well will be able to determine if these advantages are real, and if they may result in strong returns that are sustainable. This once again highlights the need for investors to restrict themselves to areas within their circle of competence.
Barring a competitive advantage, competition will erode the returns of a successful operation. Companies like Coke (KO), Intel (INTC), and Google (GOOG) clearly have competitive advantages that have allowed them to generate abnormally high returns for sustained periods. Of course, there are many more companies with competitive advantages, even small ones. But if the investor is counting on such returns to be persistent, he should be able to identify that advantage, lest he overpay for a company that is soon to see its earnings return to more normal levels.

Disclosure: None

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