Many intelligent people make mistakes not because they have the wrong answers, but because they have asked the wrong questions. Smart investors are no different. There is an antidote! Readers of "A Dash" know that I strongly recommend the go-to guide on critical thinking written by my own favorite professor, Neil Browne. The book title, Asking the Right Questions, tells an important part of the story.
Critical thinking is always important, but this may be a special time. It is so easy to be confused. Let me take a different tack.
Let us start with a positive, strong answer from James Altucher on tonight's CNBC Kudlow show. Asked about the pressure on profit margins, Altucher said, "At the end of the day I don't care that much about profit margins, I care about profits....growing huge...."
This seems so obvious, yet is missed by so many. Margins don't matter if overall earnings are great.
A Little Background
When the economy and stocks started to recover, skeptics predicted the worst for corporate earnings. It would be easy to find specific quotes, but why pick on anyone? Most people will remember the general perma-bear litany from last year:
- There will be a double-dip recession, crushing corporate earnings.
- Corporate earnings are only up through cost-cutting. This cannot continue. We need revenues!
- Increased corporate revenues are not enough. Earnings growth is only due to peak profit margins. These margins must fall.
By contrast, I predicted that companies (Caterpillar was my prime example) cut costs to maintain profits during hard times. These companies had great earnings leverage as the economy got better. We are now entering a time when companies are increasing work forces to match growing demand.
This is smart corporate management, and a very natural progression. Instead of understanding this process, many stock pundits are on a mission, trying to find any false note in the story.
The Miller Rule (Good Idea, Bad Name?)
There is an important principle called Occam's razor, which emphasizes simple explanations. My "rule" takes the opposite side.
The more variables, the more spin potential.
I proposed this last year. It is a good concept, perhaps in need of a cooler name (My dad was not called "Occam" so I have a disadvantage! What is the opposite of "razor"?). Here is my list of ways (from last July) that skeptics could distort earnings reports:
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 current earnings growth is proving strong enough to defy the entire list.
The Margin Question is Wrong!
The pre-eminent figure on profit margin reversion is Vitaliy N. Katsenelson, whose book I reviewed favorably in January. He regularly updates his work, including the compelling chart here, which has been republished by everyone of the bearish persuasion.
I agree about profit margins. In my own article from January, I listed profit margin reversion as #1 out of ten things that will be more normal in 2011.
The problem is that Vitaliy's analysis is too limited. Many other factors are at work. As margins narrow, employment will rise, revenue will rise, housing will stabilize, skepticism will decrease, P/E multiples will improve and stocks will rise. Why not look at the big picture, not just one variable?
Vitaliy's book, as I wrote, is quite valuable as a guide to stock selection, but I predict he will be wrong about the sideways market thesis.
Compare his approach to the Altucher answer -- earnings growth, whatever the reason, huge.....
Earnings Season Shopping
I'm looking at stocks with good reports and a poor reaction. Stryker (SYK) fits my themes (health, graying of the population) and is also a pick of my respected colleague and source, Eddy Elfenbein. I own this in some client accounts and have been looking to add in others.
[long CAT, SYK, and other cyclical and health names]
