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My Short-term Plan IX:

This is a continuation of my 10 part series on the core concepts I am focusing on in this difficult market environment. (Part I, II, III, IV, V, VI, VII, VIII)

Number 9:

One of my most successful Value Rules is something I call The 5% Rule.

Whenever I assess management of a company I look to see if they have the pulse of the business at all times. My biggest fear is investing into a company where management is out of touch with employees, industry trends or customers/clients.

Why?

Management are a group of individuals who make decisions on a daily basis that affect the operations, revenues, expenses and profits of the business. If they don’t understand their customers, the barriers affecting their business or limitations on their own capabilities than mistakes can happen. I don’t like mistakes because mistakes cost the company money and cost me money as a shareholder. My 5% Rule hinges on the fact that when a company’s management provides revenue, expenses or profit expectations for a quarter or year of a business that those results are within +/-5% of their guidance.

I’ll help put this into perspective:

Company MNO & Company PQR sell premium bandaids to consumers in a specific geographic area of Europe. Company MNO gives guidance for the quarter that sales will increase 10% year over year while Company PQR gives the same guidance (sales to increase 10%). When each company reports their quarterly revenues Company MNO reports an increase of 10.3% and Company PQR reports an increase of 15%. Based on that information, which company would you be happier with?

Investors at first glance might quickly respond “Company PQR!!…they sold more bandaids than they expected.” The question I pose to those investors is: Who has the pulse of their market better and why should that matter?

Company PQR originally guided for sales to increase 10%, but ended up with 15%. That’s 50% higher than they expected. Company MNO guided the same 10% increase, but missed sales by 3% (0.03) from their stated expectations. If this was a single quarter of unexpected sales increases than Company PQR might be ok, but if it happens consistently what it shows me as an investor is that management can’t adequately predict where sales will go. They don’t have the pulse of the business.

Let’s put this in a different perspective. Company PQR increases sales by only 5% from stated guidance of 10%. That would be the same 50% change, but to the downside and what would likely happen to the stock? If Company MNO reported an increase of +/- 3% from their guidance likely the market reaction would be to a lesser degree and as an investor your downside would be limited.

Bottom Line: The predictability of operations is imperative to me as an investor. I stick very closely to my 5% rule (+/- 5%) on a regular basis to gauge how management is doing on taking the pulse of the business. Whether its revenues, expenses, profits or margins I expect decision makers to know what is going on in all aspects of their business and to deliver on what they expect the numbers to be. I need to know that the company has a good hold on what is going on at all times.

Suggested Stocks I Own: Kimberly Clark (KMB), Thomson-Reuters (TRI) & Power Financial (PWF).

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{ 2 comments… add one }
  • Michelle October 7, 2008, 11:54 am

    How do u take analyst predictions into account?
    If a company reports earnings that miss analyst expectations the stock generally gets hit also

  • Nurse B, 911 October 7, 2008, 12:36 pm

    Michelle,

    I’m often not a big fan of analysts to begin with.

    When I generally forecast future earnings for a company I use their internal guidance because they’re the ones with the inside look on the business.

    Analysts often have a conflict of interest because they want to sell an opinion and look from the outside only. They can use complex consumer information to forecast demand or use earnings projections across an industry as a benchmark, but generally I look to trust the managers of the business to accurately give me, as a shareholder, a perspective of where earnings will be and come from.

    An analyst doesn’t know if a company’s sales team is meeting their own forecasts or how costs are directly affecting the bottom line. They can assume, but the reliability of those opinions are never something I feel comfortable placing my invested capital on.

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