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The 5% Rule:

Reports, forecasts, target prices, analysis from analysts, upgrades and downgrades.

Investors today are overwhelmed with information they can access at a speed we never could before. Logging into the updated version of WebBroker (TD) alone has me asking, “Why all the fluff?”

I’ve always been a concentrated specialist when it comes to researching my investments and their opportunities. I read their quarterly and annual reports, I follow them in the news, I attempt to interact with their products and services as much as possible and try to stay informed. As a nurse I like to “take the pulse” of the business to know how they are doing and then match this with the spin the investor relations and PR department at the company attempt to send out.

One of the trends I’ve noticed in 2016 is that earnings misses got hit hard and beats have been rewarded handsomely. While I expect this to continue into 2017 the severity of the downside on earnings misses has been impressive as has the exuberant rise in valuations after beats. This has reminded me of a lesson I was taught years ago when I was only a teenager I termed The 5% Rule.

Pay Attention to Sales Companies frequently get positive media coverage for reporting revenues or profits well beyond the company’s projected analyst numbers. Usually this alone is the basis for many investors flooding into the stock in order to maximize the growth opportunities that such stories often promise. I have always been the investor who looked the other way. I’m not saying that this won’t work for investors, it just never made sense to me and here are my reasons… I avoid allocating capital to companies whose management has difficulty accurately forecasting revenues, expenses and profits. One of my longstanding Value Rules has always been to pay close attention to sales – specifically how well a company can forecast revenues, expenses and profit.

We’ll compare two (2) companies as an example; ABC & XYZ

Company ABC releases expectations months prior and then reports an unexpected increase of 15% in quarterly revenue. Company XYZ provides the same expectations but then reports an expected decrease of 4.5%.

My question to readers is – Which company alone appears to be the better investment?

While many investors will argue that ABC is the clear choice, my view is that of a contrarian and here is my justification…

I want to invest and allocate capital to a company that can consistently & accurately forecast consumer demand, costs & profitability. Specifically I want a management team that execute on this. These actions demonstrate to me, along with all other aspects of my fundamental analysis, that the company has control over their business model, their products or services and a secure understanding of their target market. This management team can accurately anticipate consumer demand, habits, wants and needs in order to control their business and portfolio of products. If demand rises in one segment they can anticipate further changes and compensate to maximize profitability. If revenues, expenses or profits are varying significantly in different directions over the short & long-term this often shows me that management in Company ABC is not in control or is able to effectively predict the behavior of their target market. The company may have initial success with impressive numbers over the short-term, but I have often watched the subsequent declines in the stock price as distance grows between forecasts and financial performance of the company. In summary, no information a company reports should ever be a surprise to them. It can and will surprise the market, but if a company has a strong grasp of their business model and practices then they will anticipate and adapt their strategies to best fit the company and consumers’ needs. Control of costs and accurate forecasts of sales are essential in any successful business. Profits may increase or decrease due to increased material costs of conducting business, but knowing the direction of the target market and how it will affect your business is paramount from my value standpoint.

This is why I literally pay no attention to earnings forecasts by analysts. I would much rather evaluate a management team on their ability to provide a forecast they know is reasonable and then follow up with financial results that correspond with their projections.

* A version of this post was first published on June 16, 2007 and was updated in 2016 to reflect changes in market conditions and to reflect an update of my investing experiences.

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