One of my most successful Value Rules to date has always been the 5% Rule. Back on June 16th, I wrote a post about this rule and the impact it has on the long-term ability of a company’s management to deliver results consistently over a period of time. In this post I took the time to contrast two different companies:
“…Company ABC & Company XYZ each forecast revenues for the upcoming quarter. When the earnings reports are released, ABC reports an unexpected increase of 15% in quarterly revenue where XYZ reports an expected decrease of 4.5%. Which company appears to be in better financial shape?…”
Many investors might choose Company ABC as the clear winner because of the increase in revenues that it generated versus the decrease of Company XYZ. Yet time after time I will have continued to choose Company XYZ. Why?
This Value Rule revolves around the ability of a company’s management to accurately and consistently anticipate all elements of their operations; including demand, supply, costs, revenues and profitability. If a company is generating forecasts internally that vary wildly one quarter to the next, I have absolutely NO interest in placing my capital at risk as I view that management has weak control or understanding of their business operations.
Investors are welcome to invest in Company ABC despite this unique approach, but I tend to explain this to others as the Hoola Hoop Effect. These companies always start out doing fine keeping the hoop rotating on their hip with a perceived element of control, but after a while the rotation becomes increasingly unstable and unpredictable to control. After a period of time it simply falls to the floor with a thud. Most often, this is exactly how these companies match their forecasts to results. In the beginning they perceive the results as positive and within their control, until larger and larger swings begin to appear in actual numbers.
No better was this evident than in a research report commissioned by KPMG LLP Canada.
Through a survey of 544 senior business executives (30% CFO’s) EIU determined that firms who forecast within 5% of actual results saw share prices increase 46% over a three year period in comparison to 34% for others (a 12% premium). The study also found that only 22% of companies came within 5% of their projections, often finding information technology as a hindrance instead of constructive (TIBX anyone?). The most significant finding that I read was even though executives felt inaccurate forecasts cost money; they estimated that those same forecasts removed 6% off their share prices.
Although I wouldn’t suggest that one study accurately serves as a basis for this Value Rule, my hope is that investors will pay closer attention to quality management providing accurate guidance than the contrasting opinions of analysts who are not responsible for running these companies. The better the control, the more accurate you can predict where the company is going, how the stock price may behave and how profitable your investment may turn out to be at some point down the road.
