Investing Advice AGAINST Future Earnings and Trend Lines

[Justo]

Last Thursday I watched a segment on BNN in which the co-host (some Asian man) kept valuing stocks based on their forward earnings. He talked about how the price was undervalued or overvalued or on par with what the company was expected to earn in the future. Some of his valuations were even “justified” by selling (in his words) at ONLY 10X forward earnings. Are you kidding me?!?! These are absolute blasphemous words to the value investor, which I will delve into in a moment, but first I must issue a warning to ANY and ALL investors that believe this.

*WARNING * By basing a stock’s price on forward looking statements you will (most probably) lose your money!

And here’s why:

Basing a stock’s value strictly on future earnings is ridiculous in that we do not know what those future earnings are! Are you a fortune teller? A psychic?? An enthusiastic optimist??? They could be less or more or the same as they are now couldn’t they? So by this very notion we are either speculating or can see far into the future, in which you should already be a very wealthy individual (If I was psychic I would win every lottery ticket and win every sports bet I made).

 “But wait!” they’ll say. “We can make a trend line to show that future earnings are going to be greater than they are!” Let me make this clear. Trend lines are for people who do not believe in change, and this attitude will ultimately lead to failure in the stock market. They have no notion of the idea that those which often go up must come down. If we were to take a trend line as absolutely true, then we are saying that the stock market is strictly based on mathematics. And if this is true, then trend lines would work.

However, IF this is true then a trend line going up must go up to infinity, and a trend line that is going down must also decline forever. You’re catching where I’m going with this I hope. Stocks do not go on like that forever, they fluctuate and advance and decline and do all sorts of crazy things. To think that a stock’s price can only keep advancing is foolishly optimistic, and a person with this mentality deserves to lose every dollar that he owns. If we could rely on trend lines it would make investing extremely easy and everyone could be a mega billionaire, as stocks that were going up would continue to go up forever making the price of that stock infinite.

Stock investing then cannot be based entirely on mathematics or trend lines, nor can it be based strictly on news alerts or management (which we will not talk about today). To roughly quote Ben Graham “Stock investing is neither purely mathematical nor purely artistic, but lies somewhere in between.”

Let’s break down what this Asian man was trying to say though, just to get a better understanding on what he means. He is saying that based on the trend he sees future earnings growing from $1 to $2. We would then use this $2 figure, multiply it by 10, and get $20 for the price of the stock that we would currently pay. So we would pay $20 now to receive something that makes us $1. In reality we would be paying 20X current earnings! I don’t have to tell value investors that this number on its own would grossly overvalue the price of a stock.  If I told you that in the future $1 would be worth $2, would you pay me $1.50 right now for something worth $1? Heck no you wouldn’t!!! You would pay me $1 for something worth $1. Be wary of any investor who tries to sell you stock based on future earnings.
   
An example of how foolish it is to base a stock’s price on future earnings or trend lines can be seen in the case of Worldcom. If we took the trend line for Worldcom between 1992 and 1999 we see that the stock advanced from about $30 per share to a high of $63.50! If we continued this trend by 2011 the stock price would be roughly $121. So how did Worldcom do?
   
Well by the end of 2002 the stock was trading below $1, during which the company soon filed for bankruptcy.
In conclusion, it is absolutely and utterly ridiculous to base a stock’s price based on future earnings. While some investors may make money by using this system, many will succumb to an annihilation of their principle. It is far better to evaluate a stock’s price based on a value approach, as this will offer a greater safety of principle. (I’ll cover aspects of this in the future).

 It hurts me to see people losing money, so please, stay away from anyone who talks about basing a stock’s current price on future earnings or trends. Good luck!

[DCA]

But always in the fine print they have the words: `Past performance is not a guarantee of future performance`

I have a theory on the stock market.  All prices are magically set at the correct value by an all-knowing entity.  (Lets call it FSM  Think of it as a tangley sort of reddish with brown round lumps sorta entity)  Now the problem is that after setting the price evil is let loose (We will call evil Barney and colour him purple.) Now Barney sends out over hyped press releases, pays of politicians, cooks the books (no spaghetti  sauce) and pays of politicians, off-shore banks, and pays of politicians....

The picture  is further complicated by the invisible pink unicorns.  No one ever sees them but their point horns bump into the price charts and push the lines up and down.  They are responsible for it not being a smooth line that FSM sets or the Barney saw-tooth drop of the cliff style.

Now you may laugh at this but the theory is as valid as most that other`s have explained to me.  Besides, it also serves as an illustration of the quote:  `The market`s ability to remain irrational exceeds your ability to remain solvent.`

D

[DCA]

The thing is that there is really only two ways to make money on the stockmarket - 1) the company earns money and pays dividends that are ultimately worth more than sticking the initial money under the mattress. or 2) the GFT where I believe that tomorrow I can find someone who will pay me for than what I payed because they believe in either case 1) or case 2) being true.

Now for 1) this does involve looking at future earnings and trends (but not chart trends).  This involves reading the company news release and forward looking statements to see what they expect to do be doing in the future.  The trends to pay attention to are management.  Do they have the same managers as last yearÉ  Do those managers have a history of being correct on their forward looking statementsÉ is the product called Blackberry or iPhoneÉ  (Note: the first one I would predict a degree of recovery on the second is going to cool off at some point.  No statement on the time frame involved. Don`t believe me on the coolingÉ  Then examine what would happen to the value of the company compared to the US GDP if it continued to grow for the next ten years at the same rate as the last ten.)

2) often involves the silly theory that stock prices have test points, resistance, momentum.  This is only believed because no one sees IPU and Barney has paid of the politicians.  However, people do have test points, resistance and momentum.  Anyone old enough to drive will remember the hype around the turn of the millennium and if you are not in a coma you should have heard something about the Mayan calendar and 2012.  (Is it just me or is that hype dying an early deathÉ) Psychology is a much more useful tool here than graphing.

The sad thing here is that 2) is always more profitable than 1).  (This is why Barney hangs out only in the 2) area.  The IPU are everywhere.)

D