Thinking about growth - Part 5

After six years, we explore how reality has diverged from theory in a popular series comparing CSL and Commonwealth Bank.

In Part 1 of this series from 8 Feb 02 we began comparing an unlikely investment pair, Commonwealth Bank and CSL. Part 2, Part 3 and Part 4 followed the initial one (12 Jul 02, 1 Nov 02 and 3 Oct 03). This is Part 5.

The idea was to present a rough, but common sense, process to help you line up various stocks against each other – even ones that don’t seem obviously comparable. We’ve used a more in-depth version of the process on Leighton Holdings and Macquarie Group over the years, and it starts with some broad assumptions about how quickly a company might grow its earnings.

Precisely wrong

Using this assumed growth rate in conjunction with the current earnings per share (EPS) figure, you can take a stab at earnings a number of years into the future (we used ten years in our example of Commonwealth Bank and CSL). You’ll end up with a number which economist John Maynard Keynes might have described as ‘precisely wrong’ (as opposed to the more preferable ‘vaguely right’), and it’s important to recognise this. But it does at least give you something to go on.

From there it’s only an analytical stone’s throw to guesstimating a future price; you just multiply the forecast earnings by an imagined price-to-earnings ratio (PER). You can then calculate the percentage capital gain (or loss) you ‘expect’ over the period and boil it down to an annual rate of return. By adding a presumed dividend yield, you can finally get a figure for total expected return.

That’s the theory, anyway. Now, more than six years on from our initial comparison, we can see how bumpy business reality has corresponded with our smooth theoretical framework.

Table 1: Earnings per share
  2001 (A) 2011 (F)
Comm. Bank $1.90 $3.40
CSL $0.17 $1.08
Table 1 reproduces the figures in that first review (note that we’ve adjusted all historic CSL numbers to account for the October 2007 3-for-1 share split).
Now take a look at Table 2, which shows the actual reported EPS and dividends per share (DPS) for each company for their 2007 financial years. As you’ll see, both companies are rapidly closing in on the 2011 earnings per share figures we estimated six years ago.
Table 2: The story so far
  2001 2007 CAGR*
EPS      
Comm. Bank $1.90 $3.45 10.4%
CSL $0.17 $0.98 33.9%
DPS      
Comm. Bank $1.36 $2.56 11.1%
CSL $0.09 $0.35 25.4%
*Compound annual growth rate
 In other words, the original growth rates we assumed (6% and 20% per year respectively for CBA and CSL) have proven far too conservative. Even allowing for accounting changes (the 2001 figures include a non-cash charge for goodwill amortisation, but the 2007 figures don’t), we were a long way off in our projections, especially for CSL.

Lessons to be learned

There are investing lessons to be learned here, though not everyone will agree on exactly what they are. The one we want to focus on is the difference between making predictions about the future based solely off historical numbers (‘quantitative analysis’, in the jargon) and having a genuine understanding of what Platinum’s Kerr Neilson described as the ‘ecosystem’ behind the numbers in our December interview (‘qualitative analysis’).

CSL’s ecosystem has produced the world’s first cervical cancer vaccine, Gardasil. This life-saving breakthrough has benefited customers and shareholders alike, but it merited only a brief aside concerning ‘significant clinical studies’ in the 2001 accounts. You’d have had to draw a long bow to get from there to where we are now. That’s not to say it would have been impossible, but you couldn’t have forseen this success just by crunching the numbers, and you couldn’t have been sure – or even confident – about it on any basis.

Hardly infallible

This is why we distrust mechanical methods of stock analysis. A computer program or spreadsheet, no matter how detailed, is no substitute for careful research and thoughtful contemplation about the factors that may influence a company’s future. But there are no guarantees. Human insights – even those rigorously tested by diligent peers before being published for intelligent readers – are hardly infallible. That’s what diversifying your portfolio and seeking a margin of safety in each new stock purchase is all about.

What we were saying in 2002 was that CSL’s high share price demanded a correspondingly impressive future growth rate. In this case, the company has delivered. But the mortality rate of darling stocks is significant enough for the conservative investor to steer clear of them unless there’s reason to be unusually confident in the growth materialising.

More than expected

Our general conclusion throughout the previous instalments of this series has been that the more predictable CBA was the better bet of the two stocks. Our moderate assumptions were going to produce a respectable return and, happily, it turns out the business has delivered more than we expected.

As sod’s law would have it, though, in this case the highly-priced darling stock has turned out to be the better investment. But investors in other darlings of early 2002, like failed animal drug company Chemeq, or even Flight Centre (then $25 and a Sell recommendation from us) and Harvey Norman (then $3.61 and a Hold recommendation) might have cause to look enviously at those who opted for good ol’ Commonwealth Bank.

Identifying a growth company is one thing; identifying the right price to pay for a stock with already high expectations priced in is quite another. And that’s exactly what we hope the back-of-the-envelope methodology presented in this series has provided for you – a rough and ready framework to think about what you’re getting for your money when you choose to buy one stock over another.

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