Saturday, 30 July 2016

Predicting Future Earning


Author: Icon8888   |   Publish date: Fri, 24 Jun 2016, 04:19 PM 

1. Introduction

Yesterday, I wrote an article advocating picking stocks based on future earnings. In the final section of that article, I briefly discussed how one can do that in real life :



In this article, I will go into further details on how to do it.



2. How You Can Predict Earnings

(a) Macro Factors

When you buy a stock, you are not buying a piece of paper, you are buying into part of a business. Businesses do not operate in a vacuum. They are subject to various external factors. One good way to predict earning is to take leads from those factors.

One good example is dairy product companies.



Milk powder is the main raw material used by Dutch Lady and F&N. When milk powder price declines, their profit IS LIKELY to increase. It turns out that if you make a bet based on that, you would have made some money from those stocks. 





Other examples are export plays (beneficiary of weak Ringgit), plantation plays (CPO price), plastic plays (certain plastic companies such as Superlon and SLP benefit from weak oil price), poultry plays (beneficiary of low corn price), etc.


(b) Catalytic Events

Certain things done by PLCs need to go through a gestation period. Market will not factor in the benefits of those future positive contribution immediately. Full re-rating will usually only happen when the trees start bearing fruits. You can start buying when you see the trees start blooming. Many tiny tiny durians are on the way, and the trees will soon be raining Musang King.

One good example is Thong Guan's capital expenditure programme. 

Another good example is YTL Power. It is currently constructing a huge power plant in Jordan. You can expect a re-rating of the stock when closer to completion in 2018. However, it is too early to buy now. You need to time your entry such that you don't get in too early and have your capital tied down in the sleepy phase.

Not all catalytic events are in the form of capital expenditure. In MBSB's case, the group's business infrastructure is capable of generating few hundred million Ringgit of net profit per annum. However, due to the need to make provisions (to achieve full fledge commercial bank status), overall profit has been suppressed, causing share price to decline substantially over past two years. You shoukd keep track of the stock and wait for right opportunites to enter. Aggressive provisions is expected to cease somewhere around 2017/2018 (I have yet to buy).   


(c) Recent Strong Earnings

One way to "predict earning" is to take cue from companies' recent strong profit performance.

Businesses went through boom bust cycles. When a company is doing well, there is likelihood that it will last for several quarters. It is POSSIBLE to make money by buying into stocks that fulfil the following criteria :-

(a) Strong earning in previous one to two quarters;

(b) Still not expensive. For example, trading at below eight times prospective PER. One way to derive the prospective PER is to base it on annualised EPS. It is up to you to decide whether the annualised figure should be based on latest one quarter, or two, three quarters.

(c) Has not run up substantially, preferably less than 30% since the first time earning registered strong growth; and

(d) Casual examination shows that operating environment is likely to remain conducive in the next one to two quarters. Of course, you need to bear in mind that "no research has proven with statistical significance that one can accurately predict the future, in particular macro factors".  

Please note that to get it right, it should preferably be a combination of ALL the above, not only one or two of the 4 items. Emphasis on "AND", not "OR". 



3. The Process of Re-Rating

3.1 The Meaning of "Future Earning"

When I mentioned "future earning", many people mistaken me for referring to "earning growth". 
That is not necessarily the case.
"Future earning" can also be refering to "sustainability of existing earning".
Future Earning = Earning Growth OR Sustainability of Existing Earning

3.2 Re-Rating Through Expansion of Valuation Multiples

To benefit from "future earning", the stocks that you invest in do not necessarily need to register growth. As long as it can keep delivering the same level of strong earning, there is alikelihood that it will go further up through expansion of Valuation Multiples.

Do not believe me ? Let's take Jobstreet as an example.

The period of interest is from 2012 until 2014 (this is the period Jostreet share price was on an upward trend).

As shown in table below, during the period from 2012 until 2014, Jobstreet's net profit hardly grew at all. 

Quarter Result:
QuarterRevenue ('000)Profit Attb. to SH ('000)
2014-09-3048,76016,872
2014-06-3051,29719,830
2014-03-3147,58516,617
2013-12-3141,45913,147
2013-09-3046,48416,283
2013-06-3046,53716,634
2013-03-3143,17615,351
2012-12-3136,43314,830
2012-09-3041,39615,893
2012-06-3045,09617,245

However, its share price rose from RM2.00 to RM6.00 (it undertook a one for one share split in second half of 2013), a 200% increase !!!  

As the group's earnings has not grown by much, the re-rating was caused by expansion of Valuation Multiples. 


(Jobstreet share price during the period from 2012 to 2014)

Jobstreet was not the only stock that experienced that. Prestariang, Pintaras Jaya, and even Public Bank, experienced re-rating by way of expansion of Valuation Multiples at certain point. Please dig out the relevant info and take a look.

3.3 But Why ?

Why do certain of these companies experienced expansion of multiples ? There are two possible explanations, and both of them can be valid :-

(i) Spread of Information - Investors flock to a stock in batches. Early birds will buy at PER of let's say, 10 times. Latecomers don't mind buying at 20 times, if they find the theme sexy and convincing enough.     

(ii) Continual Improvement In Fundamentals - Have you ever heard of the saying, "money can solve a lot problems" ? That is actually true. When you are rich, you got to enjoy many goodies.
Businesses go through cycles of ups and downs. When a company is doing well, even though the profit has stopped growing, quarter after quarter of profit is still flowing into its balance sheets and beef up reserves (and in most cases, its cash holding).
With improvement in financial position, the company will be in better position to pay out dividend or declare bonus issue. Most people are attracted to the rich. The same happens to stocks.

3.4 Re-Rating Can Be A Two Stage Process

I will sum up what I discussed so far by the following :-

"Re-rating Can Be A Two Stage Process".

The first stage, "growth", will almost certainly lead to re-rating. As such, when come to predicting future earning, if you can spot a stock that can grow its earning in a material way, you have hit jack pot. 

The second stage, "expansion of multiples", might happen or might not happen. It depends on the theme. If the market is of the view that the strong earning can sustain into the future (even without growth), they might still chase up the stock, so as to benefit from dividend, bonus or even further growth potential. This will usually happen for themes that are super sexy and convincing. 

To increase the odds of you spotting Stage 2, the various tools and financial concepts taught by KC Chong can come in handy. Between two companies that have same PE multiples of 10 times, the one that has higher Return On Invested Capital and Earnings Yield, or lower EV/EBITDA, will have bigger potential of experiencing further re-rating through Valuation Multiples expansion.    

Interested in learning more ? Contact KC Chong.



4. Big Waves vs. Small Waves

In Section 2(a) above, I mentioned that certain macro factors can help us to identify stocks with potential for strong future earnings. However, to be successful, those factors need to be sustainable and long lasting enough. Preferably, the trend should last for more than one year. This is so that the economic benefit can trickle down the company, causing EPS to rise.

One good example is recent CPO price. Many people jumped into Jayatiasa recently due to spike of CPO price. However, as CPO price came down over the subsequent few months, the rally fizzled out and the stock is back to square one.


(Jaya Tiasa share price during the period from end 2015 until now)

As shown in chart above, the rally lasted for less than one month. Not to say that you can't make money out of it, but the odds are significantly lower than those stocks with stronger and more long lasting trend, such as export stocks in 2015.


 (Lii Hen share price during the period from early 2015 until now)

Lii Hen is one good example of Big trend. Its share price appreciated by 200% during the 18 month period from early 2015 until now (from RM3.00 to RM9.00). Not only is the magnitude impressive, the long timeframe of 18 months allowed you plenty of time and opportunities to exit, should you wish to do so.  

Easier Said Than Done

Everyone wishes to invest in a Lii Hen, VS, Hevea or Public Bank. But identifying a big trend is easier said than done. How I hope I possess that wisdom and can share it here so that all of you can walk into your boss' office and fire him/her. Unfortunately, I don't. 
I guess you need to be patient to wait for it to present itself.   
Sorry, you need to go back to your desk and finish your work. Boss is watching...



5. Concluding Remarks

"Predicting future earning" is not about pulling out a spreadsheet to build a financial model to predict EPS. Garbage in garbage out. If you cannot get the assumptions right, you can't get the forecast right.

(At this point, many of my readers must be itching to point out that Icon8888 occasionally build financial model to discuss propsective earning. For example : Air Asia. Am I contradicting myself here ?
Not really. The financial model is not really a forecast, it is more pro forma figures. I made adjustments by excluding exceptional items. By doing so, I arrived at the actual core earnings).

Predicting future earning is about "following the smell of money" (my Blog tagline).

You are walking down the street, suddenly you smell something delicious. You don't pull out a spreadsheet to try to nail down what that delicious smell is. That is not worth the effort, and very likely you will get it wrong.

Instead, you should just try to walk in the direction of that smell, making adjustments or taking a break when necessary. Hopefully with perseverance, patience and a bit of luck, you will arrive at the source of that magical smell (a restaurant or a house wife busy cooking) and get to taste the food.

THAT, is the gist of this article.

Have a nice day.

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