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In the long run there is a 100% correlation between the growth in a company’s earnings and its share price performance. So, if you are an investor, concentrate on estimating earnings.
For that you’ll need to thoroughly understand the company. While you are getting to know your company, and later while you are continuing to follow the story of the earnings of your company, there will be all sorts of things happening in the economy: periods of raised inflation, stock market booms and busts, recession, even war.
In the short run these may be so powerful that they have some impact on the price of your company’s share – but in the long run it is earnings that count.
So if your company is McDonalds you are thinking about the product, the quality of the organisation, the future strength of the brand, etc.
These are the things that will determine long run share price. Do not be distracted by money supply numbers, or economist projections of consumer spending, or the coming recession, or the price of oil. Through all these ups and downs people will still buy burgers. If burger sales go up, earnings go up and over time the share price will correlate with that.
(This does not mean I’m advocating buying McDonald’s shares. Excellent companies can make for very bad investments if you pay too much for them).
Keep it simple
The second thing I want to emphasis today is the need to keep your investment ideas simple. Peter Lynch says that if you can’t explain a company “to a 10-year-old in two minutes or less, don’t own it”.
So does this mean that you can only invest in very simple to understand businesses?
Not necessarily. Whichever company you invest in you are going to have to do a lot of hard work, often work that is far from simple.
What Lynch is getting at is the skill to look at a great deal of complexity and to cut through and see the really important sources of value.
You must explain in two minutes why your company has a justified expectation of good future profits (good relative to the share price); what it does to entice customers; what barriers to entry to its segment it might have; how dedicated managers are to shareholder value and how competently they run the firm for shareholders; how secured the finances of the firm are, etc.
Professor Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk)
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