6. Práctica educativa Propuestas de intervención
6.3 Desarrollo de la propuesta de intervención
nature of the business and the character of the management. These ele- ments are exceedingly important, but they are also exceedingly difficult to deal with intelligently. Let us consider, first, the nature of the business, in which concept is included the general idea of its future prospects. Most people have fairly definite notions as to what is “a good business” and what is not. These views are based partly on the financial results, partly on knowledge of specific conditions in the industry, and partly also on surmise or bias.
During most of the period of general prosperity between 1923 and 1929, quite a number of major industries were backward. These included cigars, coal, cotton goods, fertilizers, leather, lumber, meat packing, paper, shipping, street railways, sugar, woolen goods. The underlying cause was usually either the development of competitive products or services (e.g., coal, cotton goods, tractions) or excessive production and demoralizing trade practices (e.g., paper, lumber, sugar). During the same period other industries were far more prosperous than the average. Among these were can manufacturers, chain stores, cigarette producers, motion pictures, public utilities. The chief cause of these superior showings might be found in unusual growth of demand (cigarettes, motion pictures) or in absence or control of competition (public utilities, can makers) or in the ability to win business from other agencies (chain stores).
It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided. The con- verse would be assumed, of course, for those with superior records. But this conclusion may often prove quite erroneous. Abnormally good or abnormally bad conditions do not last forever. This is true not only of general business but of particular industries as well. Corrective forces are often set in motion which tend to restore profits where they have disap- peared, or to reduce them where they are excessive in relation to capital. Industries especially favored by a developing demand may become demoralized through a still more rapid growth of supply. This has been
true of radio, aviation, electric refrigeration, bus transportation, and silk hosiery. In 1922 department stores were very favorably regarded because of their excellent showing in the 1920–1921 depression; but they did not maintain this advantage in subsequent years. The public utilities were unpopular in the 1919 boom, because of high costs; they became specula- tive and investment favorites in 1927–1929; in 1933–1938 fear of inflation, rate regulation, and direct governmental competition again undermined the public’s confidence in them. In 1933, on the other hand, the cotton- goods industry—long depressed—forged ahead faster than most others.
The Factor of Management.
Our appreciation of the importance of selecting a “good industry” must be tempered by a realization that this is by no means so easy as it sounds. Somewhat the same difficulty is met with in endeavoring to select an unusually capable management. Objec- tive tests of managerial ability are few and far from scientific. In most cases the investor must rely upon a reputation which may or may not be deserved. The most convincing proof of capable management lies in a superior comparative record over a period of time. But this brings us back to the quantitative data.There is a strong tendency in the stock market to value the manage- ment factor twice in its calculations. Stock prices reflect the large earn- ings which the good management has produced, plus a substantial increment for “good management” considered separately. This amounts to “counting the same trick twice,” and it proves a frequent cause of over- valuation.
The Trend of Future Earnings.
In recent years increasing impor- tance has been laid upon the trend of earnings. Needless to say, a record of increasing profits is a favorable sign. Financial theory has gone further, however, and has sought to estimate future earnings by projecting the past trend into the future and then used this projection as a basis for valuing the business. Because figures are used in this process, people mistakenly believe that it is “mathematically sound.” But while a trend shown in the past is a fact, a “future trend” is only an assumption. The factors that we mentioned previously as militating against the maintenance of abnormal prosperity or depression are equally opposed to the indefinite continu- ance of an upward or downward trend. By the time the trend has become clearly noticeable, conditions may well be ripe for a change.Survey and Approach [85]
It may be objected that as far as the future is concerned it is just as logical to expect a past trend to be maintained as to expect a past aver- age to be repeated. This is probably true, but it does not follow that the trend is more useful to analysis than the individual or average figures of the past. For security analysis does not assume that a past average will be repeated, but only that it supplies a rough indexto what may be expected of the future. A trend, however, cannot be used as a rough index; it rep- resents a definite prediction of either better or poorer results, and it must be either right or wrong.
This distinction, important in its bearing on the attitude of the ana- lyst, may be made clearer by the use of examples. Let us assume that in 1929 a railroad showed its interest charges earned three times on the aver- age during the preceding seven years. The analyst would have ascribed great weight to this point as an indication that its bonds were sound. This is a judgment based on quantitative data and standards. But it does not imply a prediction that the earnings in the next seven years will average three times interest charges; it suggests only that earnings are not likely to fall so much under three times interest charges as to endanger the bonds. In nearly every actual case such a conclusion would have proved correct, despite the economic collapse that ensued.
Now let us consider a similar judgment based primarily upon the trend. In 1929 nearly all public-utility systems showed a continued growth of earnings, but the fixed charges of many were so heavy—by reason of pyramidal capital structures—that they consumed nearly all the net income. Investors bought bonds of these systems freely on the theory that the small margin of safety was no drawback, since earnings were certain to continue to increase. They were thus making a clear-cut pre- diction as to the future, upon the correctness of which depended the jus- tification of their investment. If their prediction were wrong—as proved to be the case—they were bound to suffer serious loss.