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Our Theory

The primary theory behind our process is that earnings drive equity values over
time. Now this is certainly no revelation, yet it is amazing how the market appears to ignore this simple truth time and time again. A stock’s price path will follow its earnings path. If earnings rise, the price will rise. If earnings fall, the price will fall. The movement is not always of the same degree or magnitude, but within a certain range it will always hold true. Over short and intermediate time periods emotions will cause investors to bid a stock’s price well above or below where it should be. Eventually, however, the price will have to move towards its “normal” price as reflected by the earnings that materialize.

Purists will tell you that cash flow (or more precisely, free cash flow) is the true driver of equity values and they are correct, to a degree. The problem is that analysts don’t publish cash flow estimates – they publish earnings estimates! That is what most investors respond to, so that is what we focus on.

Recent history notwithstanding, the long-term average annual return of stocks has been historically around  10%. No one knows precisely what the return prospects will be for stocks going forward, but if we want to be competitive it makes sense to begin with stocks that have earnings growth prospects of at least 10% for as far as we can see. If stock valuations follow earnings then this at least gives us a chance to grow at the historic market rate of 10%.

When it comes to earnings growth, some stocks are hares and some are tortoises. Hare stocks experience fast spurts of earnings growth, but the growth is erratic and unpredictable. Tortoise stocks have a history of cranking out steadily advancing and reliable earnings growth year in and year out. So we ask you, if a stock’s price is determined by its earnings and you are attempting to predict its future price, which type of stock’s price would you be more likely to predict accurately – a hare stock or a tortoise stock? The answer should be obvious. Short-term traders focus on hares because the volatile movement of their prices allows more opportunity for short-term trading profits, assuming they can accurately predict when the hare will be sprinting or when it will be taking a nap under the tree! Our focus is long term so we prefer to stay away from the hare’s drama and ride the steadily advancing tortoise – but not just any tortoise. We want a “fast” tortoise.

As stated in the opening, “slow” didn’t win the race and 10% or more annual earnings growth rate is certainly not slow. Yet, there are some companies that fairly steadily produce just that and more year after year. These are the stocks we seek to find. Combining them in properly structured portfolios allows us to achieve returns comparable to or superior to the stock market as a whole, but with less volatility along the way.

 

Copyright 2004-2014 Thomas Smith and Associates except where noted.
THOMAS SMITH AND ASSOCIATS, INC. IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.