Many investors, even those experienced in fundamental analysis, are likely to make errors in assumptions and in reading the trends. These mistakes include the following:
1. Forgetting that trends tend to level out over time. Any long-term statistical study involves an evening out of the trend. No trend line is going to continue indefinitely, at the established rate, or without change. It is unrealistic, for example, to expect a corpo- ration to report 25 percent increases in revenues each and every year, just because they have done so for the past three years. This observation is especially true in the case of growth. A 25 percent increase in sales will be based on the previous year’s levels. So by necessity, the dollar amount needs to be greater each year. Be- cause all markets are finite, it is impossible to sustain a high growth rate forever. Keep this in mind as you observe trends be- ginning to flatten out over time. It is not necessarily a negative sign, and as long as other capital and profitability ratios remain strong, leveling out of one trend is not always a negative sign.
2. Misinterpreting a short-term or nonrepetitive matter as a trend. One of the more difficult aspects to analysis is the interpretation of
Why do sales and earnings growth curves slow down or even stop?
The answer might not be as obvious as most people believe.
Key Point
data. A common mistake is to take a solitary signal and assume it represents a new trend. Confirmation requires not only indepen- dent proof supporting an apparent trend, but time as well. In or- der for a change to become a trend, it has to last for some period of time without reversal. Some short-term changes or nonrepeti- tive spikes in growth look like trends, but they are only short- term aberrations.
3. Looking in the wrong area for confirmation. Finding valid confirma- tion requires some experience. When seeking confirmation from other trends or applying other ratios, make sure they do confirm the original indicator. It makes sense to confirm an apparent trend in working capital by also reviewing long-term debt and capitaliza- tion; it would make no sense to draw conclusions about working capital based on trends in fixed asset depreciation. And the strong relationship between sales, costs, expenses, and profits points the way to important trends and the use of valuable ratios; but you cannot judge profitability by isolating a review to changes in ac- counts receivable or inventory levels alone. While those current ac- count levels will certainly change during periods of expansion in revenues, they are not going to tell the whole story.
4. Misreading a confirmation signal. Even upon finding valid data, you still must be able to read it well. For example, when you see accounts receivable balances growing, that alone is not proof that the company is expanding its revenues and earnings effec- tively. A more detailed analysis may reveal that unpaid balances are remaining on the book longer now than in previous quar- ters, and bad debts are on the rise. These negative trends point to internal control problems, so that even with increased rev- enues being generated, the net return will ultimately suffer if the control problem is not fixed. In other words, a trend may mean one thing in a set of circumstances and another thing when those circumstances change. For example, you may limit your review of operating results to revenues. An impressive expansion in volume of sales is a promising sign, but not if net profits are declining. That is a danger signal, a sign that in the period of ex- pansion, management has relaxed its internal controls. It is not unusual for profits to decline during times when revenues are on the rise.
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5. Giving too much credence to technical (thus, short-term) indicators.
Every investor who follows the fundamentals is susceptible to temptation. Following price trends is easy; the information is up- dated every day and it is easy to find. So it often occurs that even with a lot of fundamental groundwork, decisions end up being made based on price movement and other technical indicators.
This is why profit taking is so common, and why so many funda- mental investors end up making mistakes (like buying high and selling low instead of the other way around). If you stay with long-term fundamental indicators as a guiding force, you will be more confident in ignoring short-term price volatility.
6. Overlooking obvious danger signals, such as chronic operating losses.
Everyone has heard the theme that “reporting a net loss is all right.” There is no justification for this belief. A loss is just that, a failed year. It is a reduction of net worth and a problem for every investor. No one really wants to put money behind a company that does not report a profit. Amazingly, many companies that have never reported a profit are able to raise capital, based on hype and the willing support of investment bankers. A look back to the dot.com days proves the point. But remember, a company without any history of profits has, essentially, no fundamentals to study. So how do you make any judgment about such a com- pany? The lack of profit history is one of the more glaring exam- ples of an obvious danger signal. Others may include a loss of leadership within an industry; pending and ongoing litigation;
big-scale labor disputes; regulatory problems, such as corporate officers being accused of mail fraud and, more than anything else, extreme volatility in the numbers. Do not forget that well- managed companies experience volatility now and then, but not every year. High fundamental volatility, large-scale core earnings adjustments, and technical volatility are all signs of uncertain management or an out-of-control internal environment.
In the next chapter, you will begin to see a methodical explanation of actual ratios, which become the building block of long-term trends.
Balance sheet ratios are often overlooked because some people believe the operating ratios are more interesting and revealing. As you will see, balance sheet analysis tells just as much about profitability as operating ratios—and in certain cases they are even more revealing.
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