Why earnings growth is a rubbish way to judge a stock: report

An equities fund has reminded punters that earnings growth should never be used to judge the worthiness of a share.

Sydney's AIM fund has a motto of "Successful investing is done from the perspective of a business owner, not a stock speculator" in choosing which businesses to invest in.

The firm, led by chief investment officer Charlie Aitken, explained why in a whitepaper.

"Growth only creates value for owners if the capital that has been invested to generate it earns a return above the cost of said capital."

What does 'return on capital' mean?

The paper took the example of a small cafe.

Say you were opening a coffee shop that took $100,000 to set up. After the first year of operation, the owner earns $10,000 after maintenance and inventory are taken into account.

During that second year, the first shop continues to return 10% – providing the owner $11,000. But the second cafe is less successful, only returning $5,000.

A 10% return, not bad at all.

This prompts you to open a second cafe in a different suburb for the start of the second year. The expansion store also costs $100,000 to establish.

That's a total of $16,000 earnings for the second year, which is 60% growth. Sounds amazing!

But in terms of return on capital, year 2 was a dud. The owner ploughed $210,000 into the business and got $16,000 back. 

This is a 7.6% return, which is a lot lower than the 10% after year 1.

"As the example has demonstrated, it is quite possible to generate 'growth' without creating a single dollar of ownership value (or, in fact, destroying value)," AIM stated in the whitepaper.

"Investing like a business owner means thinking about the underlying economics and returns of the business, not the year-over-year growth rate that is generated."

Jackpot: find a business with explosive return on capital

Charlie Munger, who is Warren Buffett's longtime right-hand man and the vice chair of Berkshire Hathaway Inc (NYSE: BRK.A), agrees investors shouldn't get seduced by earnings growth.

Munger said in his famous Art of Stock Picking speech that over a long period, it's unlikely a stock will earn a better return than the earnings of the underlying business.

"If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount," he said.

"Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

AIM's whitepaper stated the critical part of this treasure hunt is that the returns on capital are sustainable.

"This means performing a qualitative assessment of the industry structure and competitive advantages of the business you are invested in."

AIM plugged some numbers in to test Munger's assertion. 

Say business A returned 6% of capital per annum for 40 years, and business B returned 18% per year for 20 years.

Even if you bought business A at 7.5 times price-to-earnings ratio and B at 15 times, the returns for the latter are far superior after 20 years.

"The critical point when investing from a business ownership perspective – and to be clear, this is no small task – is to own businesses that generate sustainably high returns on capital over the very long term," the AIM whitepaper read.