Saturday, December 06, 2008

Fallacy of scruntinizing ratios for the past few years

Financial statements are very essential in fundamental analysis and value investing. To value investors, it's like soldier's M16, accountant's Excel, taxi driver's taxi, you get the idea. From the statements, we calculate the all important ratios. Basically it's one number divided by another and that's supposed to give you insights into the company's business operations, its edge or whatever. Something like adding apple juice to aloe vera and drinking the new juice will actually make you thin!

Actually around like 2% of the time, looking at ratios actually help a bit. The problem is we always only look at last yr's ratios. Or maybe some diligent analyst will look at ratios for the past 5 yrs. Not bad huh. 5 yrs quite long right? Presidential term only 4yrs. Alas, do they know on average how long is one economic cycle from peak to peak or trough to trough?

Well, its seven years on average. The recent one, 2001 to now and still going. The one before 1997 to 2001. 4 yrs, well sometimes it's shorter than average, obviously. So by looking at 5 yrs of ratios like ROE, operating margin, debt to equity ratio, can you really tell if the co. is really good? Esp if you are looking at 2002-2007 and the ratios just keep improving every yr? Like those we see in annual reports. Sooooo impressive. This co. is really something, we tell ourselves.

Our hero, Warren Buffett some yrs back started to ask co. owners to come forward to him if they intend to sell their stake to Berkshire. One of his criteria: GROWING earnings for the past 15-20 years. So seven years still quite amateur actually. Of course, most Sg co.s were not around 20 years ago. So we just have to make do with seven years lor.

So, that's the moral of the story: a co. with improving ratios for the past few years is not necessary a capable one. Rising tide lifts all boats. Keep the economic cycle in mind when looking at ratios for the past few years.