Benjamin Franklin once said, “An investment in knowledge pays the best interest.”
In 35 years of investing, we’ve seen it all — bull markets, bear markets, recessions and some of the most volatile market periods in history, plus a global pandemic. Throughout what have been some extraordinary times, we’ve observed three common investing mistakes.
To kick off this three-part series, we cover the first mistake: an excessive focus on earnings.
An excessive focus on earnings
In our experience, many analysts can be overly reliant on earnings per share (EPS) when evaluating a prospective investment. EPS is often seen as the best available predictor for identifying companies that may deliver immediate growth and strong equity price performance. However, EPS can be manipulated and lead to a short-term view of a company’s financial health. Furthermore, investors may panic when a stock they own falls in price, which can lead to emotionally driven decisions.
We try to eschew emotional reactions to market fluctuations, viewing price drops as potential opportunities rather than setbacks. Confidence in a company’s long-term financial health helps us maintain a long-term perspective. We gain that confidence through a deep understanding of each company by focusing on metrics like return on equity (ROE) and return on invested capital (ROIC).
ROE is the cornerstone of our investment strategy — we only consider companies with a 15% ROE each year for at least 10 consecutive years. This metric allows us to make like-for-like comparisons between companies, providing a starting point to identify companies worthy of further research. ROIC provides a more thorough assessment, considering the entire capital structure, but it’s harder to calculate and compare among companies. As such, we use ROIC to assess the remaining companies after using ROE as our first filter.
Lastly, cash flow is king for us. Companies with strong cash flow can reinvest in their businesses, make acquisitions and pay dividends. We view a company’s ability to generate profits above its cost of capital as an important signal of value creation. In part two of the series, we focus on the second mistake many long-term investors make: attempting to time the market.
In part two of the series, we focus on the second mistake many long-term investors make: attempting to time the market.
For a more in-depth discussion of our quality strategy and examples of our emphasis on long-term investments rather than short-term market darlings, please visit our post, Three Mistakes to Avoid as a Long-Term Investor: Observations from 35 Years Managing Money.
Past performance is no guarantee of future results. Certain information contained in this material represents or is based upon forward-looking statements, which can be identified by the use of terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue” or “believe,” or the negatives thereof or other variations thereon, or comparable terminology. Due to various risks and uncertainties, actual events, expectations or results may differ materially from those reflected or contemplated in such forward-looking statements.
The prices of growth stocks may be sensitive to changes in current or expected earnings, or may experience larger price swings.
The information contained herein illustrates a facet of management’s investment process; however, management’s plans and policies in this respect may change in the future. In particular, economic, market and other conditions could cause the process to change from the descriptions contained herein. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions.
Jensen Investment Management, Inc., is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Although taken from reliable sources, Jensen cannot guarantee the accuracy of the information received from third parties. Graphs, charts and/or diagrams cannot, by themselves, be used to make investment decisions.
© 2023 Jensen Investment Management
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