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Friday, July 30, 1999

An Investment Opinion
by Warren Gump

Extrapolation Fallacy

We're preparing to wrap up a terrific second quarter earnings season, with overall profit (before restructuring and other "one-time" charges) looking to be up about 15% from the prior year, based on combination of actual and projected results. Almost two thirds of S&P 500 companies have reported results; estimates for the remaining third are based on First Call Director of Research Chuck Hill's expectation that they will come in slightly better than published estimates. This assumption takes into account the fact that security analysts have a tendency to low-ball projections to enable companies, which are often clients of the analysts' firms, to beat expectations.

This projected earnings growth is great news for investors, as it indicates the fundamental value of their holdings is also rising. I do, however, want to caution you about headlines that are likely to sprout forth based on earnings news that will be released over the next six months. Over this period, earnings growth will likely be even higher than the 16% reported during Q2. According to Hill's projections, the number is likely to hit 21% in Q3, trailing off slightly to 18% in Q4.

While this news should be heartening, be sure not to become so excited that you extrapolate such massive percentage gains into future expectations. In a way, it's hard not to do this. The tendency of many stock market observers it to take recent trends and project their continuation indefinitely into the future, ignoring shifts that often emerge, turning those projections on their tail.

We can look at the Japanese stock market in the late 1980s, when many investors had become convinced that the companies behind those equities had become such an impenetrable force that valuation didn't matter. After rising at astonishing rates in the years leading up to 1989, the Japanese market experienced a marked about-face that lingered throughout the past decade. Ten years after reaching its peak, the Nikkei stock market lost half its value.

The reality of that loss is actually much more painful than surrendering over 50% of invested capital to market forces. In addition to that actual loss, investors saw 10 years of time tick away. Money being invested at the market top was likely expected to earn at least compound annual growth of 10% over its investment horizon. Using a 10% growth assumption, $5,000 would have been parlayed into $12,950, a 10-year return of 159%. Of course, the value in the account 10 years later would have been less than $2,500, more than 80% lower than the projected ending value.

A look at events closer to home shows a similar, though positive, alteration to projections. In the 1980s, not too many people thought the United States would ever be able to balance the budget, much less end a year with a budget surplus. Fast-forwarding through a dizzying period of economic success, we find ourselves in 1999 not only projecting another year where the government is taking in more than its spending, but the President is talking about projections showing the deficit will be paid off in 15 years. My skepticism about the ability of our government to show such fiscal restraint aside, that's a mind-boggling shift in projections over just a little bit of time.

Returning to the financial discussion at hand, the projected earnings growth for the remainder of the year is real, but it should be put in context. Do you remember what happened last summer and in fall of 1998? Economies worldwide suffered the impact of currency devaluations and crises in numerous countries. Although our domestic economy emerged relatively unscathed, many multinational corporations suffered the ramifications of the international downturn. In fact, profits for companies in the S&P 500 actually fell during the year. Using First Call's tally, ongoing profits from these companies ended 1998 2% below the level achieved in 1997.

When being compared to last year's weak performance, this year's corporate earnings are naturally going to look strong since most economies are regaining lost ground. That being said, it is unlikely that growth rates will be sustained at such a rapid pace when comparisons represent normalized market conditions.

To better visualize what's happening, let's look at an interesting story from a local beach, Sunny Point. For several decades, the visitor count has been increasing at a pretty steady 3% per year, reaching a total of 930,000 in 1997. Last year, a bunch of folks decided to go to Sunny Peak instead of Sunny Point because a mudslide closed an access road, adding an hour to the trip to Sunny Point. The beach's 1998 visitor count fell to 902,000. Hoping to overcome this reduction in travelers, the Sunny Point Chamber of Commerce introducing a new ad campaign for 1999. Based on just-completed analysis of early season data, Sunny Point expects its visitor count to hit 987,000 people this year.

An eager second-year Chamber summer intern who helped devise the ad campaign was thrilled with this news. He concluded that his work helped accelerate visitor growth to 9%, six percentage points above its traditional growth rate. Before wrapping up his summer tasks, he was asked to create a decade-long projection for visitor growth. Although the intern was confident new twists on the current ad campaign would be successful for many years, he tempered the current year's 9% growth rate to 5%, wanting to be conservative and assuming some of the ad campaign's novelty might wear off. His projection called for 1.6 million visitors in 2009, although he pointed out that the number would reach 1.9 million if a 7% growth rate could be maintained.

Do you notice any problems in the intern's logic? While the ad campaign may have helped stoke extra interest in Sunny Point, a much more important reason for the jump in 1999 visitors was that the access road was reopened. Looking at the visitor count trend between 1997 and 1999, instead of between 1998 and 1999, the growth turns out to be exactly 3% per year, in line with the long-term trend. If that 3% growth rate were to end up being the actual growth experienced over the next 10 years, Sunny Point's 2009 visitor count would reach 1.3 million, quite a bit lower than the "conservative" 1.6 million estimated by the intern.

I don't want to diminish in any way the terrific prosperity that is now being experienced by Corporate America. The soaring increases in profits and profitability are truly remarkable feats, particularly considering we are so far into a period of economic prosperity. At the same time, as investors, we should not be lulled into expecting profitability growth rates similar to those projected for 1999. Over the next few months, many analysts will be talking about the tremendous growth in 1999 corporate profits, implying that they are sustainable. While there is a very remote chance that mid-teens profit growth can be maintained by S&P 500 companies in future years, that outcome will be much less likely when comparisons are no longer based on 1998's depressed results.

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