The 5% Rule:

Pay Attention to Sales

Companies frequently get positive media coverage for reporting revenues or profits well beyond the company’s expected numbers. Usually this alone is the basis for many investors flooding into the stock in order to maximize the growth opportunities that such stories often promise. I myself tend to look the other way. I’m not saying that this won’t work for those investors, its just not something for me and my reason is as follows:

In my own practice, I tend to avoid such companies because of the inherent danger I see in not being able to accurately forecast a.) revenues, b.) expenses & c.) profits. One of my value rules is to pay attention to sales – specifically, how well can a company forecast A, B & C?

Two companies: ABC & XYZ forecast revenues for the upcoming quarter. When the earnings reports are released, ABC reports an unexpected increase of 15% in quarterly revenue where XYZ reports an expected decrease of 4.5%. Which company appears to be in better financial shape? Many investors would argue that ABC is the clear choice, but my view is that of a contrarian.

My justification is this:

I want to invest in a company that can consistently & accurately forecast consumer demand, costs & profitability. This indirectly shows me that the company has control over their business model, products and a secure understanding of their target market - with the target market being the key element. They can accurately anticipate consumer demand, habits, wants & needs in order to control their business and portfolio of products.

If element A, B or C are varying wildly in different directions over the short & long-term, it tends to show me that ABC company is not in sync with their target market and run the risk of losing control – resulting in a snowball effect. The company may have initial success with their numbers over the short-term, but would subsequently decline much further as more distance grows between forecasts and the true buying behaviour of their customers.

In summary: no information a company reports should ever be a surprise to them. If a company has a strong grasp of their business model and practices, then they will anticipate and adapt their strategies to best fit the company and consumers’ needs. Control of costs and accurate forecasts of sales are essential in any successful business. Profits may increase or decrease due to increased material costs of conducting business, but knowing the direction of the target market and how it will affect your business is paramount from my value standpoint.