When growth slows down

August 2, 2007 by Joe Ponzio

Yesterday, a visitor brought up a couple of points regarding the analysis of Johnson & Johnson. It looks as though growth might be slowing based on the 2001-2006 owner earnings growth rate and he brought up a good point-is it a cause for concern?

Looking at individual timeframes

You used the median FCF growth rate for 5 year time-periods which gave you 16.1%…is there a reason you consider this to be more accurate than say, the growth rate for the past 5 year period?

Buffett tells us:

Do not take yearly results too seriously. Instead, focus on four- or five-year averages.

If we focus on the single 5-year timeframe from 2001 to 2006, we only get a snapshot of owner earnings in 2001 and again in 2006. Doing so ignores the actual performance of all the other years in our ten years of data and makes us focus solely on two yearly results.

Was 2006 a relatively slow year? Was 2001 abnormally high? A single 5-year snapshot won’t tell us that which is why I like to look at multiple timeframes. That also brings us to the next part of the question:

Using median values for more accurate results

The past two rolling 5 year periods (ending in 05 and 06 respectively), are considerably lower than the 16.1% median used in your calculations.

From 2000-2005, the growth rate was 13.5%; from 2001-2006, it was 10.2%. Then again, from 1998-2005 it was 15.2% and from 1999-2006 it was 16.6%. Which one is the best? In truth, we don’t know. That is exactly why we use a median value of all of the data.

Looking at one period, we don’t know if a single year in the two we analyze is “normal” for the business. Looking at multiple timeframes, we see normal, above normal, and below normal. Taking a median value (instead of an average), we get the “middle of the road” number without any unusually high or low occurrences to skew our data.

(For non-math people, median gives us the number in the middle as opposed to average which is sensitive to a single ultra-high or ultra-low point of data.)

The importance of the margin of safety

Indeed, if you change that 16.1% to 10.2% in excel (the 01-06 rolling period), you would get a per-share value of $61.75- not far off from where JNJ currently trades.

Absolutely, which is why the margin of safety is so critical. According to the full ten years’ worth of data, JNJ grows owner earnings at 16.1%. But if it does not continue to do so, and growth slows to 10.0%, the company is still fairly priced today (at $61.20 with a value of $61.22).

Here’s the thing-if JNJ’s owner earnings grow at 10.0%, and if we pay $61.20 today, we should still earn 15%. Why? We are purchasing that cash using a 15% discount rate-our expected return. If the company grows owner earnings at 16.1% as projected, we should earn far more than 15%. At that rate, investors purchasing JNJ at $83.20 this year would earn 15%.

The margin of safety does two things-it enhances our returns if things go according to plan, and it protects us if things don’t. Mohnish Pabrai, value investor and Buffett fan, explains the margin of safety this way:

Heads I win, tails I don’t lose too much.

Not a bad way to make money, right?

So, how do we know if growth is slowing?

If all of the consecutive timeframes indicate that growth is slowing, then it may very well be slowing. But one or two abnormal periods out of seven is normal as businesses go through their regular cycles.

Of course, you need to look at the business as well. No matter how good the numbers look, a VCR maker with no other business line will likely run into problems in the upcoming years.

Hope that helps!

A Note From Joe Ponzio

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