Global Smaller Companies fund manager Imogen Harris shares why her morning coffee routine offers the perfect illustration of the importance of earnings momentum.
The first modern espresso machine was patented in 1939 in Italy by an entrepreneur called Giuseppe Bambi. This was not the first espresso machine, they had been around in other forms since the late 19th century, but it was the first to closely resemble the machines that we use today. Bambi’s patent was for an espresso maker with a horizontal boiler. It was designed to produce a more consistent flavour, to break less often, and to allow more than one espresso to be made at a time.
The design advantages of the horizontal boiler mean it is the technology behind my own morning coffee routine today in 2024, 85 years after it was first patented – and probably yours, too.
Traditional economics would say that companies in competitive industries can only make abnormal profits over a short-term time frame, before other players come into the market to compete away those profits. This example instead teaches us that certain competitive advantages, if correctly protected, can help elongate that timeframe. In this case, the competitive advantages were the horizontal boiler’s quality design and superior technology. Sadly, this example also teaches us about the importance of protecting intellectual property. Bambi’s patent was not renewed due to the interruption of the Second World War, and so he received more limited rewards for his creation of what is now a globally ubiquitous technology.
If the patent was held onto, the earnings power of this machine would have been significantly higher than what anyone would have expected. This is an illustration of what we, as a Global Smaller Companies team, would call earnings momentum. We would view it as a company’s ability to earn higher profits than what the market thinks it is capable of, and it is a key part of how we invest.
Market estimates tend to apply a ‘fade rate’ to earnings and assume that the abnormal profit-making period can only last a limited time. As investors in smaller companies, we can think longer term than the market, and this difference in investment time horizon can lead to companies being mispriced.
On a company level, earnings momentum can look very different: perhaps a ‘category-creating’ product fulfils a consumer need that did not exist before, maybe the application of a medical device is wider than originally anticipated, or a piece of machinery is able to drive efficiency much higher than projected.There is no reason to assume that the profit of a smaller company is always destined to revert to the mean.
The chart below is the technical reason why earnings momentum is such a key part of our philosophy. I have taken a well-known earnings momentum metric – the percentage change in consensus earnings estimates for the current financial year over the prior 3 months – and have back tested this metric across all stocks in the MSCI All Country World Small Cap Index over the past decade, from 2013 to 2023. The back testing shows that stocks with earnings momentum that sit in the top two quintiles have outperformed the universe by a significant margin.
As a fund, we want to be invested in companies that beat market expectations on a consistent basis. Great management teams will not rely on previous success but use the period of abnormal profits to re-invest in the business, further cementing their competitive advantage.
Back tested earnings revisions by quintile (%)
Source: Bloomberg 31.12.2013 – 31.12.2023. Past performance is not a reliable indicator of future returns.
There is a behavioural tendency to initially overestimate the impact of new technology over the short term and then underestimate its impact over the long term. I’m sure from 1930s Florence Mr Bambi would never have anticipated that his horizontal boiler espresso machine would be making flat whites in a Sydney coffee shop, sitting on a kitchen counter in London, or being refurbished in a workshop in San Francisco. To finish with a weak analogy, this goes to show that with smaller companies, earnings momentum is the steam that drives the pistons of the horizontal boiler.
Risks:
The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
Past performance is not a reliable indicator of future returns.
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