books about online stock trading, forex, futures, stock investing, market, trading systems
Paying Up Rarely Pays Off
Back to contents page

So FAR, we've spent all of our time analyzing companies. If the Investment process were as simple as Identifying great companies with shareholder-friendly management teams and wide economic moats, we'd be finished— and investing would be much easier. But even the most "wonderful business is a poor investment if purchased for too high a price. To invest stock successfully means you need to buy great companies at attractive prices.

This is an Idea that lost credence during the bull market of the 1990s and was thrown completely out the window during the tech bubble. Valuations mattered less and less because investors "were always willing to pay more and more—in fact, one popular investment commentary service stated baldly that business quality was 100 times more important than valuation.

For a while, this strategy—relying on a greater fool to take an asset off your hands at a higher price—was lucrative and made many people rich, at least on paper. The trouble was that no one knew "when the music "would stop. When it did, investors who bought overpriced assets hoping to sell them at even more inflated prices "were sorely disappointed.

This is the difference between investors and speculators. Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Specula­tors, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it at some point. The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator's return depends on the gullibility of others.

Over time, the stock market's returns come from two key components: investment return and speculative return. As Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. Over the entire twentieth century, Bogle found that the 10.4 percent average annual return of U.S. equities broke down into ; percentage points from div­idends, 4.8 percentage points from earnings growth, and just 0.6 percentage points from P/E changes. In other words, over a long time span, the impact of investment returns trump the impact of speculative returns. 1

However, the picture is much different when we look at it over shorter time frames. From 1980 through 2OOO, for example, the market's approximately 17 percent annual return was composed of 4 percentage points dividends, 6 percentage points earnings growth—and a whopping 7 percentage points per year from the increase in the P/E ratio.

During the horrific bear market of the 1970s, the market's investment return was a solid 13.4 percent per year, but as the aftermath of the early-i97Os Nifty Fifty craze dragged the market's P/E ratio down from 16 times to 7 times, the market's speculative return was a crushing —7.5 percentage points per year. The market returned an average of only 5.9 percent per year during the 1970s, not because earnings and dividends refused to cooperate, but because the average investor paid less for the average stock in 1980 than in 1970.

What does all this have to do with picking solid stocks? By paying close atten­tion to the price you pay for astock, you minimize your speculative risk, which helps maximize your total return. No one knows what a stock's speculative return "will be over the next year—or even 10 years—but we can make some pretty good educated guesses about the investment return. If you find great companies, value them carefully, and purchase them only at a discount to a reasonable valuation estimate, you'll be fairly well insulated against the vicissitudes of market emotion.

For example, let's take a stock that trades for $30 per share, earns Si.50 per share, and pays a $1.00 annual dividend. Assume that earnings and dividends grow at 6 percent per year, and the initial P/E ratio of 20 doesn't change.

After five years, earnings will be $2.01, so our shares would theoretically trade for $2.01 X 20 = $40.20. We've also received $6.59 in dividends, which means we have $46.79 after five years. That works out to an annualized return of 9.3 percent, which is our investment return. Because the P/E remained at 20, we didn't receive any speculative return.

However, if earnings and dividends grow at the same rate, but the P/E ratio decreases from its starting point of 20 to 15, our returns change dramatically. Although "we still have $2.01 in earnings after five years, our shares are worth only $2.01 X 15 = $30.15. Add in $6.79 in dividends, and annualized return shrinks to just 4.1 percent—our 9.3 percent investment return "was damaged by a —5.2 percent speculative return. Conversely, a rise in the P/E ratio from 20 to 25 would yield a fat 13.6 percent annual return because the speculative return builds on our investment return.

Thus, a change in the market's mood can reduce our solid 9.3 percent return to a paltry 4.1 percent or boost it to a wonderful 13.6 percent. You can buy an excellent company that kicks out earnings and dividends like clockwork, but the negative effects of a sharp decline in the stock's valuation can wipe out even the most robust investment return—and a P/E decline from 20 to 15 is hardly a "worst-case scenario. In fact, declines in valuation are usually coupled "with deteriorating corporate fundamentals—slowing earnings growth or some similar setback. When this happens, the investor gets socked "with a decline in the speculative return as the valuation shrinks and a decline in the investment return as earnings growth slows down.

Careful attention to valuation lessens the risk that something truly unknown—what other investors will pay for our asset in the future—will hurt the return of our portfolio. As investors, we can diligently work to identify wonderful businesses, but we can't predict how other market participants will value stocks, so we shouldn't try.

Being picky about valuation isn't fun. It means letting many pitches go by and watching many stocks run—stocks that never met your strict valuation criteria. But when it's done properly, disciplined valuation also greatly increases your batting average—the number of stocks you pick that do well versus the number that do poorly—and it also limits the odds of a real blow-up damaging your stock portfolio.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading