Time: The Ultimate Arbiter of Returns
How to Value Stocks
- Rule 10: Cite all past and future investment returns in a consistent unit of measure.
- Rule 11: Time heals many, but not all, self-inflicted valuation wounds.
Concentrating on valuation, quality, and depth of knowledge allows the investor to pick companies that are most likely to appreciate significantly in value. The returns an investor earns by owning the shares of a publicly traded company depends as much on the time the security is held as any of these other factors. The amount of time over which a price change occurs makes the difference between a stunning investment and a sub-par investment. In order to invest successfully, individuals must understand the critical role that time plays in determining returns and they must develop reasonable expectations about what sort of returns to expect over a given period of time.
Say you have done your homework and bought shares of XYZ Corp. After some interval, you discover to your delight that the shares have doubled in price. A real home run, right? Not necessarily. Depending on how long it takes to earn them, 100% returns can be either market trouncing or embarrassing. Just as in physics, you want to be careful to keep all of the units of measure in a problem the same or else you will get bizarre results. Thinking about all of your investment returns in one unit of measure -- annualized returns -- is critical to making informed decisions about which investments have been and will be the most attractive.
In our example of the 100% returns, if this 100% was earned over the course of a year it is a staggering return. However, if it took you ten years to double your money, you have only earned 7.1% annualized returns over the whole period. Although 7.1% ain't exactly shabby, with the Standard & Poor's 500 Index doing about 17% per year with dividends reinvested since 1980, you can see why 7.1% might seem a little anemic by comparison. Whether you are quoting past returns in your portfolio or you are looking at what you might earn two years out should a company trade at your conservative valuation, you have to convert these numbers back into annualized returns in order to compare and contrast efficiently. Simply learning to take nth roots by using the "^" function in your computer's built-in calculator or spreadsheet would do the job. Find a co-worker, a friend, or perhaps even a student who is savvy with math and they will have you annualizing returns in no time flat.
Beyond the necessity of using a consistent unit of measure when discussing returns, time also has a much more powerful and salutary effect on the investment process. You see, time heals many investment errors that are related to valuation. While certainly time does not heal all of the damage, nor does time matter a fig if an investor loses patience, the amount of time you hold an asset does decrease the valuation risk inherent when you purchased the asset. What that means in English is that if you bought a great company but paid too dear a price, over time that valuation mistake is going to be overcome by the compounded earnings growth that the company delivers. This is why focusing on quality during the investment process is so critical -- if you buy quality, then time is your friend. If you buy crap, time doesn't matter a whit.
Citing exaggerated lengths of time over which to invest your money has actually become quite faddish of late, with 20 or 30 year time frames often cited. Although investing in companies with this kind of time frame is perfectly reasonable, the assumption that even this length of time wipes out all valuation risk is not. Even the highest quality company purchased at an excessive price can deliver sub-market returns over 20 or 30 year time frames. This is particularly true if the company in question experiences a decelerating rate of earnings per share growth, as is typical of large companies growing larger.
While small companies grow earnings by 10% or 20% much of the time, in a non-inflationary environment, many large companies that have already gone through years of process reengineering to enhance productivity may find that they have reached their zenith. If EPS grows 10% per year along with sales and you purchased the stock at 10 times sales, the resulting shareholder return over the next 20 years stands a chance of being sub-optimal. Someone might not take the shares off your hands at 10 times sales and 50 times earnings 20 years out. If the P/E multiple contracts to something more like 15 times earnings, the 20-year return would be minimal.
Time decreases the chance of making a valuation mistake, but it does not remove it all together. The principal reason that Valuation came before Quality, Knowledge, and Time was because in the end -- even considering Time -- it is the primary determinant of investment returns. If you buy a great company that you know a lot about and hold for decades, you can still underperform the market if the great company experiences decelerating earnings growth and you bought it at a super-premium valuation. Although the majority of the so-called Nifty Fifty stocks have done fine over the past two decades, investors who bought names like Avon Products will probably never reach breakeven with their original investment. While in retrospect Avon may seem like one of the bad ideas of the bunch, keep in mind that in the early '70s when network marketing was young, Avon was considered a vibrant, consumer-oriented, slyly managed empire with an excellent balance sheet and plenty of cash on hand.
To conclude, the investor who purchases low- to medium-valued companies of medium to high quality where they actually have some kind of knowledge about the company and who have reasonable expectations about annualized returns will probably do quite well, regardless of the market environment. In the Buy & Hold Apocalypse, we saw that with longer and longer time frames, stocks had a better and better chance of outperforming any other asset class. What is true of the flock is true of a single bird.
The more you concentrate on becoming a long-term owner in a quality business that you purchased at a low valuation and know quite a bit about, the more likely you are to tell your friends about the shares of a $50 or $60 stock you own where your cost basis is measured in pennies. Although much attention is placed on the stocks that double or triple in a year, going up 10 or 20 times in a decade is where stocks really create wealth. By following the 11 fairly simple rules laid out in this series, I think investors heartily increase their odds of doing just that.
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