Simple Math for Safe Doubles

It's good to go back to the classics, and one of the books I find myself dipping into every couple of months or so is the John Rothchild investing biography The Davis Dynasty. It details the value-investing approach of America's No. 2 investor, Shelby Davis, who began with $50,000, passed his investing know-how along to his market-beating scions, and ended up with nearly $1 billion to leave behind half a century later.

The Davises did it without the flashy stocks of their time, the Xerox (NYSE: XRX  ) at 50 times earnings, McDonald's (NYSE: MCD  ) at 75 times earnings, Avon (NYSE: AVP  ) at 63, or Black & Decker (NYSE: BDK  ) at a P/E of 51.

There's a simple reason, and it's worth remembering today: the malignant math of multiple compression.

Classical math
Just how sick this scary cipherin' can make your portfolio is hinted at on page 185 of the book. Here's a summary of how it works, and my idea of why.

Mr. Market has the memory of a goldfish and the foresight of a mole. When he sees a company growing at 30% per year, he gets very excited. He assumes it will keep growing at that rate for years, maybe forever. He forgets flops of the past and goes ahead and pays just about anything to buy that growth. That means a very high P/E multiple on the stock, which reflects that enthusiasm.

"It's not a tumah"
But it can kill your portfolio. Consider the sick math of multiple compression on this hypothetical company: SuperCool American Mobile (Ticker: SCAM).

2001

2002

2003

2004

2005

Earnings

$1.00

$1.30

$1.69

$2.20

$2.53

P/E

30

30

35

35

17

Price

$30

$39

$59

$77

$43

From 2000 on, we had it licked. SCAM was growing like a weed, and we were in on the ground floor. The market rewarded those consistent 30% returns with a huge, and growing, multiple. Until 2004. In 2005, SCAM put up solid 15% earnings growth. But Mr. Market doesn't want 15% earnings growth from SCAM. Mr. Market wants 30%, or better. So Mr. Market stamps his feet, holds his breath, and passes out on the trading-room floor.

Now we see the malignant math of multiple contraction in full force. Because Mr. Market has a memory like a goldfish, he forgets all about those years of past glory. And because he's got the foresight of a mole, he assumes that 15% growth is the new norm for SCAM. The resulting crash takes SCAM's multiple down toward its growth rate. Now we're sitting on a measly 43% gain over four years. That's 9.4% a year, the kind of gain likely to lag the market. And that's only if we were lucky enough to get in on the ground floor. Those poor suckers who paid 35 times earnings in 2003 or 2004? They're looking at a world of hurt.

A healthier way
What if we had invested instead in Yankee American Wet Noodles (Ticker: YAWN), a maker of mops and cleaning supplies used by industries and schools across the world? Because janitorial supplies lack style and glamour utterly, no one pays attention to YAWN at all. But it chugs along, earning a decent 12% earnings growth per year.

2001

2002

2003

2004

2005

Earnings

$1.00

$1.12

$1.25

$1.40

$1.57

P/E

12

13

13

12

15

Price

$12

$15

$16

$17

$24

Since no one expects great things from YAWN, it draws a sleepy multiple, despite its solid growth. Then, in year five, the folks on CNBC have some time to fill, so they end up interviewing the CEO of YAWN. Suddenly, the market takes notice and bids YAWN up to a marginally higher multiple of 15. From $12 to $24, we're looking at a 100% gain. (In the book, using a slightly different set of assumptions, they call a buy like this a Davis Double.) That's a compound annual growth rate on your investment of more than 18%.

Look at those tables again. SCAM outgrew YAWN the entire time. Earnings growth-wise, SCAM even beat YAWN in the very year that it came crashing down. Yet YAWN proves a far superior investment? Why? Because YAWN investors paid a reasonable price for sustainable growth. The people buying SCAM could not see the obvious, which is that no one grows at 30% forever. Few do it for long.

Foolish bottom line
Don't believe this can happen to you? It's happened to me. And it can happen to you. Just take a look at stocks like eResearch (Nasdaq: ERES  ) or the round trip at OmniVision Technologies (Nasdaq: OVTI  ) . When growth stalls, the market bites. This is why I look to buy firms that are boring growers. The Davises looked to insurers like AIG (NYSE: AIG  ) . Peter Lynch loved his boring hotel chains and faucet makers. I tend to look at retail. But I also look for those fallen angels in tech. (Over the past nine months, eResearch has returned 50% to investors who were patient and smart and saw that the growth wasn't gone forever.)

This simple market-beating math is central to the approach at Motley Fool Inside Value. Growth isn't worth your investment when it's overpriced. The key to consistent doubles is in paying less for what you buy, whether that's slow and steady or the fallen angel. You can get some of each with a free trial to Inside Value.

Seth Jayson is always on the lookout for a bargain. Got a good idee-er? Send it his way. At the time of publication, he had no positions in any company mentioned here. View his stock holdings and Fool profile here. Fool rules are here.


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