FOOL ON THE HILL
For no apparent reason, investors seem fixated on a return of 15%. It's the rate above which people define stocks as "growth." Trouble is, it's a tough number to reach. There is nothing at all wrong with getting 13% or even 11%. In fact, those rates of return will do an investor quite well when the power of compounding is brought to bear.
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If there is a magic number in investing, it seems to be 15%. This is the bar, for example, that growth companies must cross to avoid being called a cyclical -- or even a value -- stock. As such, you often find that managements feel tremendous amounts of pressure to keep earnings growth estimates above 15%. For several years now, Coca-Cola (NYSE: KO) seems to have predicted annual growth of 15%, only to downwardly revise it later on. And 15% also seems to be the number individual investors have set as the minimum expected return for their stock portfolios. For many this goal has actually dropped since the heady times of 1998, when some people thought even 40% annual growth was somehow unacceptable. Now, a year or so after the collapse of the Internet bubble and many, many Internet years of experience later, the revised goal seems to be 15%. (Fortune's Carol Loomis wrote about this phenomenon in "The 15% Delusion.") Generally speaking, this is as it should be: If someone is going to select her own stocks, outperformance of the stock market averages should be one of the goals. But 15% annual investment growth is an awfully tough mark at which to shoot. The investor best suited for long-term success is the one with realistic expectations. The person who achieves 13% compound annual portfolio growth has in no way failed; in fact, this person has soundly beaten the historic average return of the S&P 500, the oft-quoted 11% growth rate. (And investors seeking to meet the market's return can do this simply and inexpensively through index funds, beating most managed mutual funds in the process.) That difference of two percentage points adds up over time: A $10,000 investment compounded at 13% annually for 20 years is worth some $34,000 more than the same stake growing at 11%. It may seem that 2% is not that great a difference, but when dealing with growth rates we must adjust our math a bit. While 13 is two integers more than 11, it is also18.2% larger -- which is significant. Think about this: When a company reports its earnings, it expresses them in terms of the percentage change over the last period. So a company that reports $0.02 per share in earnings, compared to $0.01 the previous year, has shown earnings growth of 100%. Unfortunately, a quote from George Box applies here: "All models are wrong, but some are useful." There really is no investment that gives a reliable 11% (or 13%) return year in and year out. An investor who manages to earn a 13% annual compounded return over many years likely will have had some years of exceedingly high growth and some of low growth -- or even losses. If someone racks up a loss the first year out of the gate, how is he to know whether his strategy is bad or whether the conditions of the market simply did not favor him at this time? How, indeed. This is one of the most difficult questions in investing, right up there with discerning an appropriate future growth rate for companies. Unfortunately, it's one of those things that can definitively be determined only in hindsight. And that's where expectations come into the picture. Many investors who bought into any of the dozens of former high-flyers were probably kidding themselves if they expected 15% return on investment from the points at which they bought it. At Cisco Systems' (Nasdaq: CSCO) highest point, 15% annual growth implied a future market cap of $2 trillion by 2010 without any additional share dilution or acquisitions. For frame of reference, the U.S. economy has grown about 3% per year over the last century. Let's be aggressive and assume it grows over the next decade at a historically unheard-of rate of 5%. That would put Cisco in the year 2010 at more than 12% of the total U.S. economy. This isn't about Cisco, though. It's about the difference between the assumed rate of growth of public companies and the overall growth of the economy. Even when the U.S. economy was barreling along at nearly 6% growth in 1998 and 1999, the growth rate was considered too high. In some ways, the current economic slump is a hangover from that torrid growth, as the debt taken on by so many companies in expectation of continued hypergrowth has instead become an albatross as those returns have failed to materialize. When we target growth rates of 15%, we essentially expect that public companies -- or at least the ones we are invested in -- will continue to grow at a rate exceeding three times (using our 5% target) that of the overall economy. While it is plausible that the fastest-growing portions of the economy will grow at several times the average, one must take extreme care to sniff out these outperforming companies, and purchase them at prices that provide some margin of safety. Cisco probably fulfilled the first requirement, but it failed miserably on the second when it was priced at $80 a share. Yet someone out there bought it, thinking that its past performance indicated some sort of linear continuance into the future. Brother, it just ain't so. It is for this reason that The Motley Fool is so fond of S&P 500 Index funds. Although the overall market is just as prone to periods of insanity, the S&P 500 is made of 85% of the total market cap of U.S. stocks, and has a survivorship bias that almost guarantees that underperforming companies or sectors will be weeded out. Given the above statistics, if you are not convinced that you have the ability to beat the average, an index fund will be the best investment decision you ever make. Fool on! Bill Mann, TMFOtter on the Fool Discussion Boards Bill Mann recently learned the children's song "Ring Around the Rosie" may have originally been about the Bubonic Plague. He can neither confirm nor deny this since he was not around during said plague. At the time of publishing, Bill held beneficial positions in Coca-Cola and Cisco. His holdings can be viewed online, as can the Fool's disclosure policy.
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