Misconceptions come in all shapes and sizes. Quick, what's the capital of Australia? Up until a year ago, I would've sworn it was Sydney. I can even imagine it on the map, with a little star next to it. I've been to Sydney; it certainly looks like it's a capital city. But the capital of Australia is Canberra.
Investing misconceptions are like that: The untruth we've learned persists, even in the face of logic. I believe the best way to deal with investing misconceptions is continually to attack and disprove them. Here are just a few mistakes that need correcting.
"Wow, that stock's cheap at $5 per share."
The whole concept of price per share should be done away with. The fact that White Mountains (NYSE: WTM ) trades at $578 per share and Sun Microsystems (NYSE: SUNW ) trades at $5 per share does not mean that one is cheap and the other expensive.
A share of stock is simply a piece of the pizza. The fact that I have five pepperoni on my slice and you have two doesn't mean my slice is superior. What's important is how big the pizza is, and what percentage of the pizza your slice comprises.
What should investors focus on instead? A company's market capitalization is the price per share multiplied by the number of shares outstanding. The enterprise value is the market cap plus net debt. Whenever you buy a share of a company, make sure you know what market cap and enterprise value you are paying. If you wanted to buy White Mountains, despite its sky-high share price, you'd only pay $6.3 billion (the market cap), compared to Sun, which is nearly three times more expensive at an $18.3 billion market cap.
"I never buy at the bottom or sell at the top."
I am as guilty as anybody of trying to time the bottom and top. I get upset when a stock drops immediately after I buy and goes up immediately after I sell. I go on a tantrum and complain loudly about how this always happens to only me.
The truth is, it's very arrogant to think one can catch the bottom or top on a consistent basis. Here's how I see it: The stock market is a gigantic auction where millions of people buy and sell stock every day. When I buy or sell a stock, I am selling or buying to or from one of those millions. It'd be impossible for me to predict what those millions of other people are going to do the second after I execute my trade.
What should investors focus on instead? I believe that investors' performance will improve immensely once they realize the futility of trying to time a top or a bottom. It will stop foolish thinking, such as "OMG, I am down 5% from my cost basis!" and promote thinking such as "What is the best estimate for the intrinsic value of this stock? How does any new information affect my estimate? Should I buy, sell or hold at the current valuation?"
"You get paid to wait with that dividend yield."
There are no free lunches in this world, and that includes dividends. The key phrases here are return of capital and return on capital. If you give me a hundred bucks to invest, and I put it in my piggy bank and give you back five bucks a year, I'm basically just giving you back your money. No value is created -- only returned to its original owner. In fact, value is destroyed, because of the cost of inflation.
A dividend yield is basically a return of capital. Some companies, like Thornburg Mortgage (NYSE: TMA ) , because of their tax-efficient REIT structures, basically have to return to shareholders most of their net income every year. Other companies, like U.S. Bancorp (NYSE: USB ) , pledge to return 80% of their net income to shareholders via dividends and stock buybacks.
This isn't to say that dividends are bad. Sometimes they're tax-efficient, sometimes investors need the income, and sometimes a dividend prevents a company from wasting excess cash -- all positive things. However, at the end of the day, the dividend is a return of capital. The company is giving you money that's already rightfully yours.
What should investors focus on instead? Return on capital. If the company is generating a strong return on capital, it'll be reflected in the stock price sooner or later. Berkshire Hathaway (NYSE: BRK-A, BRK-B ) has never paid a dividend, essentially because the money is more valuable in Warren Buffett's hands than it would be if returned to shareholders. On the other hand, Microsoft (Nasdaq: MSFT ) now pays a dividend in an attempt to return a small portion of its cash hoard to investors.
If a company has a high dividend yield (high return of capital) but a low return on capital, sooner or later, the money will run out and the company will have to cut the dividend, which will send the stock plummeting. Good measures of return on capital to watch for are return on equity, return on assets, and return on invested capital.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.