One of the resounding investing lessons that many investors (including us Rule Maker managers) painfully re-learned during 2000 is that valuation matters in investing. The price an investor pays must leave sufficient room for future appreciation in value. While the quality of the business involved will always be of paramount importance for investors looking to buy and hold for a lifetime, the price paid for that business will always have a major effect on an investor's returns, even over a 20-year holding period.
I'd like to use an example to support my point. Suppose you are a buyer of Intel (Nasdaq: INTC). Let's say that you bought Intel in 2000, and your friend (we'll call him Bob) did the same. We'll assume that you purchased your 100 shares of Intel at $75, very close to its high mark, back in August. Bob, being the procrastinator that he is, waited until October, and bought his 100 shares at $40 per share. In 2020, you both decide to sell your shares and party. Looking into our crystal ball, we'll also (just for fun) predict that in the interim 20 years, Intel has succeeded in maintaining its Rule Maker status and has doubled its earnings every five years. Now, given that extended time horizon of 20 years, and given the exceptional performance of Intel over that period, the price that you paid way back in 2000 shouldn't make a huge difference in 2020, should it?
Let's find out. What will Intel's price be in 2020, assuming that the company has doubled earnings every five years? If you double Intel's most recent trailing 12-month earnings of $1.50 per share for the next 20 years, you'll find that Intel will have $24 in earnings per share (assuming there have been no stock splits) in November of 2020. If the market is in one of its nasty spells (like it was prior to Wednesday's Fed rate cut), Intel might be valued by the market at as low as 20 times earnings. This would translate into a stock price of $480 per share. On the other hand, the market could be riding high with optimism, and Intel could be trading at 40 times trailing earnings. This would translate to $960 per share.
Depending on whether the market is pessimistic, neutral, or optimistic about Intel in November of 2020, the value of your 100 shares, purchased in 2000 at a cost of $7,500, could be worth anywhere from $48,000 to $96,000. Sounds pretty good, doesn't it? Under the worst-case scenario in our limited universe of possible outcomes, you would have made more than six times your money in 20 years. In the best case, you would have made almost 13 times your money. The following matrix describes the returns on your investment at various price-to-earnings multiples in 20 years from now.
P/E Stock Total Annual
Ratio Price Value Return Return
20 $480 $48,000 540% 9.7%
25 $600 $60,000 700% 10.9%
30 $720 $72,000 860% 12.0%
35 $840 $84,000 1020% 12.8%
40 $960 $96,000 1180% 13.6%
Now, let's look at Bob's investment returns.
P/E Stock Total Annual
Ratio Price Value Return Return
20 $480 $48,000 1100% 13.2%
25 $600 $60,000 1400% 14.5%
30 $720 $72,000 1700% 15.5%
35 $840 $84,000 2000% 16.4%
40 $960 $96,000 2300% 17.2%
The difference is pretty striking. Under the worst-case scenario, Bob makes 12 times his money over the 20 years. In the best case, Bob makes 24 times his money. If we choose the mid-range outcome, at 30 times earnings in 2020, Bob makes 18 times his investment, while you make only 9.6 times yours.
The conclusion? No matter how long your investment horizon, the price that you pay for your shares makes a difference. That doesn't mean that valuation is more important than business quality, especially over a long time horizon. The fact that Intel was able to maintain the high quality of its business over two decades was the crucial wealth-creating factor that allowed both you and Bob to prosper. But, even though Bob purchased his shares only four months later, the excellent value he received for his investment dollars makes a huge difference in return.
What does this mean for us as Rule Maker investors? To me, it means that every investing decision that we make should be a two-part process. The first part involves using the Rule Maker criteria to identify the companies that we believe will remain or become dominant businesses over the long term. But identifying Rule Maker companies is not enough, in my opinion, to give us a good shot at beating the market averages. The second part of our investing decision should be to ensure that our purchases are made at a price that provides sufficient value for our investment dollars.
In practice, I think that we have already accomplished the first part of our goal here in the Rule Maker portfolio, at least to a certain extent. Our Rule Maker universe consists of 11 companies that we consider for investment every month. While that is certainly enough to choose among for our monthly investments, I wouldn't mind seeing us expand this list to 15 or so. When allocating our investment money every month, I believe that we should attempt to identify which of these companies offers the best value. Most of the time, the market will provide us with the opportunity to purchase shares of at least one of our favorite companies at a price that offers us sufficient value. And right now, I happen to think most of our Rule Maker companies offer decent values for us. Some months, we won't find any of our companies are selling at attractive prices -- and I think it is perfectly fine for us to hold on to that cash until a better price manifests itself.
In this season of New Year's resolutions, these are the two I'd like to see us make in the Rule Maker Portfolio. The first is to slightly widen our universe of candidate Rule Maker companies for our monthly investments to 15 or so top-flight Rule Makers. The second resolution would be to incorporate the element of value more directly into our monthly transaction decisions.
As always, we'd be interested in your thoughts on how value investing intersects with Rule Maker investing. Find out what other Rule Maker investors have to say on the topic by clicking on our Rule Maker Strategy discussion board.
And finally today, I'm adding my nomination for purchasing Intel with this month's $500 savings. As Rich said on Monday, "The market is currently giving us a chance to purchase Intel at about 33x trailing free cash flow. That isn't cheap, but it's reasonable for a company with proven management, enormous financial strength, and perhaps the most efficient processes in the business." I agree. We'll pick up a few extra shares of the silicon Rule Maker sometime in the next five business days.
By the way, are you a registered Fool? If you are, why not check out the many benefits of Foolishness by heading over to our Member Benefits Center? If you aren't a Fool, I'd like to invite you to register (it's free!) by clicking on this link.
Have a great weekend!