Investor Math 101 - part 1

The Power of Compounding

It goes without saying that to a person such as Warren Buffet, the power of compounding is paramount. No force exerts more influence on your portfolio than time. Time takes a bigger toll on your terminal wealth than do taxes, inflation and poor stock-picking combined. Time, magnifies the effects of these critical issues.

A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.Trading frequently for short-term gains may net you strong gains periodically, but the overall result, validated by time, is to create an enormous tax burden that could have been avoided. Likewise, persistent inflation exacts a weighty toll on your portfolio because it destroys value at increasing rates. "Means and end should not be confused," Buffet once wrote to his partners. "The end is to come away with the largest after-tax rate of compound."

There's an old story that, if the Indians wanted to buy back Manhattan, they would have had to pay more than $2.5 trillion by January 1, 2000. That's what the $24 sale price in 1626 would have compounded into at 7% annual rates. And the clock is still ticking. Next year, Manhattan's theoretical value jumps by $175 billion which is 7% of $2.5 trillion. The following year, another $187 billion is added. The year after that, $200 billion, and so on. Letting wealth accumulate and compound in fettered and, if possible, untaxed is a potent formula individuals should use to increase their standard of living.

Let time work to your advantage. Choosing good companies at fair price seldom has produced losses for investor willing to wait patiently for the stock price to track the growth of the company. "Time is the friend of the good business, the enemy of the poor," Buffet has said many times. Strong enterprises see their intrinsic value rise consistently, lifting the stock every step of the way. Over a period of 5 years or more, there should be a very close correlation between the change in the value of the company and the change in the stock. Watching great companies increase their sale and earnings consistently is a dream come true for an investor The power of compounding begins working its magic as the year progress and allows your net worth to gather momentum and increase (in dollar value) by greater and greater amounts.

Two principles should be readily apparent:

• Time has a tremendous effect on terminal wealth. The longer that money can compound, the larger the sum will be.

• The rate of return attained acts as a lever that magnifies or minimizes your ultimate wealth. Adding just a few percentage points a year to your overall returns can have unfathomable consequences to your wealth, An investor who compounds $1 at 6% annual rates has $5.74 in his pocket at the end of 30 years. The same investor who can find ways to obtain higher returns walks away with much more. If you can obtain a 10% annual return, your $1 compounds into $17.45 in 30 years. Compounding $1 at 20% annual rates compound into $237.

The Links Between Price And Value In The Market

No assets can outrun its own fundamental forever. In the long run, there is perfect correlation between price and value. Eventually, the price of any asset seeks out, and finds, its true intrinsic value. This relationship holds for stocks, bonds, real estate, art, currencies, precious metal, etc - virtually any asset whose values fluctuate based on shifting perceptions of buyers and sellers. If you understand this basic mathematical relationship, you will have an advantage over most individual investors, for there are several truisms about price and value that an investor cannot ignore.

Between the mid-1920s and 1999, the Dow Industries index grew at a compounded annual rate of around 5.0 percent (dividends provided the remaining return). Over that same period, earnings for the 30 Dow Industrials companies grew at 4.7 percent compounded rates. Interestingly, the book values of theses same companies increased at around 4.6 percent annual rates. It's no coincidence the growth rates are so similar. Over long periods, the market value of a company's stock cannot outstrip its own internal growth rates by very much. Sure, technological gains can cause improvements in corporate efficiency and lead to temporary quantum leaps in earnings. But the competitive, cyclical nature of markets helps to maintain the direct relationship between sales, earnings and valuation. In boom times, earnings growth can outstrip sales growth as corporations take advantage of economies of scale and better factory utilization. In recessions, earnings fall faster. than sales (companies temporary become less efficient) as companies find themselves overburdened with high fixed costs that cannot be covered by sales.

This relationship between price and value is important when putting market movements and trends in their proper context. Investors must never pay prices that cannot be justified by the company's long-term growth rate. More to the point, they should be leery of chasing stocks that are climbing well in excess of the growth in the company's value. Although it's difficult to pinpoint a company's exact worth, telltale signs can be found. For example, if a stock has been rising at 50% annual rates during in which earnings rose at just 10% rates, there exists a high probability that the stocks is overvalued and destined to provide poor returns. Conversely, a stock that has been falling in price while earnings are rising should be scrutinized for possible purchase. If the stock plummets in price and trades at price-to-earnings (P/E) ratio below the company's presumed growth rate, a bargain situation may exist.

As the year 2000 opened, a huge disparity existed in the market between price and value. Dozens of high-technology glamour stocks were rising three to five times faster than their earnings as investors piled on and were willing to pay inflated P/E ratios for the chance to gloom onto a winner. Central to this frenzy was the belief that old economic theorems had been invalidated, that U.S. companies had entered into a new growth phase the precluded a bust period. The irony was that none of the economic figures released by the government in recent quarters suggested that corporate performance has leaped onto a new, higher plateau as Wall Street wants us to believe.

If anything, the data suggest that companies are doing were performing or worse than could normally be expected nine years into an economic expansion. By 1999, profitability and asset utilization ratios were no higher than they were in the late 1980s, the only difference being that companies were using their capital structures more wisely to add value. But contrary to popular reports, cyclical risks had not been removed from income statement. Nevertheless, the investing public continues to salivate over the notion, still unproven, that the economy is immune from recession and that corporate earnings can be driven forever higher.

A wide dichotomy between facts and expectations can be dangerous in the financial markets. The public desire to ignore evidence and unearth fast profits has fostered, in some industries, a giant pyramid scheme, where groups of investors seemingly sell stocks back and forth to each other, raising the price with each transaction, which occurred with Internet stocks. Pyramid schemes work only as long as both sides of the transaction remain dedicated to the game. When buyers begin dropping out, the remaining participants find out in a hurry how much the goods they traded were really worth.

To be continue........"Investor Math 101 - part II"