Investor Math 101 - part 2

Price And Value Compound Together

The forces that link price to value are inevitable and immutable. Overlong time periods, earnings for Standard & Poor's (S&P) 500 companies cannot grow much faster than these companies' sales. S&P 500 sales can't grow much faster than U.S economic output (if that occurred indefinitely, the S&P 500 companies would eventually BE the economy). Therefore, if stock prices are supposed to track earnings growth, and earnings track sales growth, and sales track output growth, stock prices cannot be expected to grow much faster than the economy. But they have. Between the fourth quarter of 1994 and the end of 1999, U.S. economic output grew by roughly $1 trillion. The value of common stocks, in contrast, rose $6 million over the same period. One cannot expect a company's stock price to rise faster than the enterprise's earnings for very long. Eventually, something has to give: either the stock plunges back to the trend line of earnings or earnings accelerate. By 2000, Wall Street clearly believed in the latter, leading to inexplicable levels of valuation. Investors were valuing Microsoft, Cisco Systems, and General Electric as if they were among the world's largest economies. A virtually unheard-of upstart company called Ariba was valued at $25 billion at its 2000 peak-more than Apple Computer - despite the absence of meaningful revenues or earnings. Qualcomm was being priced in the marketplace as if its sales could rise at nearly 47% a year perpetually.

When you think logically about these comparisons, you sense the folly. The total market value of the S&P 500 index should not exceed the size of the economy. This is theorem Nobel Laureate James Tobin posited in 1969 when he devised a now-famous set of ratios that compared stock values to Gross Domestic Product and the replacement cost of assets. Applying Tobin,s research, the market value of all U.S. equities surpassed Gross Domestic Product in the late 1990s - for the first time since 1929. Never before had the investing public been willing to pay such a huge markup for the economic inputs used to produced earnings. Investors who were willing to pay extraordinary prices for S&P 500 stocks were behaving no more rationally than the movie studio that paid its star actors $ 50 million to make a film that grossed only $ 20 million at the box office.

Eventually, prices must realign with value! Bank in the mid-1960s, analysts believed that IBM could grow 15 to 16 percent a year perpetually. Had that occurred, IBM's 1999 sales would have been $612 billion, 7 percent of U.S. output. Earnings would have been 15 times that of Microsoft's. Had Wal-Mart's sales grown at the rate analyst once projected, it would soon have absorbed 14% of every customer dollar spent. In the 1980s, homeowner in California had to learn the hard way what happens when housing prices rise at thrice the rate of incomes for years on end. Eventually, prices for all investments must fall, or rise, back to their trend line level of value and affordability.

Benjamin Graham once commented that the biggest trap into which investors fall is to decouple price from value, to stray from the facts, and to base trading decisions on the actions of others ("I buy because others are buying, etc") If you expect to get rich trying to predict the trading of others, "you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market," Graham wrote in 1949.

Ignore Prediction of Performance

Most of the great investors shared a common belief that the sky was their limit, so to speak. They refuse to accept "average" performance and strove to find ways to outperform their peers. In retrospect, their tales of success should serve as inspirations for what can be attained in the investment world when you set your sights higher than those of the general population. They attained 20 percent annual returns because they tried to. One cannot attained such a level of success by luck or complacency. The market doesn't reward fools for long.

For the better part of 2007, investor were told to expect 11% annual returns in the stock market. Seven decades of data, in fact, suggest that the market's long-term rate of return may be roughly this amount. To accept this benchmark is to put yourself on a course for mediocre performance. Too many investors fall prey to Wall Street's statistics or any kinds and craft stock-picking strategies and portfolios that nearly guarantee them market-tying returns, at best. Some load their portfolios with too many stocks and, as a result, place statistical ceilings on their performance. Evidence shows that the more stocks one own, the closer one's returns will mimic those of an index (see Chapter :- Master at picking stocks). Other investors limit their long-term returns by holding too many poor-performing stocks that offset the gains of their winners. Still others take excessive risks and pay high prices for their stocks. Such strategies work from time to time, but over long time periods, buying high ultimately weighs down your returns.

Brokers, financial planners, accountants, and many managers have all tried to convince investors to expect 11% annual returns from the market. The 11% figure has been recited so many times through the years it has become hardened in the lexicon of the bull market. The 11% figure wasn't pulled from thin air - it has historical backing: this is the compounded annual return an investor would have culled by buying a basket of large-cap stocks between 1926 and 2002. Because investors have little else to go when trying to predict the direction of stocks (only a handful of the world's stock markets have operated continuously since the mid-1920s), they have had to rely almost exclusively on the 11% figure as their benchmark. But extrapolating stock-price trends is inherently dangerous, for many reasons. The stock market doesn't obey calendars and rarely behave as predicted. Just before the last great bear market in 1973 and 1974, numerous articles claimed a new era had arrived, that stocks were destined to rise perpetually. Financial planner created glossy brochures showing how investors could compound their assets into a large retirement nest egg because of the market's tendency to rise consistently over time.

Today, many arguments have been made to support the thesis that the market's long-term rend line has been breached. Economists argue that the improvement in productivity experienced by U.S. manufacturers may usher in a new era of profitability. Others contend that the economy is virtually immune from recession and, by inference, immune from the types of bear markets that mute historical averages. Indeed many market strategists have been relying on a quantum jump in growth. They want you to believe that the market will continue to grow 11% a year from present levels, not from trend lines established decades ago. They are drawing new trend lines above and parallel to the old. It's a back-door way of saying, "the past is relevant, but only the good years."

Unfortunately, the market does not obey formulas. There is no guarantee that the recent past will be replicated. Just because U.S stock market has risen 11 % annual rates for 70 years doesn't mean the next 70 years will be the same. Certainly, the past says nothing of what we can expect over the next few years. By relying on dubious statistics-rather than focusing on companies and their performance, investor undermined their goal. They diversify too much, they demean the roles of analysis, or they fail to monitor their portfolios properly. These three mistakes explain why most investors fail to achieve adequate returns.

To lay the ground work for successful investing, you must first ignore the marketing scripts. It is wrong-and frequently risky - to link past returns to the future. Just because the S&P 500 index has risen at 11% annual rates does not mean it will return 11% over the next several decades. It may return 5%, or it may return 20%. According to buffet, the market may post negative returns over the next several years before resuming an upward course. The good news is that once investors reject the sales utterances of Wall Street or any kinds, they are no longer bound by limitation when setting goals. Buffet tells investors that it's possible to obtain returns far in excess of the market-whether the market rises 10% a year, 2% or 20%.

As we showed in the section on compounding, the power of time works to the advantage of an investor who can keep ahead of the market If you can obtain minor improvements over the market's return, you will generate staggering long-term results due to compounding. Assuming the market rises 10% a year, an investor who begins with $10,000 and obtains 12% a year has 43% more money after 20 years than someone who merely kept pace with the market. After 30 years, the investor has earned 72% more money. The results explode when an investor can attain returns above 12%. By earning 14%, you would have 192% more money in 30 years. If an investor can attain 16%, he earns 391% more money by year 30.

Compounding also works in the opposite direction. The punishment for lagging behind the market is as substantial as are the rewards of beating it. After 30 years of 8% yearly returns, a portfolio lags behind 73%. It takes just a few major mistakes to keep your portfolio from attaining truly outstanding returns. Holding onto a poor-performing stock too long can put you years behind your long term goals. So can selling a strong-performing company too early. A portfolio that is too large will ensure that you never generate a return above 11%. Conversely, a portfolio that is too small, with just a handful of stocks, forces you to be nearly perfect in stock picking. One disastrous holding could keep you behind the market for years.

The goal of trying to beat the market can prove to be quite worthy, Buffet noted in his 1988 annual report, because the long-term compounded returns of beating the market can be astounding. From 1926 through 1988, Buffet noted, the market provided a total return of 10% a year. "That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically significant differential that might, conceivable, arouse one's curiosity."