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t o r o n t o i n v e s t . n d s n . c o m |
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OF PRICE AND GROWTH |
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t o r o n t o i n v e s t . n d s n . c o m |
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OF PRICE AND GROWTH |
I was recently reading Timothy Vick's book Wall Street On Sale, which is an exceptional book, and one bit of information caught my attention. Looking at the chart of a stock who's price was always increasing - Mr. Vick noted that a person who bought and sold at exactly the right moments (during the troughs and peaks respectively) would enjoy a gain that would exceed that of the long-term investor. However, if this charmed individual missed the mark at any point in time by 5% or more, trading costs and taxes would quickly erode returns to a point well below the returns experienced by the buy-and-hold advocate. With this in mind, and knowing how poorly I am at darts - this has reinforced my belief in the long-term buy-and-hold system of investment.
Keep in mind that the feat of trading in-and-out would be even more difficult with a less predictable stock - one that did not consistently rise over time, but rose and fell on the whim of the markets. On the subject of purchasing valuable businesses, I was re-reading Peter Lynch's book One Up On Wall Street. Mr. Lynch made two interesting comments: 1) He prefers to purchase businesses at a P/E equal to or less than their earnings growth rate and 2) it is better to purchase a business at a higher P/E that grows earnings at a higher rate than a lower P/E business that grows earnings at a slower rate. |
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"Well, the questioner came from Singapore which has perhaps the best economic record
in the history of developing an economy and therefore he referred to 15% per annum as
modest. It's not modest--it's arrogant. Only someone from Singapore would call it modest."
- Charlie Munger, 1997 Berkshire Hathaway Annual Meeting
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If Charlie Munger's belief that a 15% growth rate is 'arrogant' let us compare two businesses: one (A) that grows earnings at 15% per year and trades at a (higher) P/E of 15 and the other (B) that grows earnings at a slightly lower 10% per year and trades at a supposedly cheaper P/E of 10. Let us say that the price per share of company A is $15.00 and a P/E of 15. Company A (and B) generates $1.00 in earnings in year 0. In the first year earnings would rise to $1.15 and the price per share would be $17.25 (if the P/E stayed at 15). This would continue year-after-year until the 10th year where a share of company would be earning $4.05 and trade at $60.68 (assuming the P/E didn't change; with growth companies like these it is more likely that the P/E would rise during Bull markets - but that's neither here nor there). Company B starts at 'cheaper' $10 per share, and trades at a lower P/E of 10 and grows earnings at 10% per year. In the second year company B would earn $1.10 and if the P/E stayed the same it would be priced at $11.00 per share. This would also continue year-after-year and after 10 years we would see a business that created $2.59 in earnings and trading at $25.94 per share. This is the difference of making 4x vs. 2.5x your investment. The cheaper price of company B doesn't even begin to compensate for the difference in earnings growth. This shows two things:
Definitely some food for thought there. Now, I'm not advocating spending 40 times earnings in order to capture a 40% grower (or 1000 times earnings for a no-grower in the case of some internet stocks...and if 15% per year is an 'arrogant' assumption what is 40%? Insane?), however, it is important to keep in mind the power of compounding a fast grower compared to a slow grower. Purchasing companies that grow earnings faster than the corporate average at lower-than-average prices is the cornerstone advantage of the long-term investor. Cheers, |
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