People talk about price ALL the time. “This stock is selling for this…” or “I bought this stock at this and sold it at that.”
Stock price is just a nominal number, and by itself it tells us nothing. As an investor, you want to know:
What are you getting in return for buying stock at today’s price?
This concept is best illustrated with an example…
Let’s put together two mythical portfolios: Group A and Group B.
Let’s further assume that we have $1 trillion (T) to invest. You’ll see why in a second…
Group A consists of Shopify, Square, Tesla, Zoom, and Spotify. We use $1T because at today’s prices you could buy all five companies in total for that amount. Or $987B to be more precise, but you get the idea. As 100% owners, we get all the earnings, dividends, etc.
We could take our $1T and invest it in Group B which consists of JP Morgan, Applied Materials, Intel, Raytheon, Wells Fargo, Bank of New York, Capital One, and Carrier.
Group A are the highfliers. They’re the ones on the news all the time. Their fast growth is indicated by their booming stock prices. All have gone up several fold just this last year. Shopify is up 3 times, Square is up 4 times, and the poster child for absurdity — Tesla is up almost 8 times!
Group B returns are more subdued: Carrier has done well and is up 3 times. Big banks, Wells Fargo and JP Morgan, are down in this bull market as are Intel and Capital One. As a group, they have barely budged. No return at all in 2020 except for dividends.
That’s price. But by itself, price doesn’t really tell us anything we can use.
A real investor will look at, “What are we getting in return for our $1T investment?”
So let’s dig in to our two stock portfolios:
One group had $38B in total revenue in the last four quarters. The other had $426B. One group had net profits in 2020 of $94B. The other group actually lost money — $1.2B to be exact. Not chump change.
I know you’re on the edge of your seat wondering which is which, so I won’t torture you any longer.
Group B, the old stodgy names that have been around collectively for hundreds of years, massively outperformed the highfliers in Group A.
Group B had 11 times the revenue, and their $94B in earnings is a return of 9% on our original investment in the first year.
The disparity between the two should shock you. Especially when you see how the underlying stocks performed over the last year.
We could do a further calculation… If Group A grew its revenue 10 times and earned 25% more margin, it would still earn LESS than Group B.
Group A stocks are all less than 10 years old. They all lose money. Several have yet to make any money, even in a single quarter! Yet, their stock prices have skyrocketed.
Group B have multi-decade histories of profitability. They’ve weathered recessions, depressions, wars, scandals, pandemics, you name it. They’ve come out on the other side intact and, sometimes, stronger.
Will Group A show the same fortitude? We don’t know. My guess is Group A will survive, but I’m not sure all of them will. It remains to be seen.
Group A is, in essence, a speculation. It’s not an investment, since we really are getting nothing in return. We’re buying and hoping it continues to go up. The greater fool theory: I’ll buy now and resell to someone else at a higher price later…
Group B is an investment. We are calculating what we are getting in return for our money. In this case, $94B in earnings on an initial investment of $1T or around 9%.
I hope our little exercise shows you markets can be distorted, and how irrational exuberance in markets can create anomalies.
So, how will our two stock portfolios do over the next year??
I have no idea, but over a long period of time — say 5 years or more — I’ll take Group B.
The stock prices of Group B may not move for a while. But I don’t really care. I’m making 9% on my money. That’s pretty good. And it’s growing. Also, the stocks in Group B are protected by moats. They have competitive advantages that keep competitors out. You can see this by looking at their profitability.
Group A doesn’t have any protective moats. Their low or nonexistent returns on equity tell us that. Their thin profit margins tell us that. Their industries are undergoing rapid change with many players vying for position. It’s really a crap shoot.
Investing in this market today reminds me of the old poker saying, “If you feel really smart and you look around the table to see who the patsy is, it’s probably you. You just don’t know it yet…”
- Price by itself doesn’t tell us anything. You must look at price in relation to earnings, cash flow, or some other metric.
- High-flying stock prices not backed by fundamentals are not sustainable.
- Industries undergoing rapid change are very difficult to invest in.
- Stock prices ultimately have to be supported by profits and competitive advantages. (Group B has those. It is unclear if Group A ever will.)
- Over time, falling stock prices will reflect the absence of competitive advantages or, as we call them, moats.
- Speculation is betting on the stock price going up. Investment is understanding what you’re getting in return.
How CSH Approaches Things
At CSH these are the things we think about. We look at the fundamentals underlying price.
For every position we own, we keep a file and update it regularly by asking questions like the following:
- Is profitability diminishing?
- Are the earnings sustainable?
- Has the stock gone up too much?
- Should we trim our position?
- Is there something that looks more attractive?
Reach Out to Us!
Do you have questions or concerns about your investments, retirement plan, inheritance, business succession, or wealth management? We are obsessed with doing things well and serving our clients as if they were our own family. Give us a call at 217-824-4211. We’re happy to talk with you!