Warren Buffett has said that stocks are the only things people don’t want when they are cheaper. If cars, hamburgers, real estate, perfume, gourmet coffee, furniture, clothing, concert tickets, or televisions go on sale, you’ll see people lining up outside of the stores at 3 a.m. to be first in line to save money. But if the market goes south and shares of companies that serve as the backbone of America (think General Electric, Wal-Mart Stores, The Home Depot, McDonald’s, Starbucks, Johnson & Johnson, etc.) drop in price, they not only refuse to line up to buy more, they often bottleneck at the door in a panicked effort to sell. Ten years pass and then they wonder why those who have patiently stayed the course are able to retire sooner and spend more on the things they enjoy.
Here’s an actual example from my own life. In 2001, Jeffrey Immelt took over General Electric just four days before the terrorist attacks of September 11th. The United States was about to enter a recession, two wars, and only a few years thereafter, the mortgage and credit crisis. Yet, during the years he’s been at the helm, the company’s net profit has grown from roughly $14.13 billion to nearly $22.5 billion. Earnings per share have grown from $1.41 to $2.20 per share, resulting in the cash dividend nearly doubling from $0.64 to $1.24 per share. The business results have been fantastic. He’s sold off slower growing and lower return businesses and moved into global plays like infrastructure and energy to position the firm for the next ten or twenty years. Despite all of this success, the stock (with dividends reinvested) has performed just under the S&P 500 since he took the helm – up roughly 80%.
The reason is easy to understand: In 2000, just a year before he moved into the executive suite, the stock was trading at $60.50 on earnings per share of $1.29. That means that for every $1 in net profit per share, Wall Street was willing to pay $46.90 – an unbelievable price that hadn’t been seen very often throughout history except for startup companies and those with huge growth prospects such as an early Microsoft. (There is a thing called the “earnings yield” that lets you look at what a stock would be yielding if you thought of it in terms of a savings account. At that level, investors were only buying a 2.13% earnings yield yet taking on all of the risk of stock fluctuations!) Today, the company has trailing earnings per share of $2.15 and investors were only willing to pay $22.50 during the height of the credit crisis. That’s a multiple of 10.47 – or $10.47 for every $1.00 in earnings per share. In other words, investors are only paying 1/4th as much for every dollar of profits that GE produces as they were seven or eight years ago, resulting in an earnings yield of 9.55%.
To put it another way, earnings and dividends have roughly doubled, the business is more competitive going forward, yet the stock is now trading at a fraction of what it was before he took over. Why? Because anyone who bought GE at $60+ per share on $1.29 of earnings was an idiot. I’m not being trivial or exaggerating the case - to have paid those multiples for a company as large as General Electric would have required a total suspension of the basic laws of mathematics. Today, investors who buy the stock are essentially being offered an “equity bond” that pays 9.55%, generates 5% in cash dividends each year, and expects to grow earnings per share an average of 5% to 8% or more annually. Those terms are highly attractive given the size and scope of the business. That has led to me picking up tens of thousands of dollars worth of the stock in the last few trading sessions with an understanding that if it hits a certain price target, we may very well put six-figures to work in this conglomerate. The thing is, even if we were to wakeup the day after making the investment to find the stock had fallen to $12 per share, a loss of $50,000 on a $100,000 investment, it wouldn’t matter to us provided that the underlying earnings per share were still expected to compound at the rate built into our estimates. That is the secret. That is the key. I wouldn’t panic over the “loss” of 50% of our investment because we planned on selling or the underlying business prospects had changed because history has shown that the stock price always follows fundamentals in the long run and we should be able to compound our wealth at 10% to 11% per annum over the next decade. Most people can’t stand the volatility so they are their own worst enemy, buying when they should sell and selling when they should buy.
This doesn’t mean doubling down on stuff that has fallen. In cases of banks felled by the credit crisis, some of these institutions have experienced very real losses of profitability and damage to the balance sheet. They are fundamentally worth less than they were a year or two ago. That’s a different situation than simply logging in and seeing your 401k plan and index fund fluctuate 20% or 30% on the upside or downside.
To see the rest of the interview, check out the About.com Gay Life guide Ramon Johnson, who originally sent the questions to Joshua for a special he was running on his site.
