Finding Stocks To Create Wealth Is Like Taking A Walk Through Wal-Mart

With the typical blue-chip stocks I discuss, the volatility is pretty limited. With the exception of the 2008-2009 Financial Crisis, you don’t really see Coca-Cola, Johnson & Johnson, Colgate-Palmolive, PepsiCo, and Procter & Gamble experience 50% declines in stock price. That is because everyone knows these companies are excellent and the earnings per share increase over almost every three-year rolling period.

I mention this for one reason—even though I write frequently about judging companies based on business performance rather than stock price fluctuations, the typical companies I discuss do not have wild swings in volatility because they are largely followed and most people with a steady pulse are aware of their excellence.

But sometimes, there are examples of companies that have wildly volatile stock prices that do not regularly reflect the true strength of the underlying business performance, and may require you to wear your cowboy hat if you want to hold on to the stock for the long term.

Take something like IBM: the business performance has been exceptionally consistent and impressive for almost two decades straight now, yet the price performance has been wildly volatile.

A $25,000 investment, with dividends reinvested, would have compounded at 15.2% annually over the past two decades, becoming worth more than $400,000.

But the price has been crazy—on three separate occasions since 1993, the price declined by more than 40% from a high to a low—the volatility has been there, but it has not been reflective of the business performance that ultimately determines wealth in the long run.

I don’t mention this stuff out of a desire to get you to buy IBM stock—I could have easily pointed to Johnson & Johnson, McDonalds, or Microsoft to show points where business performance did not match the price (although, in the case of Microsoft, the price often exceeded the excellent business performance).

The lesson is that you shouldn’t look at a stock’s price and think, “Oh gee, that’s what the company is really worth.” No, the stock market is just a giant auction house—think a version of EBay for those interested in buying and selling companies—and it is up to you to determine whether the prices offered correspond to what something is really worth.

An offer price is only an indicator of what the person selling the stock thinks that the company is worth. Other areas of life are the same way. For instance, when you go to Wal-Mart, you can see CDs—actual, physical compact disks—selling for $9.99, $14.99, $19.99, and so on.  I saw a Bruce Springsteen Greatest Hits CD selling for $9.99. Considering I could go on YouTube and listen to any of those songs, at absolutely anytime I want for $0.00, I immediately know that paying $9.99 for the physical disk is a dumb idea.

Likewise, I view the evaluation of stocks on the exchanges in a similar manner to walking through the aisles at Wal-Mart. There are some products like bread, drinks, and meat–that you are pretty much always going to buy unless they are ridiculously overpriced. That’s my attitude towards getting Coca-Cola, Pepsi, Colgate-Palmolive, Procter & Gamble, Disney, ExxonMobil, Chevron, Clorox, Johnson & Johnson and a few others on the household balance sheet at some point in life, and not letting go of them thereafter.

And then there are the things you would buy if the price is right. In the bakery section at Wal-Mart, they usually discount many of the bread products as the expiration date nears. My attention gets caught once the price is cut at least in half or so. I’m not normally a bagel eater, but if I can get six chocolate chip bagels for $1.49, I know what I’m having for breakfast the rest of the week.

Similarly, that’s how I feel about companies that are quite solid, but they are not something I would drool over in terms of business quality—the only time they catch your attention is when they are quite cheap. Take something like Emerson Electric. Damn good company. They’ve been raising their dividends since JFK was a senator. But still, if you think in terms of decades, it’s easier to predict that Clorox bleach will still be on shelves thirty years from now than it is to make predictions about industrial equipment usage. That’s not an insult to Emerson—but an acknowledgement of how their business model plays into the analysis of super long-term investing. Buying Emerson at $20-$30 during the financial crisis and holding it indefinitely is a brilliant business move. However, at $65 per share—I’m not sure what Emerson offers you over the next 25+ years that you couldn’t get just by purchasing Coca-Cola at $38.

And lastly—there are things at Wal-Mart that wouldn’t even cross your radar unless they were dirt cheap. That means candy after Halloween, Christmas decorations after December 25th, and so on. Buying Bank of America around $4-$9 per share after the financial crisis is roughly analogous to that—it’s not a company you would ordinarily seek out to purchase for its business performance superiority (you’d look to Wells Fargo, JP Morgan, and US Bancorp for that), but rather, the mismatch between the quality of the business and the price at $6 is so great that you decide to buy it.

And, of course, even at Wal-Mart, there’s overpriced crap. The stock market is no different—we see things like Amazon and Facebook trade at prices that are in no relation to the profits generated. Twitter is going public soon enough—and who knows what the price will do—but barring years of 30% or more profit growth, it is going to prove itself a wildly overvalued stock.

The good news is that we have annual reports, 10-K’s, and all sorts of financial disclosure information right at our fingertips. When we see something indicating that a business we own might be experiencing some permanent headwinds, we can look to the company’s earnings reports to see if the terrible predictions are materializing. A lot of times, they are not. That’s an important message to keep in mind as we close out an earnings season where the short-term mentality at places like CNBC is trying to convince you to sell, sell, sell. You don’t have to participate in the foolishness. You just have to do the math and see that the profits of the companies you own are still chugging along.