Mental Anchoring And Investor Folly

When you build an ownership collection of the best companies in earth—I have in mind firms like Visa, Coca-Cola, Johnson & Johnson, and Chevron—there is a pleasant occurrence you can come to expect: These companies will regularly grow their profits, causing your calculations of the firm to constantly be subject to upward revision.

It came to my attention when I was in dialogue with a reader that had an average cost basis in Chevron stock somewhere around $63 or $64 per share, and couldn’t bring himself to pay $115 per share even though he thought the stock seemed like a good deal at the price. That’s a behavioral force worth examining—previous experience with a stock at a cheaper price can color your current perception of the company’s value now. It can have the effect of preventing you from making a good investment (into a company you already own) and lower your overall returns if you choose an otherwise inferior investment instead simply because it is something new and you don’t have previous mental baggage with that company.

Here’s how I would go about smashing through this particular mental hurdle: Study the company’s finances, and realize that the company you are studying today is not the same one with which you had previous experience. Sure, the executives are mostly the same. The products produced are the same. It has the same ticker symbol “CVX” and all outward appearances look similar. But what the business represents is something new entirely.

I didn’t ask the reader when his position of $63-$64 Chevron stock was established, but I want to follow through with this point, so let’s make the assumption that it was 2005. At that time, when Chevron was trading at $64 per share, it was making $13 billion in cash profits and divided into 2.2 billion pieces. It worked out to earnings per share of $6.54 and dividends of $1.75. The Chevron that exists today in the $115-$120 range is not the same Chevron that existed in 2005. The Chevron of today makes $21 billion in annual profits, and earns $10.80 per share while paying out $4.28 per share in dividends.

Yeah, a price of $115 per share is 80% higher than a price of $64 per share. But, earnings per share of $10.80 are 65% higher than they were in 2005, and dividends are 244%. Also, keep in mind that oil prices regularly fluctuate so you will see a snapback in earnings—after all, the reason why Chevron is affordable again is because commodities and profits are temporarily down. Just two years ago, Chevron was making $13.44 per share in profits, which was 205% higher than 2005’s profits. You will see a snap forward to earnings per share of around $15-$16 when oil prices sustain an average price of $110 per barrel of oil or more for 12 months straight, reflecting Chevron’s growing daily production.

Chevron generates $21 billion in profits this year. About $8 billion gets shipped to shareholders as dividends, and the other $13 billion gets poured into new investments, and to a lesser extent, share repurchases that eliminates some of the other owners from having a claim on Chevron’s profits. When you’re retaining $13 billion for further investment or buyback, you’re going to increase the enterprise value of the firm by launching new projects that grow production.

In a few years, Chevron might be in the $170s, and you’ll be wishing you could have bought it in 2014 at $115. I understand that anchoring can be an insidious force—I remembered reading forums about General Electric during the financial crisis where investors were refusing to pay $12 per share for GE because it had doubled from the low of $6. That $6 low had an anchoring effect that prevented someone out there from making a once-in-a-lifetime investment. Those GE shares at $12 would currently be yielding 7.33% annually, without assuming reinvestment of any kind. Maybe if GE only fell to a low of $11 rather than $6 during the financial crisis, some of those investors would have loaded up on $12. It’s better form, and you will get better results, if you define ahead of time what constitutes an attractive investment, and then compare a company’s current price against your future projections to see if it meets your requirements. It seems far more rational than latching onto prices in the past, and developing discomfort for the price of today because the price of the stock is not what it once was.