The more I study investing, the more I realize that one initial impression that I had about the stock market in general, and index funds in particular, turns out to be wrong: When I would look at index funds that returned 10% over a particular period, I initially assumed that most of the stocks delivered returns similar to that 10% mark—I figured most would clump together in the 8% to 12% range, and sure, you’d have a few outliers.
The more I dive into understanding stock market returns, the more I realize that there are often very focused “magic stocks” that are responsible for most of the results. For instance, when you look at Jeremy Siegel’s study of the top quintile of dividend stocks delivering the best total returns over the super long term, it is important to understand that one particular company—the old Philip Morris—played a key role in … Read the rest of this article!
The 1998-2000 time period should be our best friend for helping us understand the important connection between price and value. Coca-Cola stock, which has grown earnings per share by 7.2% and paid out 2.8% per share in dividends during the past twenty years, has not delivered 10% annual returns but instead has only delivered 4.8% annual returns because the P/E ratio was over 50 at the start of the period. On the other hand, Starbucks stock traded at 30x earnings in 1995 and has delivered 21.2% annual returns since then.
From a margin of safety perspective, there is a list of risk inherent in paying over 30x earnings for an investment in any company because it means that you need to achieve 15-25% annual growth to achieve exceptional returns. The main problem is that, if the growth does not materialize, the P/E ratio slides back down to the 15-20x earnings … Read the rest of this article!