One of the oldest Wall Street aphorisms is this: “A stock does not know you own it.” Usually, this quote crops up during a conversation between someone who got burned by an investment in a particular company and another person that is looking to initiate a position in that company.
I’ve always shied away from using the phrase “A stock does not know you own it” because, in my experience, its connotation has always been negative, involving some investor lecturing someone else for making a bad investment.
The classic case study example of this is General Electric. Over the past five or so years, it has really burned investors. That is because the company’s P/E ratio has fallen from above 20 to 16 while simultaneously experiencing a horrific liquidity crisis in 2008 when the GE Capital arm of the company almost brought the industrial side to its knees as a result of excessive leverage employed leading the crisis.
Fast forward to June 2013, and often we see conversations like this:
Person 1: I’m about to buy General Electric.
Person 2: Stay away! It burned me over the past five years. That company will be dead money for you at best.
Person 1: (In a snotty voice) Yeah, well, a stock does not know you own it. You should have been more careful in your due diligence process.
I hate those kinds of emotional load-isms. That’s why I do not usually use the phrase “a stock does not know you own it”, even though it contains a lot of truth. When we purchase a stock, there are five things that should be swimming through our minds: the current profits, the future profits, the quality of those profits, the likelihood of our predictions being right, and the price we are willing to pay. Those factors are straight out of the Charlie Munger textbook.
General Electric didn’t work out for investors five years ago because earnings cratered (thanks to GE Capital) and the valuation multiple was higher. Now, the company has a $200 billion backlog, is diverting all of its future profits to the industrial side, and is actively shrinking GE Capital. That changes the calculus considerably.
Right now, analysts are predicting that General Electric will generate $1.20 per share in dividends relative to $2.70 in earnings per share by the end of 2017. At the current price of $23 per share, that means a future dividend yield on cost of 5.21% and a future earnings yield of 11.73%. Your job is to check out your understanding of the business, determine the likelihood of those analyst estimates being right, and then decide whether that would be a satisfactory return on your investment from a risk-adjusted basis standpoint.
That framework state of mind is important because it takes the emotion out of stock selection. As Warren Buffett said, “the investor of today does not profit from yesterday’s growth.” Likewise, an investor that buys General Electric today is not harmed by the overvaluation around 2000 or the collapse of GE Capital five years ago. It is all about the interaction of current profits, future profits, and the price you pay today.
Everyone has their own mental devices for taking the emotion out of investing. My secret is this: I ask myself what the future profits of the firm will look like in relation to today’s stock price. That keeps it simple. It strips out bad memories from the past. But most importantly, it allows you to invest without emotion.
Originally posted 2013-06-21 20:50:39.