If you are a regular reader of the site, you’re probably not trying to answer the question “how can I make as much money, as fast as I can, at any cost”, but rather, you’re probably after a satisfactory investing strategy that answers the following question: “How can I craft an investing strategy that will not only provide sustainable gains for the long haul, while also doing it in a style that will leave me generally content and allow me to live without regrets?”
The answer to that question is a two-step process; the first simply involves thinking about the long term in the first place. To paraphrase Seth Klarman—the greatest advantage that the average guy with $1,000 here, $10,000 there, or even $250,000 on the horizon, can get himself compared to the average professional on Wall Street is to adopt a truly long-term perspective that thinks in terms of decades, not months or quarters. That’s what makes all of this racket so funny: everyone and their mother knows that, come 2024, Coca-Cola, Nestle, and Johnson & Johnson will create wealth at a rate in excess of inflation, but the question they can’t answer with any certainty is whether those three stocks will beat the S&P 500 over the next 12 months, 24 months, or 36 months. And that’s why people end up arguing whether Coca-Cola is worth $35, $40, or $45, whether Johnson & Johnson should trade at $90 or $110, and so on.
But even if you do adopt a truly long-term orientation, you may still be left wondering: What if a buy something now, and then have to deal with it falling by 25% or 30% in the next year or shortly thereafter? Here is the problem with focusing on that metric: It suggests that you are focusing on the sale-ability of the asset rather than the performance of the asset. If you choose to go there, you’re putting yourself in a position where you’re unlikely to ever be happy with your investments because you’re always worrying about the conditions under which someone would take the asset off of your hands.
There are two things you do to make peace with the notion that the price of a stock you buy could fall within a short amount of time of you purchasing it. The first is to focus on what will happen ten years later to the asset—recognize that the current time period is a but a blip on the journey. I’m not being glib when I say that.
Let’s use BP as an example, and apply a “ten-year test” to it (ten years is the shortest amount of time I would consider acceptable to start weighing the usefulness of an asset and the point at which proper valuation should be reached absent highly specific extenuating circumstances). We’ll step back in the wayback machine to 2004. At the time, BP was an asset on par with Exxon and Chevron. Essentially, it was Great Britain’s petroleum king. At the time, BP dividends represented 10% of the entire income in the entire British system. You’d have to go back to the glory days of AT&T to find something equivalent to that in the United States.
And, what happened over the coming decade? First, you had the 2008-2009 commodities bust as the world experienced either the second or third worst recessionary period in the past century, counting the Great Depression and possibly the 1973-1974 period depending on which metrics you choose to define “worst.” And then, of course, there was the oil spill that has caused BP billions of dollars and a legal settlement that still hasn’t been reached. It involved price plummets, dividend eliminations, dividend cuts, and a slow path back to dividend growth in the meanwhile.
Yet, what happened to someone that bought BP in 2004 and held through today? They would have compounded their wealth at 4%, turning a $10,000 investment into over $14,600 in the past ten years. Given the enormity of the bad things that have happened to BP in that interim, the results are outstanding. The stock fell from $62 to $50 today, the $0.84 quarterly payout got eliminated and then cut in half of its norm after the oil spill in 2010. Yet the current annual payout of $2.34 is much higher than the annual payout of $1.66 in 2004. Most people aren’t trained to think like this, or study this, but if you do, you will see how building wealth becomes much easier, with a much higher probability, if you are willing to stretch your time frame out.
The second thing you can do is focus on the underlying profitability of the company that is experiencing a decline in price. Unless it is a cyclical stock, usually the profits aren’t getting whacked the way that the stock price is. For instance, Clorox saw its stock price fall from $65 to $45 during the 2008 to 2009 stretch, yet the company’s profits per share actually increased from $3.24 in 2008 to $3.81 in 2009. And the dividend payout of $1.66 in 2008 became $1.88 in 2009. The profits and dividends were going up—the business was improving before your very eyes—yet the price to acquire ownership was becoming more attractive. You can’t get upset when someone else irrationally sends the ownership value of something you own down—if you have a diversified portfolio, it will happen to some degree with something you own during every day of your investing life—but you should know that the period is easy to work through when you own a company with brands you clearly understand that is in the act of growing dividends and profits while the price is simultaneously going down.
Focusing on the underlying profitability of companies you own and expanding your time horizon is the easiest way to find contentment with what is going on in the stock market on a given day. Heck, even Berkshire Hathaway experienced four 50% declines under the stewardship of Warren Buffett, for heaven’s sake. It’s part of the game; a test that separates those who mean when they say they understand the underlying businesses of the companies they own from those who only have a vague commitment to that principle but really want to experience linear growth in what the ticker symbols report. Additionally, this is where diversification becomes useful: it’s a lot easier to handle BP falling from the $60s to the $30s when it is one stock out of thirty-five that you own, rather than one stock out of five. We’ve been removed from a recessionary stock market for a while now, but it’s the strategies and ideas that you develop and execute now that will make all the difference the next time we get our due.
Originally posted 2014-06-06 15:02:40.