It’s funny to me how the exact same actions can result in wildly disproportionate outcomes depending on the circumstances that surround it. One stock-market example of this is the price you pay to acquire your ownership position in a given stock.
Let’s say you read the annual report of General Electric stock and concluded that it is a company worthy of a $25,000 investment.
If you made that decision in 2010, you paid $15 for each share of the stock. You would own 1,670 shares of the stock.
If you made that decision in early 2015, you paid $25 for each share of the stock. You would own 1,000 shares of the stock.
Ignoring, for this exercise, the added dividends that would have been collected from owning GE between 2010 and 2015, the entire future of these investors would have been quite different simply because of the time at which they initiated their purchase.
Imagine if GE delivers 8.5% annual returns between 2016 and 2040. The 2016 through 2040 compounding returns from the investor that got the 2010 purchase price would result in $331,000 in final wealth. The investor that paid the $25 per share price would end up with $198,000 in net net wealth. And again, this is without taking into account the wealth that would have been created by owning and reinvesting GE dividends from 2010 and 2015. This is only a comparison of per share compounding that compares a $15 per share price to a $25 per share.
Both investors owned that stock for 24 years–owned the same wind turbines, the same light bulbs, the deepwater drilling machinery, the same electronic imaging technology–and yet one ended up with 1.67x as much wealth simply because of a better starting price. The same process: Save money, study for an attractive to business to purchase, and then buy it, created vastly different results. The effort expended was the same, but the terms of the deal altered the results. It’s worth thinking about for awhile because it’s often the small things that can lead to dramatically different results.
I had this principle in mind when I studied American Express. Because the credit card industry is subject to rapid shifts in sentiment, American Express does not trade at a typical P/E ratio year in and year out. This isn’t a situation like General Mills where the P/E ratio is between 17x earnings and 21x earnings throughout almost every point in the business cycle. American Express can trade at 12x earnings. It can trade at 15x earnings. It can trade at 30x earnings.
This fluctuation means that owning American Express for the long haul results in drastically different outcomes based on purchase price. If you bought American Express in 1972, when sentiment was high, you spent 40+ years compounding your money at 9%. That’s by no means a tragedy, and would have contributed nicely to your fortune, but it’s not the kind of result that would steer you away from S&P 500 index funds. Meanwhile, someone who bought American Express in 1992, around the time Warren Buffett was adding to Berkshire’s position, would have compounded wealth at 13% over the past twenty-two years. And if you truly nailed it, buying American Express in 2009, you would have earned 22% annual returns over the past six years while the S&P 500 delivered 16% annual returns.
What catches my attention about the current trading period is that sentiment surrounding American Express is low because of the lost Costco exclusivity and the superior revenue growth generated by peers Visa and Mastercard. It’s created a situation where American Express is expected to generate $5.60 per share in 2015 profits while trading at $77 per share right now. That is a P/E ratio of 13.75.
That’s the kind of valuation range where American Express tends to generate superior returns. It traded at 13.75x earnings in 1985, and then went on to generate 11.6% annual returns through 2015. And because the stock is moderately cheap, those long-term returns may be understated: If American Express goes up to $110 per share, suddenly the cumulative compounding becomes almost 13% over the past thirty years. I am especially interested in the management guidance that the company will grow 12% or so annually after being expected to deliver no growth this year.
If American Express hits its target of $8 per share in profits by 2020, it will likely trade at something close to 20x earnings. It’s not inconceivable that American Express will be a $160 stock in 2020, plus you’d get to collect a growing dividend stream along the way. Large, profitable businesses under mild stress are a good place to look in the current environment for a company trading at a discount that might beat the S&P 500 over the next sixty months.
American Express has almost doubled its profits since 2010. It’s almost tripled its profits over the past decade. This is a company with a sound track record. But it also hiccups along the way. There are three-year periods you can find during 2007-2009, 1989-1992, and 1972-1975 in which the company delivered no earnings growth. Investors get scared or disinterested, and leave. This is a mistake because the business struggles give you a gift: A nice initial entry point. If you wait for the business to grow 12% a couple years in a row, the discount will disappear.
It seems to be a timeless lesson. Value investing is almost always accompanied by something going wrong, either with the company specifically or the economy in general. Certainly, you wouldn’t want these conditions to continue indefinitely. But they do provide something important–an opportunity for you to be the General Electric investor that ends up with $331,000 in 2040 instead of $198,000.