Back in 2003, Microsoft stock traded in the $20s. And guess what happened? It continued to do so every year for the next decade that followed. Between 2003 and 2013, there was at least one trading day in each year in which the software giant traded in that price range. During this 2003-2013 stretch, Microsoft’s earnings grew incredibly from $0.97 to $2.65 per share. The profits quadrupled!
As Seth Klarman once said in Margin of Safety:
“Investors are sometimes their own worst enemies. When prices are generally rising, for example, greed leads investors to speculate, to make substantial, high-risk bets based upon optimistic predictions, and to focus on return while ignoring risk. At the other end of the emotional spectrum, when prices are generally falling, fear of loss causes investors to focus solely on the possibility of continued price declines to the exclusion of investment fundamentals. Regardless of the market environment, many investors seek a formula for success. The unfortunate reality is that investment success cannot be captured in a mathematical equation or a computer program.”
Based on the questions that I have received since founding The Conservative Income Investor, I am continuously amazed by how many people look to the price of the stock itself rather than the net profits or other critical business performance to determine the quality of their investment.
When a stock has gone up 20%, people ignore the bad news because hey, the price went up, so it can’t be that mad. When the price goes down 30%, people feel like they made a dumb investment, and often forget that they owned shares in a perfectly profitable business that’ll be around for the long haul (look at the Aflac, BHP Billiton, and Gilead Sciences stock forums on places like StockTwits when their share prices were low. People act like earning $2 billion in profit instead of $3.5 billion to match the previous year is the same thing as a bankruptcy event that wipes out the shareholder base, the type of conflation that makes it absolutely impossible to build any kind of real meaningful wealth over a lifetime.
If you looked at Microsoft’s numbers five years ago, you would seen the incredible amount of share buybacks that were reducing the share count by 3% each year, the core earnings were growing at the rate of 8% per year, the Microsoft suite of Office products was as dominant as ever, and the cash hoard exceeded $85 billion (which has since almost risen to $150 billion). The net profit margin during this time period comfortably in the 25-30% range.
This is what I tell myself: If one of the most objectively successful businesses in the world, flush with cash, high profit margins, and a dominant market position, is capable of stagnating in price for over a decade, no investment performance is timely guaranteed just because the business itself is performing well.
Price declines and extended stagnation in the price of a given stock is the necessary condition for superior returns. The reason you can get 10% annual returns from a stock rather than 2% from a savings account is because you are willing to accept the absence of a guarantee. Stomaching the volatility is what must be endured for those higher returns.
Warren Buffett once said that the stock market is a gradual transfer of wealth mechanism from the impatient to the patient.
In my entire life of studying stocks, I can think of any business whose stock I would want to discard if its stock price fell while the net profits were correspondingly growing or at least steady.
It is easy to picture someone discarding their shares of Microsoft in 2013, thinking, “Hey, this stock hasn’t gone up in a decade. I’m just sitting here collecting the dividend.” If you made that decision to sell, the investor who scooped up the shares would have compounded at a rate of 22% annualized over the next five years. You would have been the patient one with nothing to show for it; the guy who came along would’ve profited from your patience (enabling him to enjoy part of the meal while you paid the whole tab).
The common criticism is: “Okay, well ten years is a fifth of the typical investing lifetime. What am I supposed to do when the price stagnates?”
The answer is “hold, and maybe buy more” which can be facilitated by two things: (1) diversification of investments, so that some stocks increase in value to offset those that stagnate; and (2) further development of your primary cash-generation asset, which may be enhancing your skills in your job or growing the business that you operate.
I still remember when I found that 2012 Dalbar study that indicated most mom and pop investors are effectively traders that buy and sell stocks every six months, and they have paid the price by only earning 3% annual returns during the 1992-2012 stretch when the S&P 500 delivered annual returns just shy of 9%.
It left an impression on me because it provided concrete data indicating that, despite every website’s bromides about long-term investing, most people really just want to be told what will go up in the next 12 months and aren’t really interested in the see-saw total returns that come with patience but are capable of turning $10,000 investments into $250,000 if held over the course of a lifetime.
If you are tempted to sell a stock, out of dissatisfaction with the stock’s performance, pull up the annual report and see what the net profits have looked like over time. I’ve always found it crazy to trash-talk and loathe a company for its performance when it is selling more products and services each year, keeping a profit net of expenses, just because it is not meeting the expectations of an outside observer.
Successful investing isn’t about IQ. It’s about patience.