There is a very important reason why this site focuses on individual companies instead of, say, gold or treasury bonds. The reason is simple: actual businesses come with a growth component that does not exist when you buy gold or treasury bonds. An ounce of silver, gold, or palladium in 2114 will still be…an ounce of gold, silver, or palladium. A 5% payment on a U.S. bond, or a Wells Fargo corporate bond, will still be returning 5% of your cash outlay next year, the year after that, and until the specified duration of the terms comes to an end.
But I was curious: If you were seeking the same total returns with stocks as bonds, what is the handicap between a basket of American stocks, measured against a basket of corporate bonds and US Treasury bills? It’s a question that gets ignored because the answer is necessarily imprecise—what’s the holding period? What’s the growth rate? What’s the P/E multiple at the start of the period? What’s the start of the P/E multiple at the end of the period?
Here’s what I know: From 1800 to 2000, inflation ran at 3.4%. Stock returned 10.0%. Gold returned 4.1% (this fact, incidentally, is why you don’t see many value investors hold gold in their portfolio; they know what kind of lagging returns are inherent in something that doesn’t experience a growth component). Bonds issued by American corporations returned 7.0%, and bonds issued by the United States government returned 6.1%.
If you were trying to answer the question, “What’s the greatest way to build long-term wealth?”, then you are going to have a significant advantage by construction a basket of stocks of companies with superior business/growth characteristics. After all, if a stock of ordinary quality can return 10.0%, you have at least a three percentage advantage over an ordinary corporate, and almost four percentage points over bonds created by the United States government.
In other words, for almost the entirety of the republic’s history, you could get a risk-free 6.1% return from the US Treasury (the last times you could this in reality were 2000 when thirty-year bonds yielded 6.5%, and you could have come pretty close in March 2002 when long-term U.S. Treasuries yielded 5.8%.
At what point in time would blue-chip stock performance become worse than this ordinary 6.1% rate?
A few dummy samples: In 1998, Coca-Cola traded at 51.3x profits. That was seen as a hysterical high tipping point, the kind of overvaluation insanity that shows up two, maybe three times in a lifetime. Of course, what makes Coca-Cola interesting is that it grew profits from $0.71 in 1998 to $2.08 at the end of 2013. Bonds, by definition, can’t do that.
For someone that purchased Coca-Cola at the height of the madness, they would have received returns of 4.04% today, counting the dividends paid out but not reinvested. In other words, paying $50 for every profit for a company that investors would eventually come to pay $20 for every dollar in profit, even when the business is superior, is not give you the returns of ordinary Treasuries in American history.
But do take note of this: if you do overpay, time eventually starts to absolve you of your sin of overpaying for the stock. For instance, let’s take a look at how the total returns gradually improved with the passage of time, gradually erasing the sin of overpaying.
In 2003, five years into the Coca-Cola investment, you would have been down 4.09% annually, turning every $10,000 invested in Coca-Cola into $7,900. By 2007, however, you would have been down only 0.70% annually, giving you $9,600 in 2007 based on your $10,000 investment in 1998. By 2011, you were into positive territory, as your Coca-Cola investment had grown 2.34%, turning your $10k into $13.6k. By 2014, the return had become 4.04% per year, turning your $10k into $19.1k.
Here’s what happened: the valuation for Coca-Cola shifted from $51 per $1 in profit to $20 per buck in profit. In other words, when Coca-Cola was making $0.71 per share in profits back in 1998, investors were willing to pay $36.21 per share. Really, though, their business more appropriately reflected a value of $14 per share. Okay, so paying over twice what a stock is worth, even for an excellent company, is not wise, but does start to work out gradually as you expand your time horizon.
What, though, if the overvaluation is more modest? Let’s look at someone like Colgate-Palmolive, which traded at 33x profits in 1999. That’s still problematic, but it’s not the same absurd territory as Coca-Cola experienced in 1998.
From 1999 to 2005, Colgate returned 6% per year. From 1999 through 2010, Colgate returned 8.7%. And from 1999 through 2014, Colgate returned 10.7% annually. That’s much more interesting; when Colgate, a superior business, experienced P/E compression from 33 to 25 (in other words, a premium in the 24% ballpark), you still got returned equal to U.S. Treasury averages at the five-year mark, and from then, the growth of the business started to take over and deliver returns superior to the 6.1% long-term U.S. bond threshold.
What about something like Johnson & Johnson? Like its peers, Johnson & Johnson’s stock prices got absurdly bid up by investors in 1999, to slightly over 31x profits. What is interesting though, is that Johnson & Johnson kept growing earnings by 8.5% and dividends by 11.5%. Eventually, Johnson & Johnson has settled in at a valuation of 19x profits. So the dilemma is this: What happens if you paid a 38.7% premium for JNJ shares, but also got to hold on for the ride as you get drenched in higher dividends and profits continued to grow every year without missing a beat?
Well, from 1999 to 2004, Johnson & Johnson investors achieved returns of 7.84% annually, because of that rapidly increasing dividend payout and growing earnings. By 2008, the total returns continued to come in over a full percentage point above long-term U.S. Treasuries, turning your $10k in 1999 into $19.2k in 2008. And by 2014, the total returns reached 9% annually, turning your $10,000 in 1999 into a bit over $37.8k today.
There’s a reason why Yacktman, Munger, and Buffett don’t sell stocks when they come 15-25% overvalued. People say things like, “Why would you hold a stock if it is selling at a higher price than it is worth?” And it has to do the fact that stocks of high-quality businesses selling at a 15-25% premium still tend to deliver returns above the risk-free rate of return delivered by bonds during two centuries of American data. The real, significant impairment doesn’t seem to begin until you start doing things like paying a multiple of 40+ profits for blue-chip stocks, as we saw in the Coca-Cola example. My lesson learned would be this: With excellent businesses, you don’t worry about 15-25% prices above fair value. That shouldn’t be cause to sell when you’re dealing with one of the best companies in the world. However, once you start seeing your company trade at a 50% premium to value, then the wisdom of selling even an excellent company starts to become apparent.
My guess, though, as to why a most people receive inadequate returns is twofold: first, there can be a tendency to sell low, when you believe that a falling stock price is actually indicative of a collapsing business. The other mistake is the tendency to want to lock in gains, and sell the moment your stock trades at a premium. That kind of logic will prevent you from ever being the person that turns a $10,000 check for Johnson & Johnson stock in 1970 into a $2.1 million fortune in 2014 (even if you waited to start until the early 1980s, you still could have turned $10,000 in Johnson & Johnson into over a million-dollar fortune today). If your time horizon is sufficiently long, I think Johnson & Johnson at a 20% premium would beat a typical government bond, but I also understand this isn’t the textbook advice in this area, and you could be wise to do different.