InvestorsFriend Inc. Newsletter August 1, 2010
Good is the Enemy of Great
In investing as in life, “good” and “good enough” are the enemies of “great” and “truly excellent”. In life, let’s face it, more often than not we don’t do our very best work.
There are many examples of this phenomena at work.
The athlete who trains four hours per day might be settling for “good” whereas it might take eight hours per day to become “great”.
Due to time constraints or lack of energy or lack of intense motivation we all tend to complete most jobs to less than a 100% great standard. And most times that is appropriate. Other times we probably should have pushed ourselves a little harder to achieve something great instead of merely good.
Perhaps automobile companies could build cars to much more exacting standards that would last much longer. But the time taken might make the cars unaffordable.
Good is also the enemy of great when it comes to investing. Ideally, you would invest in only the absolute best investment opportunities.
In an ideal world you (or your financial advisor(s)) would examine every investment opportunity in the world and somehow identify a short list of only the absolute best investment opportunities available in the world.
In the real world it’s not possible to construct such a list. Even if 10 of the top analysts in the world were given the time and resources to construct such a list, they would no-doubt come up with 10 very different lists.
In the real world investments always tend to get added to our portfolios in less than a perfect way. Some investors may be selecting investments after very substantial analysis – but which still must fall short of the ideal world scenario described above. Other investors may be selecting investments in a completely haphazard fashion – a tip from a friend here, a stock mentioned in an investment newsletter there, and so on.
Just because a company is likely to be a “good” investment does not mean that you should invest. Ideally you would restrict your investments to “great” opportunities and eschew the merely “good” opportunities. Your money can’t make 10% if it is all tied up in companies destined to make closer to 6%.
Remember, there’s a company under that there stock
Most investors appear to invest as if a company’s shares were not really very much connected to the actual company.
When you ask for a graph of a company’s performance you will almost certainly be given a graph of the share price performance over the years and not a graph of how earnings per share have grown (or not) over the years. And as a typical investor, that is what you expected to see.
My belief is that if a company grows its earnings at a strong rate then, unless the shares started out way over valued, the share price will take care of itself by following the earnings per share growth upwards over time.
If you owned your own business it is likely that you would keep a close eye on its earnings and you would not be primarily concerned with how much you could sell the business for. Yet when people own a small share of a business they seem to obsess about the price at which the shares could be sold and pay little attention to the actual earnings per share of the business.
What return can you expect to make in stocks?
There are ways to calculate the return that you might reasonably expect on your stock portfolio. The calculations require you to make certain assumptions.
Consider my own portfolio. It has an overall P/E of 16.0. This means that the earnings yield is 1/16 or 6.25%. One estimate of my expected return is this 6.25%. If all of the shares that I own paid out all of their earnings and dividends and if therefore the earnings would not grow and if I expected to sell the shares at some point in the future for the same 16.0 P/E then my expected return would be 6.25%.
However my portfolio only dividends out an average of 32% of the earnings. The rest is retained and reinvested by the companies I own shares in. The weighted average ROE of my portfolio is 14.1%. If I assume that the retained earnings will also earn this same 14.1% ROE (which is only an assumption), then the earnings on my portfolio should grow at about 14.1% times (1-0.32) = 9.6%per year. For each of my stocks I have estimated a reasonable lower and higher estimate of the P/E at which I might sell those shares. Applying the 9.6% growth rate, the dividends and the assumed selling P/E I can calculate that my expected return is 10.3%.
If I hold these shares for five years and if they continue to earn their current ROEs and if they can be sold at the P/E ratios that I have estimated then I can expect (but am certainly not guaranteed) to earn an average of 10.3% per year. In any given year I certainly can’t expect to make 10.3%. Actual returns tend to be volatile as share prices move around.
While my expected 10.3% per year average return is not guaranteed it at least gives me some basis in reality. If I hope to make 20% then I had better be planning to trade astutely because there is no rational basis to assume that the portfolio that I now hold can earn me an average of 20% per year.
See our new Article that explores in detail the question of how much return to expect on a stock based on its ROE, the dividend policy, the P/E ratio paid to acquire the stock and the P/E ratio at which it might be sold after a five year holding period.
Beginning Investors
At InvestorsFriend we fully recognize that not everyone is a seasoned do-it-yourself investor. We have an article on how to get started investing in stocks.
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Shawn Allen, President
InvestorsFriend Inc.
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