THIS ARTICLE WAS WRITTEN BY DAVID GOH
What would you do if you had a dollar in 1983?
For starters, one could invest in several of the following options:
- An Index fund
- Treasury bonds (risk-free)
- Cherry pick the best of Corporate America
In hindsight, the answer seems obvious. A dollar invested in 10Y Treasury (rolling forward each decade) would return $10 in 2013. Likewise, $1 put into a 30Y Treasury would return $29. In contrast, $1 invested in S&P Index would only return $23, which was worse off than a risk-free 30Y Treasury bond.
The best way to invest the dollar would have been to cherry pick the best of what Corporate America had to offer. The same dollar would return $86 if one had invested in Wal-Mart Stores Inc (NYSE:WMT), $69 in The Coca-Cola Company (NYSE:KO), $67 in Johnson & Johnson (NYSE:JNJ), and $58 in McDonald’s Corporation (NYSE:MCD). These out-sized returns were at least two times that of the S&P index and a 30Y Treasury bond, which show the importance of stock picking – and more importantly, to justify our presence as stock pickers.
Return of a Dollar Between 1983-2013
What’s more interesting was that if you had invested the same dollar three years earlier in Wal-Mart, you would have earned $287 over 30 years – versus $86! This links to my second point that even if it was the best of Corporate America, one should never overpay for a company!
What changed over the three years was that earnings yield (E/P = EPS/Market Price) of Wal-Mart had depressed from 5.4% (18.5xP/E) in 1980 to 3.2% (31.3xP/E) in 1983. However, despite the compression, the company was still able to grow its earnings at an astonishing cagr of 17.7% between 1983-2013. Not many companies in the world can achieve this kind of remarkable growth over a substantial period.
Return of a Dollar Between 1980-2010
Take Coca-Cola – one of the finest companies in the US – for instance, if you had invested in the company at a low earnings yield of 2.2% in 1997, you would only achieve a low CAGR of 3.6% between 1997-2013 versus S&P of 6% over the same period.
Even the mighty Wal-Mart only returned 2.4% CAGR between 1999-2013 if you had invested at an earnings yield of 1.7% in 1999. Unlike the 17.7% growth rate between 1983-2013, earnings merely grew at a 7.8% cagr between 1999-2013.
Looking at a longer horizon of 80 years, S&P had returned ~10% annually, forming a strong basis for the right discount rate to apply. If a company could not return at least 10% annually, it would be better off to just invest in an Index – saving the trouble (and risks) of stock picking. To earn 15% CAGR over a substantial period, the company must have done something “magical” (like Wal-Mart) or that we purchase the company at a reasonable valuation and preferably with a “margin-of-safety”.
There are two scenarios when we can purchase a good company cheaply. First, the company hits a brick wall as it confronts structural problems, resulting in a turnaround situation. Second, the whole market (for example China now) is unloved. The poor macro factors result in a temporary slowdown, which the company could adapt to and recover quickly as growth resumes. The latter seems to be less complex – and preferred – situation. To quote the Sage of Omaha: “Turnarounds seldom turn”.
We can see from the previous examples of Coca-Cola and Wal-Mart that returns would be anaemic if you overpay for earnings. And from empirical data, the figure for poor performance seems to lie somewhere along 2% (50xP/E). If 10% was the right discount rate to use and you purchased a company (even the best of the best that Corporate America has to offer) at an earnings yield of 2%, it would imply that the company would need to grow at a terminal growth rate of 8%. Or put it in another way, a company would need to grow at a 17.5% CAGR for the first 10 years and a subsequent terminal growth of 2%. How many companies can achieve that? Not many, I guess.
A safe arbitrary number to pay for an excellent company lies somewhere near the 5% figure, which implies a 10% discount rate with a 5% terminal growth rate (a reasonable number slightly ahead of inflation).
Value In Action
In Asia, due to the relatively shorter history of the stock markets, not many companies have market history that could trace back over three decades. Nonetheless, the principle of cherry picking the cream of the crop at a reasonable valuation should apply. Our job as stock pickers is to find the next Wal-Mart or Coca-Cola in Asia.
For example, in China, Sun Art Retail Group Ltd (HKG:6808) is the largest hypermarket operator, and Tingyi (Caymen Islands) Holding Corp (HKG:0322) and Uni-President China Holdings Ltd (HKG:0220) are the two largest beverage players. With over four times the population of the US, the potential of these finest companies in China is immense.
The message is simple: The right way to invest is through cherry picking the best companies, but never to overpay. Have patience and wait for the right price.
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All views and opinions articulated in the article were expressed in David’s personal capacity and do not in any way represent those of his employer and other related entities. David does not own any shares in the companies mentioned above.