One of the Most Important Lessons When Buying Stocks
InvestorEducation / Learning to Invest Jul 12, 2015 - 07:30 PM GMTBy: DailyWealth
You're not going to succeed in the stock market by just buying the world's best businesses...
For the past several years, my colleague Dan Ferris and I have urged Extreme Value readers to buy great businesses... Businesses that gush free cash flow, reward shareholders, have great balance sheets, earn consistent profit margins, and have high returns on equity.
But if you pay too much, even a fantastic company can turn into a mediocre and possibly terrible investment...
That's why we also tell readers to never buy a great business until it's trading at a cheap price. This is a discipline I impose upon myself and encourage you to embrace.
To see just how a great business can turn into a mediocre – and even terrible – investment if you pay too much, let's look at American candy icon Tootsie Roll Industries (TR)...
We've never recommended Tootsie Roll, but Dan and I have followed the high-quality business for years. Tootsie Roll's results don't change much from year to year or decade to decade. Since 2005, revenue and free cash flow (FCF) have compounded at low levels of about 1.5% per year. Since revenue doesn't change much year-to-year, neither do dividends or shareholder equity.
Return on equity, or "ROE" (using free cash flow instead of the usual net income because the business is capital-intensive), is routinely a strong 15%-20%. Occasionally, when manufacturing equipment is updated and capital expenditures exceed 2% of revenue, the ROE drops to 5%-10%.
Since things don't change much operationally, it's crucial you buy shares at a cheap price. Otherwise, you lock yourself in for years of meager returns, despite the regular cash and stock dividends.
Let me illustrate...
Right now, shares trade around 24.5 times trailing 12-month free cash flow. That's expensive for outside passive minority investors like us.
If you'd bought Tootsie Roll in 2005, you'd have paid a similarly expensive multiple. Shares ended that year at $28.93, valued near 23 times FCF.
Since then, approximately $10 in cash dividends and stock splits would have reduced your cost basis from $28.93 to $18.66. (Capital returned to you lowers your cost basis dollar for dollar.)
At the end of 2014, shares closed at $30.65. That produced a compound return of just 6% per year over the full nine-year holding period. At Extreme Value, we want our investment capital to earn double-digit compound returns of 10% or better.
It was the same story if you bought in 2010. Shares were trading near $29 and at an expensive 23 times 12-month FCF. By the end of 2014, your cost basis would have been reduced to $24 by cash dividends and stock splits. Again, that's a compound return of only around 6% per year over the four-year holding period.
If you had bought when shares were cheap, though, it would have been a different story entirely...
Shares temporarily dropped to $20 in 2009 and the valuation multiple was a much-lower 15 times FCF. Since then, cash dividends and stock splits would have reduced the cost basis to about $13.68... and the compounded return on investment would've been closer to 18%, not 6%, per year.
This is one of most important lessons I can teach you about buying stocks: A great business is a great long-term investment only if you buy it when it's unusually cheap. Pay too much and you're doomed to underperform, or possibly even lose money.
This is why you should be choosy about making new trades. Stock prices have soared the past six years so most individual stocks are still too expensive to buy today.
In short, if a great business you want to buy is expensive right now, be patient. Prices tend to fluctuate. Eventually, you'll get a chance to buy it at a price that will also make it a great investment.
Good investing,
Mike Barrett
The DailyWealth Investment Philosophy: In a nutshell, my investment philosophy is this: Buy things of extraordinary value at a time when nobody else wants them. Then sell when people are willing to pay any price. You see, at DailyWealth, we believe most investors take way too much risk. Our mission is to show you how to avoid risky investments, and how to avoid what the average investor is doing. I believe that you can make a lot of money – and do it safely – by simply doing the opposite of what is most popular.
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Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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