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15 Mar 2011 14:07
The price you pay for an asset will determine how much money you make out of it. If you pay too much for a property or a share, it will take longer to make your return.
If you pay a fair value you will receive a return in line with the long-term average, and if you buy it at a discount, you will see above average returns.
This all seems rather simple, yet people lose sight of this concept all the time, as demonstrated by the returns from some global companies since 2000.
While leading global companies have increased their earnings by more than 100% over the last 10 years, their investors have seen virtually no returns.
At a recent presentation, Coronation portfolio manager Gavin Joubert put up a slide that compared the share price and earnings of some large US and UK companies between 2000 and 2010.
The figures are extraordinary and teach a very valuable lesson about pricing an investment.
In 2000, global IT firm Cisco was trading at a share price of $38,25. This gave the company a price-to-earnings ratio (P/E) of 81,4. That means it would take over 81 years of earnings per share to cover the share price. The long-term average of the Dow Jones is around 16X.
Ten years later the share price was trading at $19,20, investors had halved their money. But the interesting figure to look at is what happened to Cisco’s earnings over that time.
The earnings from Cisco in 2000 were 0,48c per share; 10 years later this was 166c - a massive 246% increase.
The share price has certainly not reflected the growth of this IT giant, which has performed extremely well. If investors had paid a reasonable price for the share they would have made a lot of money over the last 10 years.
In 2010 Cisco was trading at a P/E of 11,6x—below the long-term average, and far below the 81,4X it was trading at 10 years earlier.
If an investor had bought Cisco at a similar P/E rating in 2000, they would have paid just $5,57 per share. That means over 10 years investors would have nearly tripled their money.
Other examples include Coca Cola, which has seen its share price flat over the last 10 years, yet grown earnings by 143%.
Vodafone’s share price fell a massive 56% over 10 years, yet its earnings are up an extraordinary 680%. With those earnings, Vodafone was clearly a share to have in your portfolio, but not at a P/E of 174! Ten years later the share price is trading at a P/E of 11,1X.
Even shares that looked “reasonable” relative to some of the overvalued companies have seen their earnings far outrun their share prices. IBM, for example, was trading at a relatively “cheap” 19,1X in 2000.
It did perform better than most in at least delivering a total 17% return over 10 years, but nothing compared to its earnings, which are up 158% over that time.
Tesco managed to deliver 59% to investors over the last 10 years, yet this is lacklustre compared to the 191% growth in earnings. Its P/E ratio has moved from 24,1X to 13,4X.
Differentiate between a great business and a great investment
What this teaches us is that value of investing really is the key to long-term returns. In a recent article, Cannon asset manager Adrian Saville writes that investors fail to differentiate between a great business and a great investment.
For example, Vodafone may have been a great business but at a P/E of 174, it was a very poor investment.
“A perverse behavioural attribute of many market participants is that they often want to buy more of a stock as prices rise and go ever higher and, when prices fall, they want less or want out. This behaviour turns the foundation of successful investing—buy low and sell high—on its head. In this vein, over-paying for shares turns a great business into a bad investment,” says Saville.
Saville says an effective way to manage this investment risk is the Graham and Dodd P/E ratio. A maximum ratio of 16 is advised for investment purchases. “This flags a number of much-loved companies in South Africa that are priced on very demanding multiples and, whilst they may be world-class businesses, they are priced for perfection which leaves the investor naked to the risk of disappointment.
“Such examples include Naspers, Capitec and BHP Billiton. Amongst others, compellingly priced businesses include the under-loved building and construction firms, Aveng and Group 5, as well as Anglo American and Grindrod, to name a few,” says Saville.
While you do not want to be timing the market based on global or local events, you do want to be investing at reasonable valuations because that is how you will make money over the long-term.
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