Today, many continue to prioritise “price” over “quality” when it comes to stock investing.
Such is evident as most want to know if a stock is undervalued or overpriced for the moment. Less focus is on the stock’s fundamental quality. Such behaviour is understandable if your holding period is short (less than 3-5 years). However, as ultra-long term investors, price is less of a concern.
As you know, I’d been studying the investment letters of Fundsmith. The edition of its 2017 letter includes a quote by the late Charlie Munger:
‘Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.’
So, what matters is the stock’s efficiency in using capital to earn profits over the long-term. This comes first. Price comes later.
In this article, I’ll perform a simple experiment to verify and explain the concept so that we all can focus on what really matters in compounding wealth via good old value investing.
The Base Case
Let’s say we have $200,000 in capital. We split it equally and invest into 2 stocks namely, Stock A and Stock B. Both stocks are purely growth stocks and thus, will not pay a single dime in dividends to shareholders. Also, in regards to valuation, both stocks would be fairly valued at P/E Ratio of 20 and this would be constant over the next 40 years.
The difference between them is their long-term Return on Equity (ROE) and the initial investment prices.
Stock A: ROE = 6%; Bought at 50% Discount
At Year 0, Stock A has $100 million in equity and made $6 million in earnings. In this case, its Return on Equity (ROE) is 6%. Stock A retains and reinvests all of its $6 million in earnings at ROE of 6%. Thus, Stock A is able to grow its earnings to $6.36 million in Year 1, $6.74 million in Year 2, $7.15 million in Year 3, and so on and so forth (refer image below).
Stock A issued 100 million shares. Thus, at Year 0, its Earnings Per Share (EPS) is $0.06. Its fair valuation at Year 0 is $1.20 a share (P/E Ratio of 20). However, the thing is – We invested in its shares at $0.60 a share, which is a 50% discount.
Then, we hold onto its shares for the next 40 years. Stock A’s EPS grew by 10x in 40 years from $0.06 at Year 0 to $0.62 in Year 40.
Based on P/E Ratio of 20, the fair valuation of stock A had increased from $1.20 at Year 0 to $2.15 in Year 10, $3.85 in Year 20, $6.89 in Year 30 and finally, when it comes to Year 40, its stock price hits $12.34, which is 20x our initial price.
Link: The Charlie Munger Experiment
Now, if we calculate our total returns based on CAGR, we learn that our returns would gradually decline and reflect Stock A’s ROE of 6% a year in the long-term.
Stock B: ROE = 18%; Bought at 50% Premium
Note: It’s never recommended to overpay for a stock.
For Stock B, it has $100 million in equity at Year 0. It earns $18 million. Hence, it has a ROE of 18%. Stock B retains & reinvests all earnings, but at ROE of 18% for the long term. So, its earnings increased to $21.2 million in Year 1, $25.0 million in Year 2, $29.6 million in Year 3 and so on and so forth.
Stock B issued 100 million shares. Hence, its EPS increased from $0.18 in Year 0 to $0.21 in Year 1, $0.25 in Year 2, $0.30 in Year 3, and so on and so forth. Here, Stock B’s fair valuation is $3.60 and guess what – We’d invested in its shares at a price of $5.40 a share, which is 50% above its fair valuation.
Then, we hold onto its shares for the next 40 years. Stock B’s EPS increased by a whopping 750x in 40 years from $0.18 at Year 0 to $135.07 in Year 40.
Based on P/E Ratio of 20, the fair valuation of stock B had increased from $3.60 at Year 0 to $18.84 in Year 10, $98.61 in Year 20, $516.13 in Year 30, and as high as $2,701.36 in Year 40, which is 500x our initial capital.
Link: The Charlie Munger Experiment
Now, if we calculate our total returns based on CAGR, we learn that our returns would gradually rise and reflect Stock B’s ROE of 18% a year in the long-term.
From $200,000 in Invested Capital
We invested $100,000 in Stock A and $100,000 in Stock B.
After 40 years, our initial investment in Stock A (bought at 50% discount) would be worth $2.06 million. This works out to be a CAGR of 7.85%. As for Stock B, as at Year 40, the value had increased to $50.0 million, which is a CAGR of 16.81%. Such is even after initially purchasing Stock A at 50% above its fair valuation.
But, isn’t 40 years too long? Well, how about this? Here is a chart that depicts a huge difference between Stock A and Stock B in terms of investment value after 10, 20, 30 and 40 years.
So, what are keys to investment success? They are as follows:
1. Focus on fundamental quality. Both stocks have compounded wealth for they are consistent in increasing their profits over the long-term.
2. Between the two, Stock B compounded substantially more wealth for its ROE is higher than Stock A. This is despite Stock B being bought at premium. Thus, it is important to prioritise fundamentals first over valuation.
3. Be ultra-long term when investing. Capitalise on short-term price declines for stocks like Stock B especially in market downturns. There is no need to sell off a stock like Stock B even when it is overvalued for it can continue to compound & further compound wealth over the long-term. (Caveat: Unless of course, there’s a mania on the stock that causes its P/E Ratio to rise to 100x earnings. Then, we would consider selling its shares).
By Ian Tai: Financial wizard with KL Lau.com
