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Creating Wealth with Equities: GETTING THE BEST TOTAL RETURN ON YOUR INVESTMENTS -- Part I

July 25, 2007
Dr. Paul Price

Dr. Paul Price

86 followers

THE PHILOSOPHY

I am of the “Value Investing” school of thought. As in the days of Graham and Dodd, I believe in buying dollars for fifty cents and assets for less than full price. Every stock has a high and low each year. I prefer to purchase near the bottom of this range. Valuations key my stock selection process. Rather than comparing a share’s P/E to that of the “market”, I compare it to its own historical range. When the current valuation is well below normal I will consider ownership. A share in its normal range is the hardest to predict as to future direction. Overpriced stocks are likely to revert downward to more normal levels. “Regression to the Mean’ is thus a key consideration. Unless a clear reason exists as to why “this time is different”, I go on the assumption that it is “business as usual” and historical valuations should prevail over time.

MARKET TIMING IS FUTILE

I am not a “market timer” nor “technical analyst” or “fortune teller”. What the market may do tomorrow or next week is anybody’s guess. Since I don’t trade the short-term market, day-to-day fluctuations are not of great concern except as opportunities to buy or sell at favorable prices.

VALUATION IS CRITICAL

In general, I prefer low P/E’s, high yields, and moderate price/book value and price/cash flow relationships. Different industry groups vary in terms of normal, and my screening techniques allow for these variations. Other factors I use in evaluating securities are balance sheet items such as debt as a percentage of total capital and current ratios.

MANAGEMENT COUNTS

I give a plus mark to any company where management owns a significant stake in the shares, rather than just drawing hefty salaries. It’s comforting to know that they are riding on the performance of the shares right along with us. “Insider” buying is another plus. Multiple Insider purchases are certainly positive. Insider selling is noted, but I consider this a less reliable indicator, as there may be many reasons for selling but only one good reason to buy.

PATIENCE IS REWARDED

Each stock I recommend comes complete with target price projections. Generally, my targets should be reached within 6 to 18 months. What I am really waiting for is for the public to see what is already obvious. It is my firm belief that, over time, most shares revert to their true values. The 1997 change in tax laws concerning capital gains rewards investors for holding longer than 12 months. A top tax rate of 15% on capital gains and dividends is a significant advantage over time.

CREATING WEALTH

You might be amazed at how many times a month I am asked, “How can I achieve financial security?” The average person tends to look for guaranteed returns. Historically, this guarantee has come with an amazingly costly price tag, a much smaller than necessary accumulation of wealth. Let’s analyze two examples to illustrate this point. Our first investor is 40 years old with a 401k, IRA, or other sheltered account with a present value of $100,000. This investor wastes no time opting for an easy, safe and predictable portfolio of 5% US Zero Coupon Treasury Bonds, which are AAA rated, pose not credit risk and have no principal risk. At maturity, assuming no new contributions, our investor’s portfolio would grow as follows.

 

$100,000 compounded at 5% for 25 years

VALUE AT AGE 65 $338,635

Let’s now look at our second investor, also 40 years old with a 401k, IRA, or other sheltered account with a present value of $100,000. This investor has decided to go the “risky route” and creates a diversified stock portfolio, which is not AAA rated and has a principal risk. He divides his money into five investments of $20,000 each. Here are the results, once again assuming no new contributions.

$20,000 was invested speculatively and was lost completely
Value at Age 65
$0
 
$20,000 earned nothing over the entire 25 years
Value at Age 65
$20,000
 
$20,000 earned a mediocre 5% per year
 
Value at Age 65
$67,727
$20,000 yielded a respectable return of 10% per year
Value at Age 65
$216,694
$20,000 did well but not spectacularly, earning 12% per year
Value at Age 65
$340,001
 
THE RESULTS
$100,000 invested for about 25 years (as outlined above)
VALUE AT AGE 65
$644,422

 

Despite having a net negative return on 40% of his portfolio, the second investor accumulated $305,787 more [90.29% extra] than the bond buyer. A well-managed portfolio that averaged 12% per year on the initial $100,000 would have grown to $1.7 million over the 25 years.

STOCKS versus BONDS:  

Over the past seventy plus years, the return on equities has far outdistanced the return of bonds. People who shun volatility because they feel more comfortable with fixed income investments need to ask themselves the question:

AT RETIREMENT AGE,

WILL I FEEL MORE SECURE WITH

A $1,000,000 PROTFOLIO THAT FLUCTUATES, OR

A $500,000 PORTFOLIO THAT IS SOLID AS A ROCK? *

Obviously, the bigger the “nest egg”, the more income that can be generated for living expenses. If you think that CD buyers take no risks, ask a current retiree how they feel about their income now, at around five percent per year, as compared with the eight to ten percent available just a few years ago. By staying in “risk less” CD’s they lost thirty to fifty percent of their income, not even counting the devastating effect that inflation has inflicted on their purchasing power.

*There is no assurance that the stated result will be achieved by an investment in equities.

VALUE OF $1000 INVESTED 1925 – 1996

 

According to IBBOTSON ASSOCIATES, since 1925, small stocks have outperformed S+P 500 stocks by a wide margin. $1000 invested in S+P 500 stocks would have turned into $1,370,950 by 1996. Not bad, but $1000 invested in small stocks would be worth a whopping $4,495,990 over the same time period. History says that small stocks have outperformed large stocks over time.


       INFLATION    T BILLS    T BONDS    S+P 500    SMALL CAPS

 

About the author:

Dr. Paul Price
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.3/5 (16 votes)

Comments

billytickets
Billytickets - 7 years ago
well done Paul. it is clear you are a TRUE VALUE INVESTOR and reat asset to this unique DETERMINED group.peace
Dregw
Dregw - 7 years ago
Interesting how you were a dentist that was "taken" by the market. I'm in a similiar situation and would be interested in knowing if you sought a finance or MBA degree prior to joining Merrill Lynch.
armeetofo
Armeetofo - 7 years ago
king solomon: there are nothing new under the sun.

warren: it is hard to teach a kid an old trick.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
Nasty markets like the one we're in right now are hell while they're happening but end up making you more money in the end than if they didn't happen. It's a perfect chance to re-evaluate every one of your holdings and to triage them as to their attractiveness from this point forward. Repositioning your portfolio can save taxes and set you up for even bigger gains when the market turns around. The biggest risk is in exiting the market and then missing the turning point. Every bear market in America's history has been a temporary bear market. If you're doing things right you'll hit a new all-time high net worth once conditions improve. I've lived through many cycles and always gone on to new highs- usually sooner and higher than I ever thought possible during the downturns.
Smileyguy
Smileyguy - 7 years ago
Dregw Wrote:

-------------------------------------------------------

> Interesting how you were a dentist that was

> "taken" by the market. I'm in a similiar

> situation and would be interested in knowing if

> you sought a finance or MBA degree prior to

> joining Merrill Lynch.

Where does it say he's a dentist?

I'm in the same boat and a good friend of mine at Merrill told me at lot of the money managers there don't have MBA's but are highly qualified professionals from other sectors.

kfh227
Kfh227 premium member - 7 years ago
The example on the power of compounding (breaking $100K into $20K chuncks) is obvious, but it still amazes me.

I use a similar principle.

I like a mix of "growth" stocks with low yields and income stocks that grow slowly over time with higher yields. Why? Those income stocks give me cash to diversify with and those growth stocks will shine over the long term as compounding shows its power.

The irony though. Today, I like stocks that are on sale. So I should get a good return and as a nice side effect a nice yield. Take PFE and BAC for examaple.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
I practiced dentistry from 1977 - 1987.

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