In the past 10 days I have spoken with 3 friends of mine who all invest in the stock market. These 3 people do not know each other but all 3 of them are predicting bad times for the stock market since the bull market has lasted 5 years. They have complained about how Coke, General Electric, Johnson and Johnson, IBM, Merck and Pfizer have performed poorly for them. (Each of the 3 at least owned one of these stocks) Of course when it mentioned to them that I have recently taken a large position in Johnson and Johnson, all 3 of them "warned me" that the stock has performed poorly in the past 8 years and many included Jim Cramer and themselves told me it was "dead money" (FYI this is a bullish response for me). When I mentioned to them that JNJ has an Return on Equity of 25% and a PE near 15, all 3 had the same response "SO WHAT" and proceeded to tell me that while I have had success in the past that this time I had miscalculated and one went as far to say that my reliance on low PE stocks was "outdated". Hence another "Billytickets” experiment was born.
Of course as was stated in the forum yesterday a Low PE stock is not necessarily better than a high PE stock with a high ROE which I agree with. But what about 2 stocks BOTH with High ROE's? My exercise was to take an identified member of stocks (Dow Jones top 30) and check how many stocks had an ROE of at least 25% the previous year (or 5 year average) and had higher earnings than capital expenditures, and then examine them when 1) Their PE was 15 or lower based on previous years ACTUAL earnings not "projected earnings”. 2) The same stocks when the PE was 30 or higher. My "universe" of stocks was whittled down to 11. They consisted of MMM, MO, AXP, CAT, KO, GE, IBM, JNJ, MRK, PFE, PG. 4 stocks were purchased by BOTH number 1 and number 2. Each stock was purchased from the 10 year period from 1996 to 2006.
The Dow stocks with PE of 15 or less and a ROE of at least 25% had 28 purchases over that span that cost $1222.10 and were held for an average holding period of 5.39 years. As of Friday's close the portfolio totaled $2,085.82 for a gain of 70.67% .This translates into almost 12% annual return compounded in portfolio gain ONLY. The present dividend from this portfolio is $59.95 which translates to about 4.9% yield on purchase price. This does not take into consideration the "reinvested dividends" which is certainly material and will add to the overall return. Ironically in 2000 the year the market "topped out" only 1 purchase (3.57% of total purchases) was made and that investment has doubled.
The Dow stocks with a PE of 30 or more and a ROE of at least 25% had 39 purchases over that span that cost $1784.30 and were held for an average holding period of 7.410 years. As of Friday's close the portfolio totaled $1996.01 for a gain of 11.86%. This translates into slightly more than 1.5% annual return compounded. The present dividend from this portfolio is $53.04 which translates into a 2.97% yield on purchase price. In 2000 the year the market "topped out" 8 stocks were purchased (20.55) and 4 of the 8 are still lower 7 years later and none achieved double digit annual compounded returns. 8 of the highest ROE Dow stocks with PE's over 30 seems to be an indicator that the market was "overvalued” it would seem. 2 factors even make this scenario worse for the High 30+ PE stocks. 1) As stated above the reinvested dividends were more than 65% higher on the low PE portfolio which makes the differences in return even more drastic. 2) On more than 40% of the High PE purchases the PE was over 30 for the entire year and I used the LOW for the year as my "entry price". Doing this favors the high PE purchases but a material and significant margin. Despite this "advantage" the portfolio still performed horribly.
Buying the right stock at the right price is PARAMOUNT to achieving above average returns in the market. My friends purchase of GE, JNJ, PFE, and MRK was not the problem. All 4 companies have achieved favorable results. Their entry point during a PE of 30 or more caused their poor returns not the CEO's. 2 other stocks Home Depot and Wal-Mart did not meet the 25% ROE or the results would have been even WORSE for the high PE’s. In the final analysis "value investors" need to 1) Buy the right stock (a stock with a ROE of 25% or more is "preferred" . 2) Buying that stock at the lowest possible PE ratio will give you the "margin of safety " needed to achieve success in investing. So when someone tells you that the stock is a buy at ANY price, hopefully the "results" in this article will bring you back into "reality". As a side note NONE of the Dow 30 stocks with the highest ROE's have a PE of 30 or more which it makes the probability of a stock market "crash" like we had in 2000-2002 to be minimal. Please give me your feedback, positive or negative.
The actual purchases are available if you want them faxed to you, please contact me.