I believe, and there is plenty of evidence to back my belief, that current market conditions are at an extreme. Although rare, it is not unusual for aberrant market action to occur. Warren Buffett (Trades, Portfolio) once said, The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.
The important point is to understand the unpredictability of it all so as to not fall prey to the illusions. The late John Kenneth Galbraith, one of the most renowned economists of modern times, once quipped: In economics the majority is always wrong. Therefore, what we really need to do is put our attention on and only on the important issues that are predictive in nature.
Hope is not an investment strategy
Regarding investing in common stocks, there are two primary factors that can be relied upon as true determinants of capital appreciation. Neither can be viewed in a vacuum. When evaluated together, however, they are highly accurate capital appreciation calculators. The first, and I believe the most important, is the rate of change the business grows its profits at (i.e., the companys earnings growth rate). A company that grows at 8% can be expected to generate an 8% capital appreciation and a 15% grower a 15% capital appreciation, etc. Faster growth leads to higher capital appreciation potential that is consistent with that growth, and vice versa. However, this principle only applies when valuation is fair or rational at both the beginning and the end of the measuring period.
Therefore, both the beginning and ending valuation must also be taken into consideration. A high beginning valuation will decrease capital appreciation relative to the companys earnings growth. A low beginning valuation will increase capital appreciation relative to the companys earnings growth rate. However, there are numerous combinations of beginning and ending valuation that will also impact capital appreciation relative to the companys earnings growth rate. For example, valuation can be high at the beginning and low at the end. Valuation can also be high at the beginning and high at the end.
Once you clearly understand these drivers of capital appreciation, you are empowered toward making realistic assessments of what returns your stock investments are capable of providing you in the longer run. Therefore, you will no longer be subjugated to investing in a stock solely on the hopes it might go up. Instead, you will have a very realistic understanding of how much capital gain a given stock might offer. Moreover, you will be able to make specific stock selections capable of achieving your unique goals, objectives and risk tolerances.
For example, if you invest in a low-growth utility stock, you will not be surprised if and when it underperforms the market. Based on its potential earnings growth rate, you will realize high capital appreciation is not in the cards. On the other hand, you might rationally expect a higher level of dividend income than the market is capable of achieving. In this case, your performance expectations would apply more to dividend income than to capital appreciation or a high total return. This directly relates to my notion of having realistic or clear expectations about what your investments are capable of. Hope is clearly not an investment strategy.
An additional benefit of focusing on the practicality of growth and value is a clear perspective of risk relative to potential results. One of the oldest axioms in investing is risk and greater return are (or at least should be) inversely related. In other words, you should only be willing to take on a higher risk when there is the promise of a higher rate of return. In conjunction with this notion is the idea it would be foolish to take on greater risk where there is a promise of a lower future return. This is where the benefit of paying attention to valuation really pays off.
Astute investors recognize investing at a higher valuation will typically lead to a lower future level of capital appreciation than the business being invested in is capable of generating. Therefore, paying a high valuation implies taking on a higher risk while simultaneously exposing you to a lower level of potential capital appreciation, all things remaining equal. This is simply counterintuitive to the risk-return principle.
This is not merely stating the obvious
Much of what has been written thus far might seem obvious to many readers. My experience in talking with investors spanning almost five decades, however, suggests that what might appear obvious is not so obvious at all. In my personal experience, and I acknowledge it is anecdotal, most portfolios I have come across look more like a junk drawer than a strategically designed and cogent strategy. Everyone tries to invest in stocks they hope will perform well. However, very few have a clear and well-defined expectation of what the most likely results of investing in a given stock might produce.
I am a firm believer in designing portfolios to meet specific goals, objectives and risk tolerances. This is not to suggest every portfolio should be designed to beat the S&P 500 or the market. Nevertheless, this notion of beating the market seems to be the standard many judge their portfolios by. Perhaps a specific investor might be more concerned with risk or perhaps the amount of income they might need to live on. Typically, the highest-yielding stocks rarely generate the highest levels of capital appreciation. Consequently, if income is your objective, generally speaking you must be willing to accept the possibility of a lower level of capital appreciation.
So it all comes down to growth and value. With common stocks, there will be many variations of growth, ranging from slow to fast. There can also be the total destruction or collapse of business prospects. Therefore, each company should be judged upon its own merits. The principles of value, however, are precise and only differ as they apply to each unique case relative to earnings growth potential. Once understood, determining the capital appreciation potential of a single stock or a portfolio of stocks is straightforward. This does not suggest perfect calculations, but it will provide a reasonable expectation of whether future returns might be high, moderate or even low.
Therefore, to be clear, what I am suggesting is you choose your common stock investments to meet your precise goals and objectives. Evaluating your investments through the use of these time-tested principles keeps emotion from eroding the framework of your decision-making process. It feels better too! So if you are looking for maximum total return, seek out companies that offer the potential for the highest level of growth and then be sure to purchase them at a rational valuation. If current spendable income is your objective, look for companies with above-average yields and histories of increasing their dividend each year. As the old saying goes - different horses for different courses.
Running the numbers out to their logical conclusions
With the following FAST Graphs fundamentals analyzer software tool video, I will provide clear examples and explanations of the growth and value relationship. When this undeniable relationship is clearly understood, investors will be more likely to make common stock investment decisions that support their objectives and, perhaps more importantly, their risk tolerances. As I have written many times before, I call this investing with your eyes wide open. The key is to run the numbers out to their logical conclusions. Never invest simply on the hope a stock might go up. Instead, invest in stocks that are capable of producing the precise results at the most appropriate levels of risk you need or are comfortable with.
Summary and conclusions
A common investor tendency and a major mistake is the penchant for projecting the current situation to persist into the future ad infinitum. Common sense will tell you nothing goes on forever. A booming economy will at some point end with a recession. A bull market will one day give way to a bear market. Conversely, a recession will evolve into a powerful growth cycle and bear markets will become bulls.
This applies just as effectively to individual stocks as it does markets. Do not be attracted to a stock simply because it has gone up. And more to the point, do not reject a stock simply because it has recently gone down. Although this is not true in every case, the stock that has gone down is more likely to be the better long-term investment than the one that has recently gone up. Bargains are found when stock prices fall below fundamental values, and avoidable risk occurs when stock prices rise above fundamental values.