Get Real About Assessing Your Stock Investments: Growth And Value Impact Capital Appreciation
I believe, and there is plenty of evidence to back my belief, that current market conditions are at an extreme. Although rare, it’s not unusual for aberrant market action to occur. Warren Buffett 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. However, when evaluated together, 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 company’s 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 company’s earnings growth. A low beginning valuation will increase capital appreciation relative to the company’s earnings growth rate. However, there are numerous combinations of beginning and ending valuation that will also impact capital appreciation relative to the company’s earnings growth rate. For example, valuation can be high at the beginning and low at the end. Or, valuation can be high at the beginning and high at the end, etc.
Once you clearly understand these drivers of capital appreciation, you are empowered towards 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 that 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 that are capable of achieving your unique goals, objectives and risk tolerances.
For example, if you invest in a low growth utility stock, you won’t be surprised if and when it underperforms the market. Based on its potential earnings growth rate, you will realize that 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 and/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 that 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 that 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 that 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.