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A Timeless Rule Followed By Every Wealthy, Sophisticated InvestorBy
Wednesday, December 14, 2011
On June 15, 1998, Coca-Cola – owner of the world's most powerful brand – traded for $88.94 per share.
For many years, I've been telling my readers to keep the bulk of their equity holdings in companies like Coca-Cola, which has fat profit margins, high returns on capital invested, a great brand name, and a sustainable competitive advantage. I call companies like Coke "World Dominators."
Owning dividend-paying World Dominators and compounding their gains over many years is the surest, easiest, greatest way to get rich in stocks. But anyone who bought Coke in late 1998 ignored a timeless rule that wealthy, sophisticated investors hold sacred. And they suffered big losses.
What is this rule of the wealthy? How did violating this rule allow some investors to actually lose money on one of the world's greatest companies? And how can you begin using it to make a fortune in stocks?
The rule is that the price you pay is the most important thing when it comes to succeeding as an investor. If you pay a cheap enough price, you can make money in even the worst businesses. If you pay a dear enough price, you can lose money for long periods of time in even the best businesses.
Back in 1998, Coke's annual earnings amounted to $1.43 per share. So at the all-time high of $88.94, the market was valuing the business at 62 times annual earnings.
That's crazy expensive. Investors were accepting an "earnings yield" of about 1.6%. The "earnings yield" is the amount in earnings the company generates as a percentage of your purchase price. So take $1.43 in earnings, divided by an $88.94 share price, and you get 0.016... or 1.6%.
Think about it this way: It's like buying a $100,000 house that you can rent out for about $1,600 a year, or $133 a month. It would take you 62 years to get your money back out of that investment. And only another fool would pay you $100,000 to take the house off your hands.
When you accept terms like that, you're almost guaranteed to lose money in stocks. And that's exactly what happened to investors who bought Coke at the wrong time.
Less than three months after Coke nearly hit $90 a share, it was down more than 30%. Five years later, it was down 50%. Even 13 years later... counting dividends... those investors haven't made a dime in Coke... which is one of the world's greatest companies. Nothing much changed about Coke's business during that time. It's still one of the world's most recognizable brands. It still sells soda all over the world. It still has high profit margins.
The losses incurred by folks who bought in 1998 were directly the result of paying a ludicrously high price to become a shareholder.
The same thing happened to investors who bought retail giant Wal-Mart, one of my favorite companies, in 2000. Shares peaked at $70. Today, the shares trade for a little less than $60.
Investors who bought back then lost because they paid the wrong price. The stock was offering a 2% earnings yield. At that rate, it would take you 50 years to get your money back.
I don't know about you, but I don't have that kind of time. I'd much rather see a "payback period" of 12 years or less. That means getting an earnings yield of 8%-10% or more. And fortunately, we're seeing that in some of today's greatest businesses.
Wal-Mart is trading for 12 times earnings, with an 8.3% earnings yield. Coke itself is also selling for about 12 times earnings. If you're buying right now, you're not taking on the crazy deal investors got 12-14 years ago. You're paying the right price to see large long-term gains.
Smart, successful investors know that the price you pay is everything when it comes to making money in stocks, commodities, or any private business. You can lose money even in the world's greatest businesses if you pay too much. If you take that lesson to heart, and only pay the right price – the cheap price – you're virtually guaranteed to make money over the long term.
Good investing,
Dan Ferris
Further Reading:
Coca-Cola is one of Warren Buffett's greatest investments of all time. So when he bought 1.5 million shares of another familiar name earlier this year, Frank Curzio told Growth Stock Wire readers to follow suit. That was the right call… Shares are up nearly 30% in less than four months. Get the full story here: Why the World's Greatest Investor Is Loading Up on This Stock.
Another one of Dan's cardinal investing rules played out in the press recently. "If you understand and take this lesson to heart," he writes, "you'll be ahead of 99% of your fellow investors." Read more here: The Simple Secret of Consistent Stock Market Profits.
Market NotesTHE EURO HITS A MAJOR SHORT-TERM MILESTONE The slow-motion financial train wreck in Europe is finally taking its toll on the euro. The currency just staged a major downside breakout.
Most folks don't realize it, but the collective economies of Europe represent a larger economic block than the 50 U.S. states. This makes it a vital region to monitor. Should its debt crisis get worse, it will throw Europe further into recession and cause economic disruptions all over the world.
We monitor the state of the debt crisis with the pan-European currency, the euro. Back in August, we highlighted the euro's "compressed" state... a situation where an asset's normal day-to-day volatility gradually dries up and the highs and lows move closer together. These low-volatility periods are often the calm before a storm.
As you can see from today's chart, the euro broke to the downside, as we expected. It then spent the next few months chopping up and down with little headway made in either direction. But just this week, the currency broke through its October low. It's now free to fall further and continue its bear market. That's bad news for Europe… and the world.
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