Infosys was a great stock in March 2000. If one looked at the returns a decade later, it would have returned only 32% over this time frame. HUL was a great stock in 2001 but generated returns of just around 34% over 10 years. I am referring to point-to-point returns and not CAGR.
The list of such ‘great’ stocks is endless – stocks that were loved so much by investors but failed to return much over the long term. Let me clarify one thing here – ‘great’ here means stocks that investors love so much that they are willing to pay any price to own them.
This makes ‘great’ stocks really bad investments for the long term.
Confused?
See, there are two factors that you must consider before buying a stock:
1) What is the value of the company’s business (also known as its intrinsic value)?
2) How much is the price of the stock in relation to the company’s intrinsic value?
So while a business that is doing well, has a good management at helm, and has the potential to grow strongly and profitably in the future is a great business, if its stock price is high in relation to its business value, it isn’t a great investment.
Take a look at Infosys in March 2000. At the peak of the peak of the dot-com bubble, the stock was trading at three-digit price to earnings (P/E) multiple, which made it very expensive. It was a ‘great’ stock because every one wanted to buy it at any price, but a ‘bad’ investment.
As Benjamin Graham, the father of value investing, taught, the price you pay for an investment matters a great deal. In fact, price is the primary determinant of the return you earn on your capital. If you pay Rs 10 to buy ownership of Rs 2 in profit, your return is 20%. If you pay Rs 50 to buy Rs 2 in profit, your return is just 4%.
So never forget this: Price matters.
No matter how great the business is, if you overpay for your ownership, you are going to earn a sub-par rate on your money even if you hold the stock for the long term (like 10 years).
It’s basic math.
This article is written by Vishal Khandelwal and initially appeared on his blog Safal Niveshak. The returns are as on September 10, 2011.
