I have made the point in the past that, if you want to beat the market, you need to pick stocks of companies that have a higher mathematical expectancy than that of the S&P 500. Of course, this could come in many forms, for example, a higher earnings yield, better growth prospects, higher certainty in the company’s future prospects, or a cheaper stock price in relation to the business’s underlying assets.
To determine a stock’s mathematical expectancy, you need to do the math. For example, if you buy a stock that sells for a P/E of 30 and that you project to grow at 12% per year – something very few companies can do – for the next 10 years, what will your return be if it sells at a market-average multiple of 15 in year 10? It turns out that your return would only be about 4.5% – hardly mouthwatering! Moreover, you would have given yourself little or no margin of safety.
When he spoke at Columbia in 2010, Tom Russo explained how Buffett thought about Internet valuations during the tech bubble of the late 90’s. At the shareholder meeting, a questioner pressed Buffet on why he was not buying tech stocks such as Cisco. At the time, Cisco was earning about $1 billion annually and had a market cap of approximately $500 billion. Buffett started out by saying that the same $500 billion – Buffett often thinks in terms of buying the entire company – would earn $30 billion if invested in 10-year treasuries. Moreover, Buffett had some doubts whether the $1 billion in earnings was solid, given such items as options. So after year one, if you invested in Cisco, you would be in the hole for $29 billion in earnings. Take the analysis out two years and the earnings deficit would become much bigger still. Buffett doubted a person investing on these terms would ever catch up with the earnings forfeited by not simply buying treasuries.
There it is: simple math – no algebra, fancy spreadsheets, or Greek letters.
Next time you are looking at an investment, do the math. In fact, do the math on all your current holdings, if you have not already done so. Use common sense. Make reasonable assumptions. Consider what would happen if things do not go well. Build in a margin of safety.
It is not complicated, yet many do not have the discipline to do the basic blocking and tackling that makes all the difference. Resolve today to always “do the math”.