By: Dividend Sensei
In part one of this series I explored a key investing principle that has been proven to boost total returns while lowering risk. Today I want to highlight the other “free lunch” that is potentially an even more powerful way to maximize your portfolio’s wealth compounding power over time. It’s so deceptively simple, and yet it’s something that most investors ignore to their long-term detriment; valuation. The simple fact is that if you overpay for a stock, no matter how great it is, then your returns will suffer.
In fact a Yale study examining the inflation adjusted total returns of stocks from 1881 to 2016 found a strong inverse correlation between starting valuation and total returns over time. And lest you think that valuation only matters in the short-term, Yale’s researches found that this relationship held true for periods of time between five and 30 years. In other words assuming that a quality stock will eventually grow into your starting valuation and make it a good investment isn’t necessarily true. Sure if you happen to own one of the epic winners such as Amazon, Apple, Starbucks or Home Depot, then you’ll probably beat the market and end up wealthy.
But these are rare exceptions that otherwise prove the rule. In fact Warren Buffett, the greatest investor in history, has even gone so far as to quip, “price is my due diligence”. Now of course the Oracle of Omaha doesn’t literally mean that you should only look at valuation and nothing else. After all Buffett has also said that, “It’s better to pay a fair price for a wonderful company, than a wonderful price for a fair company.”
However what Buffett and market studies show, is that you shouldn’t fall in love with a stock. That means being willing to pay any price to own the next “can’t miss blockbuster”. More often than not crazy valuations result in long periods of underperformance. For example in 2000 Cisco Systems was growing like a weed, since it supplied the internet router switches that were powering the rise of the global internet. However when it peaked in April 2000 at a price of about $80, a market cap of $550 billion, its PE and price to free cash flow ratios were about 240, and 110, respectively.