Buying right stock when market fall.
How Falling Stock Prices Can Make You Rich
Part 1 of 2
In general terms, there are three ways to make a profit from owning a
business (buying stock is merely purchasing small parts of a business
whereby you get these nice little certificates depending on how many
pieces of stock a company is divided into, each share will receive a
certain portion of the profits and ownership).
1.Cash dividends and share repurchases. These represent a portion of
the underlying profit that management has decided to return to the
owners.
2.Growth in the underlying business operations, often facilitated by
reinvesting earnings into capital expenditures or infusing debt or
equity capital.
3.Revaluation resulting in a change in the multiple Wall Street is
willing to pay for every $1 in earnings.
An Example to Illustrate These Points
It may look complicated, but its really not. Imagine, for a moment,
that you are the CEO and controlling shareholder of a fictional
community bank called Phantom Financial Group (PFG). You generate
profits of $5 million per year and the business is divided into 1.25
million shares of stock outstanding, entitling each of those shares to
$4 of that profit ($5 million divided by 1.25 million shares = $4
earnings per share).
When you open a copy of the stock tables in your local newspaper, you
notice that the recent stock price for PFG is $60 per share. This is a
price-to-earnings ratio of 15. That is, for every $1 in profit,
investors seem to be willing to pay $15 ($60 / $4 = 15 p/e ratio). The
inverse, known as the earnings yield, is 6.67% (take 1 and divide it
by the p/e ratio of 15 = 6.67). In practical terms, this means that if
you were to think of PFG as an equity bond to borrow a phrase from
Warren Buffett, you would earn 6.67% on your money before paying taxes
on any dividends that youd receive provided the business never grew.
Is that attractive? It depends on the interest rate of the United
States Treasury bond, which is considered the risk-free rate because
Congress can always just tax people or print money to wipe out those
obligations (each has its problems, but the theory here is sound). If
the 30-year Treasury yields 6%, why on earth would you accept only
0.67% more income for a stock that has lots of risks versus a bond
that has none? This is where it gets interesting.
On one hand, if earnings were stagnant, it would be stupid to pay 15x
profits in the current interest rate environment. But management is
probably going to wake up every day and show up to the office to
figure out how to grow profits. Remember that $5 million in net income
that your company generated each year? Some of it might be used to
expand operations by building new branches, purchasing rival banks,
hiring more tellers to improve customer service, or running
advertising on television. In that case, lets say that you decided the
divvy up the profit as follows:
$2,000,000 reinvested in the business for expansion: In this case,
lets say the bank has a 20% return on equity very high but lets go
with it nonetheless. The $2,000,000 that got reinvested should
therefore raise profits by $400,000 so that next year, they would come
in at $5,400,000. Thats a growth rate of 8% for the company as a
whole.
$1,500,00 paid out as cash dividends, amounting to $1.50 per share.
So, if you owned 100 shares, for instance, you would receive $150 in
the mail.
$1,500,000 used to repurchase stock. Remember that there are 1,250,000
shares of stock outstanding. Management goes to a specialty brokerage
firm and they buy back 25,000 shares of their own stock at $60 per
share for a total of $1.5 million and destroy it. Its gone. No longer
exists. The result is that now there are only 1,225,000 shares of
common stock outstanding. In other words, each remaining share now
represents roughly 2% more ownership in the business than it did
previously. So, next year, when profits are $5,400,000 an increase of
8% year over year they will only be divided up among 1,225,000 shares
making each one entitled to $4.41 in profit, an increase on a per
share level of 10.25%. In other words, the actual profit for the
owners on a per share basis grew faster than the companys profits as a
whole because they are being split up among fewer investors.
If you had used your $1.50 per share in cash dividends to buy more
stock, you could have theoretically increased your total share
ownership position by around 2% if you did it through a low-cost
dividend reinvestment program or a broker that didnt charge for the
service. That, combined with the 10.25% increase in earnings per
share, would result in 12.25% growth annually on that underlying
investment. When viewed next to a 6% Treasury yield that is a
fantastic bargain, so you might jump at such an opportunity.
Now, what happens if investors panic or grow too optimistic? Then the
third item comes into play revaluation resulting in a change in the
multiple Wall Street is willing to pay for every $1 in earnings. If
investors piled into shares of PFG because they thought the growth was
going to be spectacular, the p/e may go to 20, resulting in a $80 per
share price tag ($4 EPS x $20 = $80 per share). The $1.5 million used
for cash dividends and the $1.5 million used for share repurchases
wouldnt have bought as much stock, so the investor is going to
actually end up with less ownership because their shares are trading
at a richer valuation. They make up for it in the capital gain they
show after all, they bought a stock for $60 and now its at $80 per
share for a $20 profit.
What if the opposite happens? What if investors panic, sell their 401k
mutual funds, pull money out of the market, and the price of your bank
collapses to, say, 8x earnings? Then, youre dealing with a $40 stock
price. Now, the interesting thing here is that although the investor
is sitting on a substantial loss from $60 per share originally to $40
per share, knocking 33+% off the value of their holdings, in the long
run theyll be better off for two reasons:
1.The reinvested dividends will buy more stock, increasing the
percentage of the company the investor owns. Also, the money for share
repurchases will buy more stock, resulting in fewer shares
outstanding. In other words, the further the stock price falls, the
more ownership the investor can acquire through reinvested dividends
and share repurchases.
2.They can use additional funds from their business, job, salary,
wages, or other cash generators to buy more stock. If they are truly
concerned with the long-term, the losses along the way in the
short-run dont matter theyll just keep buying what they like, provided
they have sufficient diversification levels so that if the company
were to implode due to a scandal or other event, they wouldnt be
ruined.
There are a few risks that can cause problems:
Its possible that if the company gets too undervalued, a buyer might
make a bid for the company and attempt to take it over, sometimes at a
price lower than your original purchase price per share. In other
words, you were absolutely correct but you got pushed out of the
picture by a very large investor.
If your personal balance sheet isnt secure, you might need to come up
with money and be forced to sell at massive losses because you dont
have funds anywhere else. This is why you shouldnt invest in the
market any money that could be needed in the next few years.
People overestimate their own skills, talent, and temperament. You
might not pick a great company because you dont have the necessary
accounting skills or knowledge of an industry to know which firms are
attractive relative to their discounted future cash flows. You might
think youre able to watch losses pile up while you purchase stocks,
but very few people have the temperament for it. In my own case, it
doesnt even cause my heart rate to elevate if we wake up one morning
and before coffee, the office portfolio is down hugely in a matter of
minutes. It just doesnt bother us because what were doing is building
a collection of long-term cash-generating ownership stakes in firms
that we want to hold for a very long time. Were constantly buying
more. Were constantly reinvesting our dividends. And many of our
companies not only reinvest for future growth, but also repurchase
their own shares.
Now, this is a gross oversimplification. There are many, many, many
details that havent been included here that would factor into a
decision about whether or not a particular stock or security were
appropriate for investment. This is designed to do nothing more than
to provide a broad sketch of the outline of how professional investors
might think about the market and selecting individual stocks within
it.
The bottom line for a guy running a mutual fund, hedge fund, or a
portfolio with a limited amount of capital, big drops in the market
can be devastating both to their net worth and their job security. For
businessmen and businesswomen who think of buying stocks as acquiring
partial ownership in companies, they can be a wonderful opportunity to
substantially grow your net worth.
As Buffett said, he doesnt know if the market will be up, or down, or
sideways a month or even a few years from now. But he does know that
there will be intelligent things to do in the meantime. Not everything
is doom and gloom - the collapsing dollar has been a magnificent thing
for multi-national firms such as Coca-Cola, General Electric, Procter
& Gamble, Tiffany & Company, et cetera that are able to ship money
back from overseas markets into cheaper greenbacks. Just remember
there is a buying and seller for every financial transaction. One of
those parties is wrong. Time will tell which one got the better deal.
