When your stock falls by 50 per cent, it needs to gain 100 per cent to break even.
That’s just math.
But if you have been in the stock market long enough, you will know that huge declines are largely unavoidable.
It’s just part and parcel of investing.
Here’s the thing: when a stock is halved, most investors will assume they have made a mistake or overpaid for the stock.
Yet, as you will see, it is not always the case.
Price is what you pay, value is what you get
How do you know if you paid too much for a stock? Well, it depends on how you valued it in the first place.
Let’s say you are looking at a restaurant that owns a valuable piece of land.
If you follow the Ben Graham style of investing, you would care more about the land than the restaurant. You would focus on the assets, not the earnings.
In this case, the price you pay for the stock is crucial.
Here’s why.
The stock price has two components: the book value (where the land’s value resides) and the price-to-book (PB) ratio (the premium or discount over the book value).
For Graham-style investors, the key is to ignore any potential gain in the book value.
Instead, they look for stocks that trade below their book value, or have a PB ratio of less than one. They hope that the market will eventually recognize the true value of the assets and close the gap.
To make a good return, investors need to be disciplined in paying the right price.
They can overpay for the stock by not leaving enough margin of safety in their valuation. They can also lose money if something unexpected happens that destroys the value of the land.
And then, there is the issue of how long it takes for the value of the stock to be realised.
Some investors, like Michael Price, look for a specific catalyst that can unlock the value of the stock.
These could be events such as a spin-off, a merger, or a buyback.
Others, like John Neff, demand a dividend while they wait for the value of the stock to be outed.
For Neff, getting a dividend is like enjoying the appetiser before the main course (a stock gain from a higher PB ratio) arrives.
You’re not buying a stock, you’re buying income
If you love dividends as much as my co-founder David Kuo does, this section is for you.
For him, investing is not just about buying a stock — it’s about buying income.
Unlike a Graham-style investor, who cares more about the assets than the earnings, David focuses on the profits and wants a share of them in the form of a dividend.
That’s the discipline of a dividend investor: he won’t buy a stock if it doesn’t pay a dividend. Period.
The price he pays for a stock matters to him, but not as much as the income he will receive from a lifetime of owning the stock.
He doesn’t mind if stock prices fall.
He cares more about whether the stock can keep paying a dividend. If the dividend is sustainable, then a lower stock price is an opportunity to buy more and get a higher dividend yield.
And where does he get the money to buy more stock?
You guessed it, it’s from the dividend he receives.
By reinvesting these dividends, he can earn even more dividends in the future.
David believes that if you do this for a long time, you will be amazed by how much income you can generate from holding a stock. You may even come to a stage where you become salary independent.
But wait, what can go wrong in dividend investing?
It’s not too hard to figure out.
Dividends are paid in cash. To have enough cash to pay dividends, the business has to be profitable and stable enough to maintain or increase its dividends over time.
If the business runs into trouble, and the cash flow dries up — so will its dividends.
Innovation is value you can’t see
What is the difference between talent and genius?
According to German philosopher Arthur Schopenhauer, talent is the ability to hit a target that no one else can hit, while genius is the ability to hit a target that no one else can see.
Keep this quote in mind when you invest in innovative companies.
Let me give you an example.
Think of Apple (NASDAQ: AAPL), the maker of the revolutionary iPhone.
I bought Apple’s shares in 2010, after it earned US$0.32 per share in fiscal 2009.
By fiscal 2012, Apple’s earnings per share (EPS) had skyrocketed to US$1.58, almost five times higher than three years ago.
This is kind of phenomenal growth which is hard to imagine ahead of time.
What’s more, the story does not end here.
Today, 13 years later, Apple’s EPS has increased by more than 19 times compared to fiscal 2009 levels. Interestingly, my shares have also appreciated by 21 times since I bought them, closely matching the growth in Apple’s EPS over this period.
In other words, the rise in Apple’s share price was driven by the growth in its profits.
This is the essence of investing in innovative companies.
Unlike Graham-style investing, which focuses on the assets of a business, investing in companies like Apple depends on the growth of their business, not just their assets.
When done well, this growth will lift the stock price even if we are pay up for the stock.
In my case, I paid over 27 times its EPS in 2010, a price that can hardly be considered cheap. Yet, the EPS growth did the hard work and delivered a great outcome.
Can this approach fail? Sure, it can.
Like dividend investing, the outcome largely depends on the future growth of the business itself.
If you pay too much for a growth company that fails or matures sooner than expected, you will end up suffering from a lower multiple and shrinking profits.
Get Smart: How it started, how it’s going
Having the right expectations from the stock is crucial when figuring the right stock price to pay.
You can’t expect a mediocre business to grow much, you might be better off looking at the value of its assets. On the other hand, if you are waiting for a growth company to sell below its asset value, you might miss the opportunity to buy the stock.
For me, valuation is not just about the price you pay for a stock.
It also depends on the performance of the business behind the stock, especially if you are investing for dividends or growth. If the business does well in the future, you have a higher chance of making money.
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: Chin Hui Leong owns shares of Apple.