Wednesday, September 14, 2011

My net worth did barely increase the last 5 years. Is that bad?

We seem to always focus on how much more our net worth compares to last year or five years ago. Since 2007, my net worth graph shows barely an increase. Yet is that bad?

This is the frustration many of us investors may feel. Because that is how we measure our investment success. Professional managers compare their performance with that of a benchmark index, e.g. the total performance of the S&P/TSX. This may sound like a cop out, but it is a known fact that the indexes often outperform the professionals! Hence the advance of the ETF.

But let's look at our performance in terms of valuation and cash flow. Now an entirely different picture arises. Let's look at one stock in particular to get this point across; yeah let's use Microsoft. In 2001, just before the hi-tech crash, it traded around $55 per share and today that same share trades at $26.50 Oh, that is terrible; especially when you bought at the peak, because then you lost over 50% of your portfolio value.

What are we really buying as shareholders? Earnings and Earnings growth! In 2001, Microsoft earned $0.66 per share; in 2011 its earnings are expected to reach $2.69. Wow that is a heartwarming fourfold increase or an average earnings growth of 22% per year. So it was not Microsoft, the company, that underperformed; it was the stock which traded in 2001 at a price earnings ratio (P/E) of 83 and today that same stock trades at a P/E of just below 10.

In 2001, investors paid 83 dollars for $1 of Microsoft earnings and today they pay just below $10. Now compare that to interest on a 5 year Government of Canada Bond which yields today 1.45% or so. That means the bond pays $1.41 for each $100 principal or investors pay nearly $71 to earn $1 on interest earnings (BEFORE TAX!) So what has changed? Investor perception, which is often irrational, has changed. Even better, Microsoft currently has $52 billion dollars of cash on its balance sheet or $6.11 per share. That means that if you were paid out the cash, each stock would trade at $20.50 and it still earns $2.69 that would be a P/E of 7.6 or an earnings yield of 13% compared to 1.45% on a Government of Canada Bond.

So in terms of today's valuation, a 2001 Microsoft share is worth $6.6 compared to $26.50 for today's Microsoft. Just as much as the cash holdings of one Microsoft share today! O.K. You may say that is nice, but all that earning's growth of Microsoft happened probably early on between 2001 and 2005; today its earnings grow a lot less! Wrong, in 2010 Microsoft earned $2.10 per share and a year later in 2011 it made $2.69. That is an annual earnings increase of 28%! Oh, and it pays currently a dividend of $0.64 per year or 2.4% compared to the bond's yield of 1.45%. In 2001 there were no Microsoft dividends!

So, it is investor psychology! In today's low valuation markets we're willing to pay much less for a dollar of corporate earnings than 10 years ago, or than in 2007. If markets were to return to more normal valuations a company like Microsoft would be trading around 15 times earnings or $40. Many other stocks are in a similar situation today. In terms of 'earnings yield' today's stock markets should be priced nearly 30% worth higher than they are.

It is the bearish sentiment of today's investors who discount everything that can go wrong with the economy and more. In fact, they have discounted the market prices so much that the 24% decline of the average bear market would result in a higher valuation than we have today! 40% of today's investors are bearish (think that the market will decline even more) and this is near record highs. Typically such high rates of bear sentiment indicate a nearby market bottom.

Now look again at your portfolio in terms of number of shares and the average earnings per share. Think of the dividend income from the last 5 years that you converted into additional stocks. Think of the cash in your portfolio which you can use to buy even more cheap shares. Now, how do you feel about those so-called lost years when you bought shares on sale from your dividend income and when you high graded the quality of your stock portfolio? Do you still feel that the last 5 years were for nop?

These years were not lost; these were the years where you weeded out the crap and where you created a dream portfolio the benefits of which you'll be reaping for years to come!

No comments:

Post a Comment