“Buy great companies,” is a cliché one often hears from people who make a living out of peddling stock market tips. But what they don’t bother to tell us is “how do you identify a great company?” And even if one has done that, does a great company always make for a great stock? Or is the timing of buying the stock equally important?
Gary Smith, answers a part of this question in his book Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics. He takes the example of an American company called Sears. It was dropped on November 1, 1999, from the Dow Jones Industrial Average (Dow), which is one of America’s premier stock market indices. Stocks which are a part of the Dow are supposed to be “substantial companies—renowned for the quality and wide acceptance of their products or services—with strong histories of successful growth.”
Sears was one of America’s biggest success stories. It sold everything from watches to toys and even ready to assemble houses. It had been a part of the Dow for 75 years before it was dropped. It was replaced by Home Depot.
So why was Sears dropped and replaced with Home Depot? “Sears…was struggling to compete with discount retailers like Walmart, Target and yes, Home Depot. Revenues and profits were falling, and Sears’ stock price had dropped nearly 50 percent in 6 months. Home Depot on the other hand, was booming..and was opening a new store every 56 hours,” writes Smith.
The question is if a stock is dropped from an index and replaced by another stock, which stock gives better returns in the days to come? The stock which is added to the index? Or the one which is dropped?
Common sense tells us that the stock which is added to the index is the one that should give us better returns. But that is not what happened in this case. Sears gave a return of 103% over the next five and a half years, before it was bought out by Kmart. On the other hand Home Depot lost 22%.
Interestingly, in 1999, four substitutions were made to the Dow—Home Depot, Microsoft, Intel and SBC. These stocks became a part of the Dow at the cost of Sears, Goodyear Tire, Union Carbide and Chevron. All the four stocks that became a part of the Dow were great companies. Nevertheless, they performed poorly over the next ten years.
An investment of $ 2,500 each in the four stocks that were added to the Dow would have been worth $6,604 ten years later. An investment of $2,500 each in the four stocks that were deleted from the Dow would have been worth $16,367 ten years later.
The basic point that comes out of this example is inherently simple. As Smith points out: “No matter how good the company, we need to know the stock’s price before deciding whether it’s an attractive investment.”
Another great company that Smith talks about in his book is IBM. In 1978, the earnings of IBM had been growing at about 16 % per year (adjusted for inflation) for more than 50 years. A saying that was popular at that point of time was: “No purchasing manager ever got fired for buying IBM computers, and no portfolio manager ever got fired for buying IBM stock.”
Given this, many portfolio managers recommended IBM stock in 1978 and predicted that its price would triple over the next ten years. Based on the earnings that the company made during the period 1968-1978, it was predicted that by 1988, the earning per share of IBM would be $18.50. The company achieved only half of that.
What went wrong? The analysts were simply projecting that IBM will continue to grow at the same rate as it had in the past, without realizing that it was simply not possible. As Smith points out: “If IBM kept growing at 16 percent annually and the overall US economy continued to grow at its long-run 3 percent, by 2003 half of US output would be IBM products and in 2008 everything would have been made by IBM.”
This example also tells us that IBM may have been a great company in 1978, but it was no longer a great stock—at least not something on which you could earn fantastic returns. Log story short—the point of time at which an investor buys a stock is extremely important.
An excellent example in the Indian case is Infosys in the late 1990s. As Parag Parikh points out in his book Stocks to Riches: “The stock price [of Infosys] shot up from around Rs 2,000 (Rs 10 paid- up) in January 1999 to around Rs 12,000 (Rs 5 paid-up) in March 2000. Nothing spectacular had happened to the company to justify such a steep increase. But by the end of September 2000, the stock was down to Rs 7,000. Nothing had gone drastically wrong with the company either since March when it was quoted around Rs 12,000.”
The analysts justified this increase by saying that Infosys was growing at the rate of 100%. What they did not tell the investors was that Infosys couldn’t keep growing at such a rapid rate. As Parekh points out : “In the financial year 2000, Infosys reported revenues of Rs 882 crore. If we were to compound this figure at 85% annually for 10 years (as some people believed the growth would continue), then in 2010, Infosys would report revenues of a staggering Rs 4,14,176 crore. At that time, assuming a market capitalisation of 100 times revenues (similar to what Infosys was quoting at its peak), it would put Infosys’ value at $9.2 trillion. The GDP of the US was around the same figure!” So, Infosys in 2000 was a great company. But it was clearly a bad investment.
The moral of the story at the end of the day being—don’t confuse a great company with a great stock.
The column originally appeared on The Daily Reckoning on Mar 27, 2015