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Common Sense Investing Tips  By A. Raj Kumar          May 16, 2008

             The price you pay for a stock determines your future rate of return from that stock.  Pay a higher price, get a lower return.  Pay a lower price, get a higher return.  Although these ideas seem common sense, investors constantly ignore them in the stock market.

 

             Mary Buffett and David Clark explain these concepts and many other ideas in their book, Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor.  Mary used to be Warren Buffett’s daughter-in-law at one time.  Notwithstanding the really long title of the book, every serious investor should read the book because it contains some extremely valuable investment concepts. 

 

             I will highlight a few of them in this article.  Buffett only invests in companies that have a history of delivering growing earnings consistently.  He typically reviews a ten-year earnings period.  He wants to be able to predict next year’s earnings with a very high degree of certainty.  Another factor he looks at is the growth rate of those earnings.  If a company has predictable earnings that are growing at a decent rate, then he will consider buying it at the right stock price.

 

             Buffett views stocks as if they were bonds.  He calculates the earnings yield (EY) of a stock and then compares it to the long-term bond yield.  The earnings yield is calculated by dividing the earnings per share (EPS) by the stock price (P).  It is also the inverse of the stock’s P/E ratio.  For example, a stock with an EPS of $3 and a stock price of $24 has an earnings yield of 3/24 or 12.5%.  If we compared this EY to the current 30-year bond yield of 4.7%, it would look very enticing: getting a 12.5% yield on your investment is great.  Plus there is an added kicker: unlike the interest from a bond the earnings will grow over time!  So your EY will actually improve in the future.  An EY of 12.5% or a P/E of 8 ($24/3) indicates a cheap stock price.

 

             Let’s take another example.  Google trades around $694 today (Nov. 8^th).  The trailing 12 months EPS is $12.78.  So it’s earnings yield is 12.78/694 or 1.84%.  As an investor, would you be happy with a 1.84% annual return?  Probably not, but because people are excited about Google’s future prospects and its 60% growth rate, they absolutely must have it and hence buy the stock.  The stock price has a lot of hope built into it.  The P/E ratio is a very high 54!

 

             The price you pay for a stock determines your future rate of return.  Pay a higher price, get a lower return.  Pay a lower price, get a higher return. 

            

             Many investors in the stock market do the opposite of common sense.  They pay higher prices for a stock because they are excited about the company or because they expect the stock to continue its upward trend since it has gone up in the recent past.  What they don’t realize is that they just paid a higher price (which indicates a lower return for them in the future!).  When a stock goes down a lot, people panic and expect it to go to zero and so they bail out.  They end up selling at lower prices!  Of course, they should be buying more shares at the lower price (which will give them a higher return in the future!).  In the stock market, some people do stupid things that are the opposite of common sense!

 

             Buffett chooses the kind of businesses/companies that he would like to own ahead of time and then he patiently waits for the stock price to fall. He lets the stock price determine whether he invests in the company or not.  So please remember that the price you pay for a stock determines your future rate of return.  It really is simple: pay a lower price, get a higher return.

 

             Have a great holiday everyone!