#1 Determinant of Investment Returns

How do you get high returns—the kind of returns we look to achieve through Investment Intel and our stock investing course—by investing in the stock market?

The stock market is risky, right? If you want high returns you have to take high risk, isn’t that true?

Well, the market is risky—but you can minimize this risk significantly (and increase your returns) by knowing the right way to invest.

Simply stated…high returns are not always associated with high risk.

Let’s go back to 2000 or 2008. Most investors had no idea they were involved in a risky market with high-priced investments at the time. After all, they’ve always been told, or believed, that investing their 401k or IRA in diversified funds was supposed to take away the risk. They never would have guessed 40%+ drops were looming. Diversification meant safety and they could expect a steady upward climb in their investment accounts…

Not exactly. They neglected to apply the #1 determinant of investment returns.

As a result, investors experienced massive drops in account value. Like Warren Buffett has said, “Only when the tide goes out do you discover who’s been swimming naked.” In other words, once the economy hits a speed bump, the real risk takers are exposed. Those risk takers were the ones buying assets at high prices which didn’t line up with their true, underlying value.

These years were costly lessons for most investors who learned about risk the hard way. They were taking on high risk with almost no chance of receiving high returns. Worst of all, they had no idea they were doing so. Making investments at high prices relative to their valuation is, and always has been, a high risk, low return strategy.

Many of you are once again taking high risk right now without knowing it. That’s because every time the stock market drops, like it did earlier this year (and will again), blindly investing in funds or with advisors whose business model forces them to remain constantly invested in the stock market—will mean you go down right along with it. Too many investors, both amateur and pro, are overlooking the #1 determinant of investment returns. Now this is risk…high risk!

Wouldn’t it be so much better to minimize the effect of these major drops and start capitalizing on the opportunities they present? Let’s try to flip that whole “high risk, low returns” concept around. Stay with me now…how about low risk, high returns?

Experiencing another major stock market drop is inevitable—this is what happens to all markets. We’ve had 89 straight, bullish months without a 20% decline (the definition of a bear market), compared with the average of only 59 months. I know most of you reading this can’t afford another 40% broad-market drop like we saw in 2008. You can’t afford high risk with very little chance of high returns.

So what are the alternatives?

In our opinion the best alternative is to mimic other great investors that have proven their skill over many business cycles; guys like Warren Buffett Charlie Munger, David Einhorn, Mohnish Pabrai and Guy Spier. If you can utilize the underlying strategy these, and many other great investors apply—then you almost can’t help but compound wealth over time, while significantly reducing your overall risk. It’s how you can achieve higher returns without necessarily taking on higher risk. That strategy boils down to only buying great stocks with a margin of safety, or on-sale price.

The bottom line is that the most successful and profitable investors are not always buyers in the stock market. Not when the market is facing high valuations, decreasing earnings, record global debt, slow growth, confused central bankers…the list can go on. The news is not always good, and just because Barrons, the Wall Street Journal, and your coworkers at the watercooler say you always need to be buyers…doesn’t mean that’s always the most optimal choice for your investment and retirement accounts.

The most successful investors only buy companies when they are on sale. That is, when they are priced for less than their true, intrinsic value. This is the approach we’ve been teaching and applying with great success for years.

This doesn’t mean that we will get out of the stock market altogether, and try to call, or time, the top of the market. If we’re able to buy the right companies at the right price, then it doesn’t really matter if the market drops; because we are confident of our long-term returns with the elite companies, regardless of the general market behavior. Most great investors still have some exposure to upward market movements with these top-tier stocks—because nobody, including the world’s greatest investors, can predict the future and call the top for any market. Nobody can be completely certain when a bear market will begin.

But the great, value-oriented investors are not making new purchases, and accumulating additional shares of company stock, at prices which don’t make any sense compared to their value. And you can be sure they are trimming risky positions in high-priced markets, and greatly reducing their market exposure in order to raise cash for the next stock market correction. This is a low-risk, high-return strategy. Low-risk because the risk of exposure to massive drops is greatly reduced; high-return because once they do make a purchase, the stock has a large amount of room to move up.

If we can’t find companies on sale—we don’t buy. As simple as that. We don’t worry about missing out on the next tech bubble, or even what’s going on in the economic world around us. If a great company that is producing cash and rewarding its shareholders goes on sale—then we snap it up—and we’ll go in big. If it’s overpriced, we don’t buy. This is a very simple approach.

We look to take the least amount of risk with the highest potential for big profits. This means there are periods of time when we are not buying stocks.

For example, during much of 2015 when stocks were sitting at frothy prices, the smart money was not forcing purchases on stocks which were teetering at these overvalued price levels. The smart money, instead, maintained exposure to upward movement with their best companies, yet began building up cash to buy stocks as they started dropping in price—well below their real, intrinsic values.

During this period, smart, value-oriented investors were not worrying that the market “could” go higher. They know that highly-overvalued stocks eventually crash down, bringing the buyers of those overvalued stocks right down with it.

The reality is—those investors who are willing to buy at high price levels, with no regard for the true value, are not usually the ones selling at even-higher price levels. They tend to continually think (or assume) prices will go even higher. It’s a classic case of the greater fool theory. This theory states that there will always be a greater fool willing to pay a higher price than you—no matter how much fundamental sense it may or may not make.

Those are the type of investors who are always buyers in the market, so they’re actually buying more at the top. What does value really mean to them anyway? Then, buyers at these high price levels are usually the same ones who ride the price down—well below where they actually bought in. Eventually, the fools disappear and the greatest fools are left holding the cards.

So the true value investors aren’t dependent on the greater fool theory, requiring more people to bid prices further into the stratosphere. They aren’t concerned about missing that ride up, when they can be pretty sure that ride will eventually end and turn back down, causing stress, anxiety, and—very frequently—a smaller investment account in the end. They’d rather pick it up on the way down—not worrying about that period of time sitting in la-la (overvalued) land.

These drops occur quite frequently. It happened on a major scale in 2008-2009. The market dropped quite sharply again in 2011. There were smaller drops (opportunities) between 2012-2014 as well. It happened more recently in August 2015, and it happened again earlier this year in January and February. The smart investors who built cash positions during these times were able to get bargain deals on some great companies once the markets pulled back in price.

On the more recent pullbacks, they’ve already realize some pretty hefty returns. Mutual funds and greedy investors are still lagging those value investors who refused to buy high, in the same time period over the last year. This, despite a record-high S&P 500 index at the time of this writing.

We and our subscribers were additionally able to take advantage of the volatility in these months—by selling puts to get into stocks, and selling calls to lock in big gains and lower our basis. These are very low-risk/high return techniques.

The great investors are not naive enough to believe that the market will march upward for eternity, completely neglecting the fundamental value of a business. Because markets don’t move this way forever. They focus on the value they’re receiving for the price they are paying.

In order to become a great investor yourself, you should understand that the #1 determinant of your future returns in the stock market is the price you pay relative to the value. Once you understand this, handing your money off to somebody who does not—will never cross your mind again.

 

How to Get High Investment Returns

The way to get high returns without taking high risk…is to buy $100 bills for $50.

Half off.

By being able to put an accurate value on stocks, you’re essentially gaining the power to find $100 bills at the bank that will be sold to you for $50.

Remember that analogy.

It’s a $100 bill—you know that you will be able to sell it back eventually for $100—it’s true worth. If you buy it for $50 today—you can produce astounding compounding rates of return for a long time to come.

And where’s the risk? If you know it’s worth $100 (which you do), there is little to no risk buying it on sale.

If you follow that logic, then just transfer that thinking over to individual stocks in the market.

When you’re able to pick stocks up at prices lower than their true value—it’s simply only a matter of time before you can sell them back at their true, higher worth. As Benjamin Graham has said— “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

In other words, in the short run—stocks can become inefficient and mispriced. Great companies ($100 bills) will frequently well below their value in the stock market, because they get out of fashion or analysts and investors get pessimistic about their future.

But in the long run, they are efficient and reflective of their true value. $100 bills (great companies) are worth $100 eventually—once analysts and other investors wise up to the true value. Buying them over and over for $50, or below, will give you a great return over time.

The key, then, is in figuring out a company’s true value, and not overpaying until they sell for less than their value. In order to buy a $100 bill for $50, we need to first be able to spot the $100 bills, then be patient enough to hold off on buying them until they are selling below that, ideally for about $50. Knowing that they ultimately return to their true value in the long-run gives us confidence that we will eventually be rewarded for smart purchases.

Buying $100 bills for $50 is one of our favorite analogies for summarizing what our investment strategy is doing.

But let’s get back to the discussion and the math on what determines your future stock market returns…

 

The Price You Pay Today Determines Your Future Investment Returns

Here’s the most important statement when it comes to your returns:

The single, most important determinant of the return you get in the future is the price you pay today

Let’s look at an example.

Suppose an acquaintance asked you to loan her money for a business.

She needed $75,000 to start it up, and agreed that she would pay you back $100,000 in just 8 years.

You trust her, and you loan her $75,000—and you hope to get $100,000 in return…in 8 years. Is this a good investment?

Going over to a savings calculator, we can see that equates to a 3.66% annual rate of return.

75k to 100k in 8 years

Loaning $75,000 (present value) and getting paid back $100,000 (future value) in 8 years equates to a 3.66% annualized rate of return

That’s not very good considering the risk involved. Unless you just wanted to help her out—you probably shouldn’t take that deal.

But what if she really needed part of that loan now—and was willing to accept a little less money now in exchange for the same payout in 8 years?

She’s now willing to take $50,000, and still pay you back $100,000, 8 years later.

Looking at the calculator, now the annual rate of return jumps to over 9%.

50k to 100k in 8 years

Loaning $50,000 (present value) and getting paid back $100,000 (future value) in 8 years equates to a 9.05% annualized rate of return

Now we’re getting into some decent returns. The only difference was the present value, or the price you paid (loaned out) initially.

What if you loaned her $25,000?

25 to 100

Loaning $25,000 (present value) and getting paid back $100,000 (future value) in 8 years equates to a 18.92% annualized rate of return

The annual return on that would be 18.9%.

The future value of $100,000 was the same in all cases—we know that’s the end result. The only difference in rates of return came from the amount you paid—or loaned out—up front.

That’s why we say: The single, most important determinant of the return you get in the future is the price you pay today. The price you paid your acquaintance in the above example is what determined your annual rate of return.

The same works with companies in the stock market.

If you can place a value on a particular company’s stock, then your future return is determined by the price that you pay today. And you better make sure that price is much less than its value—otherwise your return will not be high, possibly even negative.

Let’s say you believe the value of ABC Company, 10 years from now, will be $85 per share. Let’s also assume you’re willing to put $75,000 into this particular investment.

You look at the market price and you can purchase it for the low price of…$125 per share. Is this a good deal?

Wait a minute, if you think it will be worth $85 in 10 years—then why would you pay $125 for it now? You wouldn’t. That is, if you’re able to calculate the value. The thing is, most investors have no clue what the value of their stocks are. So $125 seems like a nice number and that sounds good enough for them. After all, the market, their broker or CNBC says it’s a fair price. This is the wrong approach and will not end up well. That’s high risk with low probabilities of a high return—most likely a negative return.

This is why value investing just makes so much sense. We can easily pass up paying $125 for ABC Company stock today because that just doesn’t make sense for the value that we place on it. Sure, things could change that could up the value down the road, but an investment strategy that relies on things going even better than we plan for is not a great strategy.

So we’ll pass on the projected -3.78% annual return and look for other opportunities, or check back on this one later.

A few months later, you see the price has fallen far, and you can now buy it for $75 per share—would you do it?

Assuming the value is still $85 per share…probably not. The return is just too low. A little over 1% annually.

$75 to $85 in 10 years

Paying $75 (present value) for a stock you expect to be $85 (future value) in 10 years equates to a 1.26% annualized rate of return

That means we could invest $75,000 and turn it into just $85,000 in 10 years.

75k @ 1.26% for 10 years

A $75,000 investment (present value) compounding at an annualized rate of 1.26% for 10 years, will turn into $85,000 (future value).

Not exciting enough to get our attention.

But when we are confident of the value, the rate of return we get is determined by the price we pay today.

If we could get that same stock for $30 per share, instead of $75/share, our return jumps up to almost 11% annually.

$30 to $85 in 10 years

Paying $30 (present value) for a stock you expect to be $85 (future value) in 10 years equates to a 10.98% annualized rate of return

That means the same $75,000 investment would turn into over $212,000.

75k @ 10.98% in 10 years

A $75,000 investment (present value) compounding at an annualized rate of 10.98% for 10 years, will turn into $212,500 (future value).

Get it for $15 a share…and our return jumps up to almost 19%. That’s compounded…18.94% annualized return.

$15 to $85 in 10 years

Paying $15 (present value) for a stock you expect to be $85 (future value) in 10 years equates to an 18.94% annualized rate of return

That’s turning our $75,000 investment into $425,000 over the same time frame.

75k @ 18.94% for 10 years

A $75,000 investment (present value) compounding at an annualized rate of 18.94% for 10 years, will turn into $425,000 (future value).

These differences are enormous—and it’s all determined by the price you pay today. The intrinsic value of the stock ($85) was the same in each case. The total investment amount ($75,000) was the same in each case. The only difference was the price per share; we could purchase many more shares of the company while it was selling for a much lower price. This made our initial investment of $75,000 worth so much more once the market valued the stock more accurately.

That is exactly why we, and other great investors, will only buy stocks when they are on sale—selling for less than their true face value. That’s how we realize consistently higher stock market returns than the typical investor.

Doing it any other way (paying too much) is putting on too much risk, without the increased probability of high returns. In that case, they only way we could make above-average returns is if a whole set of greater fools came along after us willing to pay much higher prices than the true value of the company’s stock. This isn’t a strategy we want to be dependent on in order to build up our accounts and retire on.

By the way, why might a particular company’s stock sell for less than its value? People aren’t stupid—especially seasoned money managers and Wall Street banks…why would they ever sell $100 bills for $50?

There are a great number of reasons. The main two revolve around emotion and different investing timeframes.

The stock market consists of real people making decisions. People get emotional and tend to get overly depressed on a stock in bad times, and overly euphoric about a stock during good times. This routinely brings stock prices way too low during the bad times, and way too high during the good times. These emotional price swings are a great time to take advantage of both low (buying opportunity) and high (selling opportunity) prices.

Plus, most individuals and almost every professional is working with a short investment timeframe. They want to do well, or look good, every month—or every quarter. We do not.

We look for high, long-term returns, and this gives us enormous advantages. We don’t worry about short-term issues that have no impact on the long-term value of a company. We don’t concern ourselves with an earnings miss of a few cents, in the same way Wall Street does. This approach makes an enormous difference over the years.

These two reasons create massive price discrepancies because of short-term—oftentimes emotional—overreactions (up and down) without any material change in the long-term value.

Maybe there is bad news from the company, industry, or economy—and market participants don’t know what it means for the future. Down goes the stock price…mutual fund managers don’t want to be caught with a bad stock, and emotional investors think it’s the end of the world. As a result, they start selling at any price. This drives the price down even further—sometimes well below it’s true, intrinsic value. As long-term investors who don’t lose their cool, we can determine if bad news is detrimental to the long-term competitive advantage of the company whose stock is getting pummeled. This is when we’ll look to buy.

It’s comparable to someone selling us a Ferrari on the cheap because they can’t get it to start, and the paint is chipped. They’re fed up, it looks dirty and needs new paint, and it doesn’t run so it must not be good. Then we come in—buy it on sale, replace the alternator and give it some paint/detail work—and all of a sudden we have a fully functioning, impressive-looking Ferrari that we can sell at top dollar—because we understood there was hidden value there.

Maybe that’s an extreme example…but you get the point. The short-term outlooks and emotional overreactions are what create opportunities for fantastic entry points and exit points for smart investors. Sooner or later, as Benjamin Graham said decades ago, the market will once again become a weighing machine and pay us the true, full value of our stocks—or higher.

I strongly urge you and hope that you will learn to invest like this for yourself; or only invest your money with funds, managers, and advisors who understand and will apply this type of thinking for you.

You can learn more about how we find stocks on sale and value them—and even see which stocks we’re currently looking at—in the Investment Intel weekly webinars. Every Wednesday night, we personally discuss different investment ideas, strategies, and current lessons to be learned and profit from in the market.

 

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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