a great article on why we should choose great stocks
jim jubak
How important to buy at the bottom?
The bear has taken down a lot of good stocks. But before you snap them up, look at the effect price and timing have on projected returns for Dell, Johnson & Johnson and Exxon.
By Jim Jubak
Dell Computer (DELL) sure looks appetizing. At $52.50 a share, the stock's price on Oct. 13, Dell was down about 30% from its high of $69 a share on Sept. 28.
But wait a minute. I can think of plenty of stocks that looked cheap when they were down 30% a few weeks ago -- and that look even cheaper today. Merrill Lynch (MER), for example, looked like a screaming buy when it was at $75 a share, down from $109. Remember? But the stock just kept on falling. Right now it trades at about $48 a share, almost 60% below its high. And that's after a rally off its low of $35.75.
Buying on the dip used to be easy. You plunked down your money the day after a 500-point drop in the Dow Industrials and a week later you were in the black.
But this time it's different. Investors who have snapped up stocks on a dip have seen shares dip even lower. The market hasn't bounced off a bottom -- it's not even clear that the market has made a bottom. Even after Thursday's rally, I'd argue we're still stuck in a trading range at the moment. There's enough bad news ahead that it could send the market down below recent lows. And we can't tell how far off the upturn is.
But even knowing all that, I still find myself tempted. Some stocks that I've wanted to own for the last two or three years suddenly look very affordable.
So instead of either making a trade I might regret or just fretting about passing up these prices, I decided to take a look at exactly how much it matters to catch the absolute bottom for a stock. Does overpaying by 10% or more doom me to mediocre returns forever? Does being anywhere from six months to a year early insure that I'll never match the returns on 30-year Treasury bonds?
And I got a bonus for my work. Not only did I discover the answers to these questions, I learned I wasn't even asking the most important question of all in this market.
Charting the different scenarios
My study was pretty simple. I picked three stocks: A fast-growing, volatile stock, Dell; a solid growth stock that is about as volatile as the market as a whole, Johnson & Johnson (JNJ); and a solid performer that is less volatile than the market as a whole, Exxon (XON).
(I used beta, a measure that compares a stock's volatility to that of the market as a whole, to pick. Dell has a beta of 1.6. That means it's about 60% more volatile than the market as a whole. Johnson & Johnson has a beta of 1. Exxon's beta is 0.7. You can find a stock's beta on Investor in the Business Profile/Overview section. You can also screen for beta using Investor's Finder.)
Then I built 24 different scenarios for each of the three stocks using Excel. I based my first set of 12 scenarios for each stock on its historical rate of appreciation during the last five years -- that's 69.47% annually for Dell, 23.08% annually for Johnson & Johnson, and 19.08% annually for Exxon.
Files require an Excel-compatible spreadsheet program.
In Scenario 1, I assumed that the stock would climb from the current price at the historical rate for the next five years. Needless to say, those base cases were all pretty rosy. An investment in Dell, for example, under these conditions would grow by a cumulative 1,298% over five years, from $52.50 a share to nearly $734 a share. Johnson & Johnson would appreciate 182%, to $219 a share from $77.50, and Exxon 139% to $175 a share from $73.
Then I built scenarios that got progressively nastier. First, I asked what would happen if, instead of hitting the bottom, the stock fell another 10%, 20% or 30% before starting to appreciate. Then I asked to see the results if you got the price right, but the stock stagnated for a year or two years. And then, worst of all, I combined a continued decline of 10% to 30% with stagnation for either one or two years.
Of course, all those scenarios assumed that the future would mirror the past, in that stock returns would continue to far outstrip the long-term historical returns from owning equities. So I next rebuilt all these 12 scenarios for each stock with a lower rate of appreciation. I assumed that prices in the overall market would appreciate at about 10.6% a year -- roughly the long-term rate of appreciation for large-company stocks since 1926, according to Ibbotson Associates. Then I used the betas for each stock to calculate a new rate of appreciation for my three sample stocks. That gave me 16.96% annually for Dell, 10.6% (the market rate) for Johnson & Johnson, and 7.42% for Exxon. (Please don't read these, or the historical numbers I used above, as predictions for specific stocks. I'm not making predictions here.) I plugged those lower rates of appreciation into each of my 12 scenarios.
Finally, I calculated a rough benchmark by assuming that I would be able to get 5% a year in interest and appreciation if I bought long-term Treasury bonds. That gave me a kind of minimal risk appreciation of 27.6% over five years to use as a comparison to my stock scenarios.
If you think we'll get back to the gains of the last five years, then timing and pricing aren't terribly important. But how likely is that?
As you might have guessed, if a 69.47% growth rate continues to be the norm for Dell, it really doesn't matter how badly you misjudge the bottom. Buy Dell and have it fall another 30%, and the five-year appreciation sinks to a meager 678%.
Profiting from Dell is timing issue
Your profit in Dell is much more sensitive to time -- hitting the entry price right, but having the stock stagnate for two years before the historical appreciation kicks in drives the five-year gain down to 386.7%.
At worst, however, you simply can't do badly in Dell as long as this rate of appreciation holds up. If the stock falls another 30% from your purchase price and doesn't move up for two years, you'd still more than triple your money over five years.
For Johnson & Johnson, the stock in the middle, price and timing work out to be about equally important. Buy 30% too high or two years too early, and the five-year gains -- 79.2% and 86.5%, respectively -- are about the same. And again, as long as the historical rate of appreciation holds up, you simply can't lose with Johnson & Johnson. Even buying 30% too high and two years too early still produces a gain of 30.5%, better than the 27.6% from bonds.
Exxon, the stock with the lowest rate of appreciation historically, is the mirror image of Dell. The investor who overpays for Exxon suffers more than does the investor who is too early. Returns in the two cases are 54.2% and 68.9% respectively. And you can actually do worse in Exxon than in the benchmark bond scenario. If you buy 30% too high and two years too early, the five-year gain is just 18.2%.
From this half of my study, I've reached a couple of conclusions. First, stock selection is more important than calling the bottom in price or time. These scenarios do so well because I picked stocks with solid or superlative rates of appreciation. If you get the stock right, timing and price matter relatively little. And second, timing and price matter less for higher-growth stocks. You could have bought at the worst possible time and you still would have made a lot of money over the last five years.
Bull markets that produce gains about twice the historical average are mighty forgiving of mistakes in when you buy.
When the market is less forgiving
It's a very different story if you assume that rates of appreciation are going to be closer to the historical mean for the next five years. (Please note that I'm still talking about very solid positive returns.) The market is clearly far less forgiving of mistakes when prices are advancing more modestly.
For example, at this rate of appreciation, if you buy Dell at the current price and it tumbles another 30% before recovering, the gain over five years dips to just 42%. If you over pay by 30% and the stock stagnates for a year, the five-year gain is just 31%. If you buy 30% too high and the stock stagnates for two years, the five-year gain is just 12% -- way below my Treasury benchmark.
Johnson & Johnson dips below the Treasury benchmark even if you make a much smaller mistake. Overpay by 20% and see the stock only sluggishly recover for the first year, and your five-year gain falls to 26.1%. In the worst-case scenario -- pay 30% too much and see no appreciation for the first two years -- and you actually wind up with a 5.3% loss over the five years.
And Exxon, as you'd expect, dips into negative territory much more quickly. Pay 30% too much and see no growth for a year and you're already looking at a five-year loss of 6.8%, for example.
Don't leap to the conclusion that this makes Dell the superior investment, however. Some of the worst scenarios for low-beta Exxon, for example, are extremely unlikely -- a stock that's less volatile than the market as a whole isn't likely to fall 30% from its current price.
Will the future resemble the past?
To compare these outcomes, I think you have to discard the extremely unlikely scenarios for each stock and concentrate on the possible worst-case scenarios. For example, I can see a 30% fall from current prices for Dell and a one-year period of stagnation in price if the PC market continues to show anemic growth. So for Dell, a realistic worst case to worry about would be a five-year gain of 31%. For Exxon, I could see a further 10% decline from the current price and a two-year stagnation if oil demand stays depressed. That gives me a realistic worst-case five-year gain of 11.6%.
But the most important conclusion I've drawn from all these case studies is that purchase price and timing aren't the most important things to worry about. The real question is: To what degree will the future resemble the past?
If we're looking at a resumption of the gains of the last five years after this economic mess has worked itself out, then timing and pricing aren't terribly important. But if you think that the world economy will grow more slowly even after the current crisis passes, and that the amazing returns on capital of the last five years will come back to earth, you need to buy carefully. That's only when you see evidence that a stock has formed a price bottom and that sales are headed back up.
Frankly, I think the latter outlook is more likely. So be careful out there.
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