Microsoft History Teaches Us An Important Price to Value Lesson
Microsoft history teaches us an important price to value lesson. My story involves Tyler and Brandon. The example is true, the names have been changed to protect the innocent (joke!).
In December 1999 Tyler and Brandon were looking for a great long term investment. Both felt they needed to buy a quality company with a proven track record and great long term prospects for dividends and growth.
Differences in Philosophy
What do you think is most important? Company earnings, growth of profits, dividends, dividend safety, growth of dividends, cash flow? Of course all of these are important. But I’m going demonstrate that the most important lesson an investor can learn is the difference between price and value.
Each diligently did their homework and decided they found the best company to hold for the next 15 years or more. Tyler completed his research and believed in buying the best company regardless of the price. He felt because he was buying for the “long term”, as long as he bought the best company, his returns would be at least average.
Brandon has a little different philosophy. He was a value investor who believed in looking for great companies, but then wait for a price that offered a margin of safety.
Microsoft History for Tyler and Brandon
Both Tyler and Brandon chose the same stock: Microsoft (MSFT). They were both astute investors for choosing a great company that would go on to have long term success.
The difference between the two investors was Tyler immediately bought the stock at $59.97. Brandon agreed with Tyler’s choice for the best company but believed that $59.97 was too much to pay for the company. There was no margin of safety. The price already reflected the good prospects for future growth.
Brandon understood that if you pay ahead of time for future growth, and something goes wrong, he had a lot more to lose (risk), and if things went well the upside was already reflected in the price he was paying upfront. He decided to keep that portion of his portfolio in cash and wait for a better price.
Just one year later, in December 2000, the price of the stock had dropped under $22. It was the same company with the same prospects but Mr. Market was valuing it as a price that offered a margin of safety. So one year later, Brandon bought this great company at a favorable price.
Now, in April 2016 Brandon has received $11.07 in dividends for his $22 investment (a 50% return on his investment in dividends).
Both bought the same company but Tyler ignored value and concentrated on growth. Brandon insisted on buying the stock at a price that gave him a high probability of a good outcome.
Now let’s calculate their total returns:
Microsoft currently trades at $55.57 (4/01/2016).
Tyler has received $11.07 in dividends and has a <$4.40> capital loss because he paid $59.97 (fifteen years ago!). He has a total net gain of 11.1% for a 15 year investment.
Brandon has received $11.07 in dividends and has a $33.57 capital gain. His total net gain of $44.64 represents 203% gain on his $22 investment.
That’s right, Brandon has a 203% gain versus Tyler’s 11% gain just because he insisted on buying with a margin of safety. They purchased the same stock, received identical amount of dividends, and sold at the same price. Yet their returns are unbelievably different.
I used an example where Tyler and Brandon did buy a great company. How about all the investors who made the mistake of buying companies that went bankrupt or did not do as well as Microsoft? Or, how about if Tyler had panicked and sold his stock in the 20’s in 2000? In reality that is how many investors allow their portfolios to be destroyed.
Interested in Dividends?
Price vs. Value Lesson
Taking advantages of opportunities brought about by volatility requires a different mentality than the average investor. You have to think differently.
The price you pay for a stock will greatly affect your returns. It’s a double edged sword because your capital gains AND dividend yield are affected by the price you pay.
Learn how to control your emotions. You can train yourself to do the unnatural. I will admit I can almost be giddy with exuberance on days the market is getting crushed (I get to buy bargains!) and much less enthusiastic on days the market is soaring (I have to sell my stocks that are overvalued).
This is because I know when I get to buy bargains my long term returns are going to be higher. If I’m having to sell over-valued stocks I know my long term returns are going to be lower. You have to learn to think that way!
Howard Marks, in the Most Important Thing, calls it “Second-Level Thinking”! Investors allow greed, fear, and other emotions to defeat their objectivity. This leads the way to significant mistakes. Investors who choose to believe the market can’t be beat leave the inefficiencies for those willing to be second level thinkers.
“No asset is to good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough”.
The most important thing is the relationship between price and value. Investor psychology can cause prices to be mis-priced. In the short run, investing is more like a popularity contest. Before buying a stock ask yourself if your emotions are being affected by its popularity.
The most dangerous time to buy a stock is at the peak of popularity. At that time, all the positive data and assumptions are reflected in the price. Everyone that is going to buy has already bought.
The optimal time to buy a stock is when no one else wants it. At that point, all the negative data and assumptions are reflected in the price. Everyone that is going to sell has already sold.
Learn this from our Microsoft history lesson: If you have done your research and are prepared to act, Mr. Market will give you opportunities to take advantage of him. Learn to be patient. Wait for the price to value ratio that puts the odds of winning heavily in your favor!
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