Take A Profit, Lose Out On The 'Ultimate Bonanza'

by: Eli Inkrot


Many are suggesting that the market is too high right now and you can’t go broke taking a profit.

While it might be rational to expect lower returns in the future, this is certainly not the same thing as negative returns.

In this article I detail past examples and future possibilities to realign one’s perspective.

With all the market hoopla over the last half-decade, today's investor might believe that they have "missed out" on the party; that, in light of new highs being hit on a regular basis, it's simply too late to make an intelligent investment decision.

"Just look at the facts!" some might clamor. Since the bottom in 2009 the S&P 500 index (NYSEARCA:SPY) is up over 200% included dividends; a roughly 24% annualized rate. Considering the long-term average peaks out in the high single digits, the recent past is surely an aberration and "must" fall back. Expressed differently, for those trying to commit capital today: woe is you, right?

Yet lower returns do not mean negative returns. Moreover, lower returns certainly do not preclude you from reasonable progress. Someone could have made the same argument at the beginning of 2013: "You know, the market has doubled in just 3 and a half years, you can't go broke taking a profit." Subsequently missing out on the best year in the past decade and a half.

In the short-term no one has a clue. In the long-term all we can do is have rational expectations. Yes, it's rational to expect lower returns during the next 5 years as compared to the returns the market provided over the previous 5 years. But the follow up ideology shouldn't be "that means I won't invest." Instead, you simply need to be conscious of your expectations.

While re-reading Ben Graham's "The Intelligent Investor" I came across an ideology that is particularly applicable to today's investment framework:

Internal and external pressures are likely to force [you] to take what seems to be a goodly profit, but one far less than the ultimate bonanza.

With the exception of "goodly" and "bonanza" not being tossed around regularly in conversations anyone, the logic still holds. Graham was talking about the concentration of one's holdings, but this concept can certainly be applied to having a long-term time horizon.

Consider a few examples, which I have previously outlined.

In 1919, Coca-Cola (NYSE:KO) was selling for $40 a share. Now I can't be certain of the market dynamics back then, but given that it was trading (and thus a seller existed for each buyer) it's plausible that some felt it was valued too high. True to form, in the next year shares of KO dropped to just $19. Yet consider what happened in the aftermath: had you bought at $40 and reinvested the dividends that investment would be worth about $10 million today.

Of course regardless of how truly long-term an investor you are, few have 95 year time horizons. Thus I updated the example dating back to 1970:

By 1970 Coca-Cola had been paying dividends for half a century and was selling for $82 a share. And you might have thought that price was a couple of dollars too high, or the dividend yield was too low or that it had a good run, but it's time to shine in the beverage world was over. You can always find a few reasons why it's not the ideal reason to buy. Years later you would have seen presidential scandals, an oil crisis, double digit inflation, various wars, terrorist attacks and a global financial crisis, the whole thing. There's always a reason, but in the end if you bought 1 share for $82 and reinvested the dividends it'd be worth about $12,000 now. And that factor so overrides everything else. Considering the companies that you want to own for the very long-term is often just as essential as thinking about the valuations that the market is offering.

Interestingly, even "overvaluation" does not necessarily preclude you from reasonable returns. Consider the example of Genuine Parts (NYSE:GPC), a company that has not only paid but also increased its dividend for 58 years. At the end of 2004, shares of GPC had a price-to-earnings ratio of about 19.5 - higher than it had been in the past decade. Moreover, the share price was simultaneously trading at an all-time high. As such, you might have believed that caution was the word, correct?

Yet a hypothetical $10,000 investment at the end of 2004 - when shares were priced higher than ever - would now be worth about $23,000 a decade later. Your annual return would have been about 9% against the S&P 500 index's 6.5% yearly gain. It's easy to see that short-term worries could impede you from long-term gains.

A final example relates to the "market" as a whole. The news reports "all time highs" as an important event, but truly it is a required and ordinary "phenomenon." In the past couple decades a "new high" has been reached hundreds of times at an average rate of a couple times a month.

Think about a bank account with your entire net worth in it. As long as that account is paying interest (no matter how small) - and you don't withdraw from it - each and every year your balance would reach an "all time high." It's elementary math. Similarly, businesses are allowed to call themselves businesses because they make profits; they take capital and earn a return on it. It's the same concept as the bank account example, except businesses usually generate even greater returns. Thus "record profits" and the corresponding "all time highs" shouldn't be especially newsworthy as much as it should be expected.

On a forward-looking basis, these examples can be a helpful reminder. You might believe the general market is high, that prices could fall in the future or even rationally expect lower returns moving forward. Yet these concepts are not mutual exclusive from investing today. In fact, they should play a primary - although certainly not debilitating - role in one's analysis.

Coca-Cola has a P/E ratio of about 20 today and an expected intermediate-term growth rate of roughly 6%. This compares to an average P/E of 19 over the last decade and a low P/E in the 14 to 15 range. So sure, you would prefer to buy shares around 15 times earnings rather than 20 - yet that chance rarely presents itself.

If KO trades at the same P/E ratio in the future, you might expect annual returns in the 8-9% range given the growth expectation. Interestingly, even if KO trades at say 16 times earnings, this could still represent say 5% returns. Surely not impressive, but keep in mind the idea that lower returns rarely equate to negative returns. Long time horizons coupled with strong and growing businesses can provide solid results.

Genuine Parts presently trades at about 20 times earnings against an average closer to about 17 over the last 10 years. It is possible that GPC could return to this range? Absolutely. Yet despite this P/E compression, that may still mean 6-7% returns over the intermediate-term.

Finally, the S&P 500 index as a whole is trading in the 17-18 P/E range depending upon your classification of earnings. This actually isn't that far off from the index's average, but for argument sake let's see what happens if the multiple drops to 15. Given a growth rate around 6%, this could indicate an annual return in the 5-6% range with dividends.

Here's the takeaway: it can be all too easy to focus on the recent past and make expectations about the far off future. It's perfectly reasonable to expect lower returns in the next few years, yet recognize that this is not the same as negative or unrewarding prospects. Especially in today's environment, there's nothing wrong with partnering with great businesses that you believe could provide high single digit (7-9%) or better returns moving forward. Sure its not the double digits returns of the past few years, but given enough time and effort you'll be amazed at what those "lowly" 7% returns can accomplish over a lifetime; the "ultimate bonanza" of consistency and compounding.

Disclosure: The author is long KO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.