Benjamin Graham Was Right: Price Is Paramount

Includes: CL, GE, JNJ, KO, MCD, MDLZ, PG, SJM, WFC
by: Tim McAleenan Jr.

One of Benjamin Graham's most famous investing dicta is that "Price is Paramount," meaning that the initial price paid for a security by an investor will be the largest determinant of future returns. Obviously, this makes sense. If you buy $6 per share for General Electric (GE) and sell it for $18, you will do much better than if you buy at $12 per share and sell at $18.

I was looking at some historical investment calculators to gauge the long-term performance of blue-chip stocks, companies like Procter & Gamble (PG), Colgate-Palmolive (CL), McDonald's (MCD), and Coca-Cola (KO). We often hear statistics like, "If you invested $100,000 in Wells Fargo (WFC) in 1980 it would now be worth $4.7 Million" or something similar. I was struck by the difference in the long-term performance based on the point in the given year that you decided to make that initial purchase. That is to say, whether you bought that Wells Fargo stock in January of 1980, April of 1980, or December of 1980 has a stronger impact on returns than you might think.

To give you an example, I looked at the difference between an investor who purchased shares of Johnson (JNJ) in 2000 at the high of $53.00 right before the dotcom bubble burst compared with the low of $33.10 by the end of the year. Johnson & Johnson posted annual earnings of $1.70 in 2000, and paid out $0.62 in dividends. The investors who bought at the high would have purchased their shares at a P/E ratio of 31.17. Those who were able to get in at the low would have paid 19.47x earnings. As for the dividend yield, the high payers would have gotten in at a 1.17% annual dividend yield, and the low payers would have had an initial dividend yield of 1.87%. I included a chart to show the difference in annual dividend income, total dividend income, and current yield on cost that an investment at the high and the low would have come to represent.

Click to enlarge:

Johnson & Johnson currently trades at $66.00 per share. If you would have purchased at $53.00 in 2000 and not reinvested the dividends, your 188 shares would be worth $12,408 and you would have received $3,118.92 in dividend income along the way, turning your $10,000 investment into $15,526.92. And if you would have made your initial investment at $33.10 and not reinvested the dividends, your 302 shares would be worth $19,932 and you would have received $5,010.18 in total dividend income over that time period, turning your $10,000 initial investment into $24,942.18. That's the difference between a 155.26% return and a 249.42% return. Or, if you're a dividend-focused investor, that's the difference between a 4.23% yield on cost that you receive in the form of a $423.00 annual check and a 6.80% yield on cost that comes in the form of $679.50 annual check.

Looking at this kind of chart in the context of Johnson & Johnson, there are three main take-away points that we can extrapolate and craft into an overall investing strategy:

  1. Often, we see statistics that demonstrate how lucrative investing x amount of dollars in such and such a year turned into a lot more money. There is nothing wrong this; prudent investing for the long haul is certainly a wise strategy to follow. But it's worth keeping in mind that many of these eye-popping statistics use the company's low point in configuring their analysis. For instance, when Money Magazine ran an article about how a $10,000 investment in Johnson & Johnson during the 1980s turned into $200,000+ investment 25 years later, they used the low price point after the October 1982 Tylenol recall sent the prices pummeling. This isn't dishonest, but it does use price points that very few us bought in on. There aren't that many people who managed to buy General Electric at $6 per share or Wells Fargo at $8 per share in 2008/2009, that will hold those shares for 20+ years.

  2. Johnson & Johnson was trading at 40x earnings at its high in 2000, and around 20x earnings at its low in 2000. No value investor (or intelligent investor for that matter) would ever recommend buying shares of a mega-cap consumer staple for 40x earnings-the formula for getting rich generally doesn't include buying shares of Kraft (KFT) or Smucker's (SJM) for 2.5% earnings yields. Likewise, even the low price of $33.10, or 20x earnings for a mega-cap consumer staple, is generally not synonymous with value investing. Heck, the yield of JNJ stock still amounted to less than 2% at the 2000 year low, which is usually way too low of a yield for income-based investors to even consider.

  3. To end on an optimistic note, I still think it's quite commendable (and speaks to the underlying strength of Johnson & Johnson's brands) that investors who bought JNJ stock at the 2000 high with a 2.5% earnings yield and 1% dividend yield were still able to earn a 4-5% annual return eleven years later. Especially given the high exorbitantly high buy-in price. Long-term investing is a two-step process: Not only do you have to identify the excellent businesses that you would be comfortable holding for decades, but you're supposed to wait for a low-to-reasonable price to establish an initial purchase. And investors who paid 40x earnings for Johnson & Johnson stock did anything but that. That's one of the blessings of excellent businesses: Even if you overpay drastically for your shares, companies like Johnson & Johnson that grow earnings and dividends by 8%-11% per year will eventually offset that mistake and deliver positive returns. For investors who violate Benjamin Graham's "Price is Paramount" mantra, this a fine consolation prize.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.