Here's How to Get 'One Hell of a Result' from Stocks - The 5 Minute WrapUp by Equitymaster
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Here's How to Get 'One Hell of a Result' from Stocks

May 26, 2016
In this issue:
» Midcaps bask as Modi govt. celebrates its second birthday
» Bond guru Gundlach warns of big correction in US stocks
» ....and more!
0:00
Rahul Shah, Co-Head of Research

Muhammad Ali, Bruce Lee, Michael Schumacher. These guys were so damn good at what they did that their names have become synonymous with the sports they dominated.

What if investing were a sport? Whose name would you see at the top?

Charlie Munger's would certainly be somewhere close.

So when Munger spells out his recipe for getting 'one hell of a result' from stocks, our mouths water. And here's what his delicious recipe looks like:

  • If a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.

And voila! That's how you get an outstanding result.

So if you have the skills to find a business that can earn 18% on capital over the long haul (a big 'if'), Munger says you shouldn't be afraid to stretch your wallet to buy it.

But does this mean you can close your eyes and pay just any price? Let's work this out to find the answer...

So say you find a business you are sure can earn 18% return on equity over the next thirty years. Let's assume a conservative price-to-earnings (PE) of 15x at the end of the thirty years. Now, just how much should you be willing to shell out to still get a good result?

Have a look:

If you bought at a PE of... Your compounded returns over 30 yrs would be Value of your capital will multiply
15 18% 143x
20 17% 108x
25 16% 86x
30 15% 72x
40 14% 54x
50 13% 43x
75 12% 29x
100 11% 22x

Source: Equitymaster

So there it is. For such an outstanding business, you could pay a PE multiple of up to 30x and still end up with a pretty good result.

And if you're awfully sure about the company, maybe you could take that to a generous 40x. But go beyond that and you can't escape doing real harm to your returns from even an exceptional business.

Munger was right. You can pay an 'expensive looking' price and still end up with a pretty good result. However, as with most things in life, this too has its limits. Limits that you will do well to keep in mind no matter how good the story of the company.

How much would you be willing to pay for a really outstanding business? Let us know your comments or share your views in the Equitymaster Club.


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2:35 Chart Of The Day

The Modi government celebrates its second birthday today. The stock markets had greeted Modi's arrival with much fanfare. Within months of his occupying office, the Sensex went up by 20%, even reaching a new all-time high. Has the buoyancy continued? It hasn't if today's chart of the day is any indication. The Sensex has given up almost all of its gains since then and is up a mere 5% at the end of Modi's two years at the helm. While mid and small cap stocks have also had some sort of a reality check, their point to point gains of 31% and 23% respectively are still looking good.

Any guesses as to how the next three years are going to pan out? Well, we are positive on account of a couple of reasons. Firstly, irrespective of the Government at the center, the benchmark indices haven't really stopped going up from a long term perspective. Therefore, even if the Government struggles to implement key reforms, at current valuations, the indices do look a good long term proposition. In fact, with profit margins expected to revert to the mean, the earnings might receive an even stronger boost than before. And if the indices keep pace, returns of 60%-70% from a medium term perspective do look like a strong possibility. Mind you, this does not capture the upside from the Government actually being able to put in some serious reforms. Taking both of these factors into consideration, the risk reward ratio at the current juncture is definitely in favor of the investor in our view.

Midcaps the Best Performers in 2 Years of Modi Govt.

Midcaps the Best Performers in 2 Years of Modi Govt.


3:45

We expect no one, absolutely no one, to get their macro calls right ten times out of ten. However, if a person correctly predicts that oil prices would plunge, that junk bonds would live up to their names and also that China's economic troubles would pressure emerging markets, the man is worth paying attention to. Bond guru Jeffrey Gundlach is the guy we are referring to. What is on his mind these days? Well, Gundlach feels that the US stocks are dead money. They don't look incredibly healthy to him, implying a big correction could be round the corner.

Gundlach is not the only successful investor who feels this way. We have talks about how another ace investor Stanley Druckenmiller urged investors to get out of stock markets and seek safety in gold. Then there's Icahn who's apparently bet big on a stock market crash.

If all of this is sounding contradictory to the 70% upside in stocks over a medium term perspective, let us tell you, it certainly is.

Do note that while long term wealth building would require you to stay in Indian equities, you should also be on the lookout for some macro risks and prepare for it accordingly. And this can be done through having some allocation in a crash proof asset like gold and by also by keeping some cash handy. The latter because if the crash causes good quality stocks to become attractive, they can be bought into using the cash in hand.

4:50

After going up by 575 points yesterday, the BSE Sensex has continued with its positive momentum as it was higher by another 165 points at the time of writing. BSE Mid and Small cap indices were also amongst gains. Amongst sectors, capital goods looked the standout performer. Auto and power stocks also looked buoyant.

4:56 Investment mantra of the day

"Nearly all the bull markets had a number of well-defined characteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality." - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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4 Responses to "Here's How to Get 'One Hell of a Result' from Stocks"

Mohamed Shuaib

May 28, 2016

For growth of 14% for 30 years, the current Price to capital ratio works out to be (1.14/1.08)^30 = 4.98
Capital to earnings ratio = 1/0.14 =
7.14 as per ROE of 14%
So as per the above calculation current PE works out to be 4.98*7.14 = 35.57, but our considered PE is 40 which is higher.So 15% roe and 30 PE is minimum good price to buy.

Please reply if I have worked correct

Like 

SJ

May 27, 2016

Siddharth,

The way I could figure it out is,
If say today you buy at a price of 15(considering the 15x) and compound it for a period of 30 years assuming a sure ROE of 18% pa, the price of your share will go up to 15*((1.18)^30)=2150.56. This 2150.56/15 is 143x i.e your 15 shelled out today will be 143.3706*15=2150.6, thirty years from now.

Like 

subrata

May 27, 2016

Thanks for the insight! I always felt that for such outstanding business paying slightly more is reasonable, but now your article has given a mathematical angel to the amount of risk that I can take in such investments.

At Siddharth, hope the below helps! I have tried to break the table Rahul posted above.

P/E Returns Capital gains Shares bought Share price bought P/E at 30 Share price at 30 Capital gains
15 18% 143.4 6.7 15 15 2151 143
20 18% 143.4 5.0 20 15 2151 108
25 18% 143.4 4.0 25 15 2151 86
30 18% 143.4 3.3 30 15 2151 72
35 18% 143.4 2.9 35 15 2151 61
40 18% 143.4 2.5 40 15 2151 54
50 18% 143.4 2.0 50 15 2151 43
75 18% 143.4 1.3 75 15 2151 29
100 18% 143.4 1.0 100 15 2151 22

Like 

Siddharth

May 26, 2016

I m not able to understand how you would be able to earn a CAGR of 18% on a P/E of 15x

Are you assuming the P/BV to be 1x ?

Also is the assumption being made that the increase in book value would result in a proportionate increase in the Market Price of the stock ?

Like 
  
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