How Falling Stock Prices Can Make You Rich
When Buying Ownership in Good Businesses, Stock Market Crashes Are Your Friend
One of the most popular topics among new investors is how to deal with falling stock prices. Everyone talks a good game but the moment quoted market values decline, panic is not uncommon. I've seen it many times in my life. In periods building up to stock market highs, people on even conservative investment forums begin discussing the so-called prudence of a 100 percent equity asset allocation, suddenly thinking they have no business investing in bonds or maintaining reasonable cash reserves.
An ordinary 33 percent or so drop — and historically, that's business as usual from time to time — and suddenly they're gone, swearing off everything from individual stocks to index funds. I've told you this before, and I'll tell you it, again: If you live an ordinary life expectancy, you will see your entire equity portfolio decline from peak-to-rough by 50 percent or more at least once, possibly thrice or more. The individual components will fluctuate much more wildly than the portfolio as a whole, to boot. It is the nature of the asset class. It cannot be avoided and anyone who tells you otherwise, be they a financial advisor or mutual fund salesman, is either lying or incompetent. There is no equivocating or qualification when it comes to the academic data. You don't have to invest in stocks to get rich so if this bothers you, accept that you don't deserve the returns they can generate and be fine with it.
That said, I want to talk about falling prices; how you, as an investor, should think about them if you know what you are doing and buying good assets. To do that, we need to back up and talk about stocks more generally for a moment.
Three Ways to Make a Profit From Owning a Business and Investing in Stocks
In general terms, there are three ways to make a profit from owning a business (buying stock is merely purchasing small parts of a business whereby you get these nice little certificates or, if you prefer, a DRS record — depending on how many pieces of stock a company is divided into, each share will receive a certain portion of the profits and ownership).
- Cash dividends and share repurchases. These represent a portion of the underlying profit that management has decided to return to the owners.
- Growth in the underlying business operations, often facilitated by reinvesting earnings into capital expenditures or infusing debt or equity capital.
- Revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings.
If you actually own the business outright, you can profit an additional way, by putting yourself on payroll and taking a salary and benefits but that is another discussion for a different day.
An Example to Illustrate These Points
It may look complicated, but it’s really not. Imagine, for a moment, that you are the CEO and controlling shareholder of a fictional community bank called Phantom Financial Group (PFG). You generate profits of $5 million per year, and the business is divided into 1.25 million shares of stock outstanding, entitling each of those shares to $4 of that profit ($5 million divided by 1.25 million shares = $4 earnings per share).
When you open a copy of the stock tables in your local newspaper, you notice that the recent stock price for PFG is $60 per share. It is a price-to-earnings ratio of 15.
That is, for every $1 in profit, investors seem to be willing to pay $15 ($60 / $4 = 15 p/e ratio). The inverse, known as the earnings yield, is 6.67 percent (take 1 and divide it by the p/e ratio of 15 = 6.67). In practical terms, this means that if you were to think of PFG as an “equity bond” to borrow a phrase from Warren Buffett, you would earn 6.67 percent on your money before paying taxes on any dividends that you’d receive provided the business never grew.
Is that attractive? It depends on the interest rate of the United States Treasury bond, which is considered the “risk-free” rate because Congress can always tax people or print money to wipe out those obligations (each has its problems, but the theory here is sound). If the 30-year Treasury yields 6 percent, why on Earth would you accept only 0.67 percent more income for a stock that has lots of risks versus a bond that has far fewer?
It is where it gets interesting.
On the one hand, if earnings were stagnant, it would be foolish to pay 15x profits in the current interest rate environment. But management is probably going to wake up every day and show up to the office to figure out how to grow profits. Remember that $5 million in net income that your company generated each year? Some of it might be used to expand operations by building new branches, purchasing rival banks, hiring more tellers to improve customer service, or running advertising on television. In that case, let’s say that you decided the divvy up the profit as follows:
$2 million reinvested in the business for expansion: In this case, let’s say the bank has a 20 percent return on equity — very high but let’s go with it nonetheless. The $2 million that got reinvested should, therefore, raise profits by $400,000 so that next year, they would come in at $5.4 million. That’s a growth rate of 8 percent for the company as a whole.
$1.5 million paid out as cash dividends, amounting to $1.50 per share. So, if you owned 100 shares, for instance, you would receive $150 in the mail.
$1.5 million used to repurchase stock. Remember that there are 1.25 million shares of stock outstanding. Management goes to a specialty brokerage firm, and they buy back 25,000 shares of their own stock at $60 per share for a total of $1.5 million and destroy it. It’s gone. No longer exists. The result is that now there are only 1.225 million shares of common stock outstanding. In other words, each remaining share now represents roughly 2 percent more ownership in the business than it did previously. So, next year, when profits are $5.4 million — an increase of 8 percent year over year — they will only be divided up among 1.225 million shares making each one entitled to $4.41 in profit, an increase on a per share level of 10.25 percent. In other words, the actual profit for the owners on a per share basis grew faster than the company’s profits as a whole because they are being split up among fewer investors.
If you had used your $1.50 per share in cash dividends to buy more stock, you could have theoretically increased your total share ownership position by around 2 percent if you did it through a low-cost dividend reinvestment program or a broker that didn’t charge for the service. That, combined with the 10.25 percent increase in earnings per share, would result in 12.25 percent growth annually on that underlying investment. When viewed next to a 6 percent Treasury yield that is a fantastic bargain so you might jump at such an opportunity.
Now, what happens if investors panic or grow too optimistic? Then the third item comes into play — revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings. If investors piled into shares of PFG because they thought the growth was going to be spectacular, the p/e may go to 20, resulting in a $80 per share price tag ($4 EPS x $20 = $80 per share). The $1.5 million used for cash dividends and the $1.5 million used for share repurchases wouldn’t have bought as much stock, so the investor is going to actually end up with less ownership because their shares are trading at a richer valuation. They make up for it in the capital gain they show — after all, they bought a stock for $60 and now it’s at $80 per share for a $20 profit.
What if the opposite happens? What if investors panic, sell their 401k mutual funds, pull money out of the market, and the price of your bank collapses to, say, 8x earnings? Then, you’re dealing with a $40 stock price. Now, the interesting thing here is that although the investor is sitting on a substantial loss — from $60 per share originally to $40 per share, knocking 33+ percent off the value of their holdings, in the long run, they’ll be better off for two reasons:
- The reinvested dividends will buy more stock, increasing the percentage of the company the investor owns. Also, the money for share repurchases will buy more stock, resulting in fewer shares outstanding. In other words, the further the stock price falls, the more ownership the investor can acquire through reinvested dividends and share repurchases.
- They can use additional funds from their business, job, salary, wages, or other cash generators to buy more stock. If they are truly concerned with the long-term, the losses along the way in the short-run don’t matter — they’ll just keep buying what they like, provided they have sufficient diversification levels so that if the company were to implode due to a scandal or other event, they wouldn’t be ruined.
There are a few risks that can cause problems:
- It’s possible that if the company gets too undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. In other words, you were absolutely correct, but you got pushed out of the picture by a very large investor.
- If your personal balance sheet isn’t secure, you might need to come up with money and be forced to sell at massive losses because you don’t have funds anywhere else. It is why you shouldn’t invest in the market any money that could be needed in the next few years.
- People overestimate their own skills, talent, and temperament. You might not pick a great company because you don’t have the necessary accounting skills or knowledge of an industry to know which firms are attractive relative to their discounted future cash flows. You might think you’re able to watch losses pile up while you purchase stocks, but very few people have the temperament for it. In my own case, it doesn’t even cause my heart rate to elevate if we wake up one morning and before coffee, the office portfolio is down hugely in a matter of minutes. It just doesn’t bother us because what we’re doing is building a collection of long-term cash-generating ownership stakes in firms that we want to hold for a very long time. We’re constantly buying more. We’re constantly reinvesting our dividends. And many of our companies not only reinvest for future growth but also repurchase their own shares.
Now, this is a gross oversimplification. There are many, many, many details that haven’t been included here that would factor into a decision about whether or not a particular stock or security were appropriate for investment. It is designed to do nothing more than to provide a broad sketch of the outline of how professional investors might think about the market and selecting individual stocks within it.
The bottom line — for a guy running a mutual fund, hedge fund, or a portfolio with a limited amount of capital, big drops in the market can be devastating both to their net worth and their job security. For businessmen and businesswomen who think of buying stocks as acquiring partial ownership in companies, they can be a wonderful opportunity to grow your net worth substantially.
As Buffett said, he doesn’t know if the market will be up, or down, or sideways a month or even a few years from now. But he does know that there will be intelligent things to do in the meantime. Not everything is doom and gloom — the collapsing dollar has been a magnificent thing for multi-national firms such as Coca-Cola, General Electric, Procter & Gamble, Tiffany & Company, etc. that can ship money back from overseas markets into cheaper greenbacks. Just remember — there is a buyer and seller for every financial transaction. One of those parties is wrong. Time will tell which one got the better deal.
This article is part of our How to Get Rich guide for new investors.