The Cheap And The Nasty

Porsche, Dom Perignon, Rolex, Gucci...you get my drift. These are high end brands with the price tags to match. You and I don't expect anything less. In fact, we expect the quality of the product to be pretty damn good too. There is a general consensus in the market place that the more you pay for something the better the quality. This is not always true, but most of us would agree with this relationship - the more you pay, the more you get. Capisce?

If you applied this same concept to investing, you probably wouldn't make a lot of money. You see, the world of investing is quite the opposite - the more you pay, the less you get, and the less you pay, the more you get.

Think about any business. The more cash you stump up to acquire the business, it's going to take you that little bit longer to get your money back before you start making a profit after costs. It's quite simple actually.

Even an great company can be priced too high if there's a lot of glamour attached to it. - Phillip Fisher

I recently had breakfast at a popular café in Burnley. The Ginger Bread Latte caught my eye - $9. Ill have a regular soy late please. There is no way I'm paying $9 for a Ginger Bread Latte, as curious I was about it. I'm sure you've also been in a similar situation where you'll no way accept the price for a good or a service. You see, our subconscious mind makes these sort of calculations in milliseconds. Yet when it comes to investing in the stock market, investors forget about all these rules, as the human mind is wired in a certain way. We decide to apply the concept of the more you pay the more you get. Think about prior to the GFC, and any booming market for that matter. Investors rush in at the top, and head for the exits at the bottom - at precisely the wrong time.

In this week's chart we look at what happens to investor returns 10 years following the price they pay for stocks at various price points using the forward Price/Earnings ratio.

What this chart is showing on the horizontal axis, is the Price to Earnings ratio (PE), that is, the multiple investors are willing to pay for every $1 of company earnings. On the vertical axis we can see the subsequent 10 year annualised return (%). Each period is represented by the little green dots, and the analysis is since 1995.

As you can see from the chart below, the lower the multiple on the far left hand side of the chart, 10x or 12x, the higher the corresponding value on the vertical axis. As an example, a multiple of 10x-12x has historically returned around 15% pa for the following 10 years - a solid return. On the other end of the spectrum, a multiple of around 24x, the corresponding 10 year return has been around 0% pa. As you can see, the further to the right of the horizontal axis you go, the lower the green dots fall. In fact, there is a very strong relationship between these two factors - with an R-Squared of over 83%.

Look at where we are today. I've drawn a vertical red line to make it clear. Today, investors are willing to pay $21 for every $1 of company earnings - a PE (forward) ratio of 21x. If you then take a look at the range of little green dots in and around the 21x multiple, you can see, historically when investors pay such a price, the subsequent 10 year return has been, on average, between 0% and 5% pa.

Since the GFC and as interest rates have been cut to almost zero, investors have had their hands forced by central banks - move higher and higher up the risk spectrum. The last 15 years, notwithstanding the COVID-19 crash, investors have been handsomely rewarded with unusually high returns.

Have we brought forward future returns for our enjoyment today, and we should expect lower returns going forward? Or is this time really different? Have interest rates at zero changed the game? Has the market still room to run? History suggests the former. The more you pay, the less you get. But remember, the market can remain irrational for longer than you can remain solvent.