As a thirty-year veteran of the market I am astounded by the mystique that surrounds stock investing. Many very smart people I meet believe that the stock market is too complicated for them to understand or, worse, entirely random. Neither is true.
When an investor buys one share of a company’s stock he or she is buying the commensurate portion of that company’s earnings. That is measured by the price-earnings ratio or the p/e. The price-earnings ratio measures how much an investor is paying for company earnings. Generally speaking the lower the p/e the cheaper the stock. Over the long-term p/e is a meaningful and helpful determinate for investors to assess whether a stock is cheap or dear. Investors are often willing to pay a higher p/e for companies with strong earnings growth and less for companies they believe will generate slower earnings growth.
Great companies demonstrate a persistent tendency to perform over the long-term. Take for example two tech powerhouse’s: Google (GOOG) and Apple (AAPL). The hyperlink takes us to a chart comparing the two stocks over the most recent one-year period. GOOG sports a p/e of 22.9X trailing twelve month earnings; for AAPL the p/e is 9.6x. Investors have rewarded GOOG for what they believe to be a stronger earnings future. Consequently the p/e has risen as the stock has outperformed the market and AAPL.
Looking over a longer term period beginning in August of 2004 when GOOG became a public company we see that compared to AAPL, GOOG has performed well but underperformed AAPL. Both are great companies. The difference? Wall Street expectations for earnings growth during the periods measured has changed. Still you would have been well-served with either company. Or both.
Buying great companies pays off over the long term but if that task seems too daunting consider buying an exchange traded fund (ETF) that tracks the S&P 500. Over the last approximately fifty years, despite a number of devastating bear markets, simply owning the S&P 500 index would have generated a return of approximately 1600% .
But you don’t need fifty years to generate excess returns. Remember the study I cited in my first post. According to Wharton professor Jeremy Siegel since 1871 the stock market has generated an average return of 9.4% for every rolling twenty-year period.
Take a look at Vanguard’s VOO for a low cost ETF that tracks the S&P 500. That may just be a great place to start. Provided you are willing to take a reasonably long-term view.