There are only two types of investments in this world: You either own something or you lend money. For the purposes of this commentary, owning equals stocks, lending equals bonds.
It’s arguable, but most stock investors have no idea what they are actually investing in. Typically, they buy with the hope that their stock purchase will rise in value but have no understanding of what drives the increase. Most investors, therefore, are really just gambling with their money and, most likely, their financial future.
What Is A Stock?
Investopedia states: “A stock is a share in the ownership of a company. Stocks represent a claim on the company’s assets and earnings.”
As a shareholder, you have a claim on assets such as tangible property (real estate) as well as intangible property, such as intellectual property (patents). Therefore, a claim on the earnings of a company in which you have stock means you own all current and future net earnings, which, combined with the magic of compounding, may create large amounts of wealth.
Here’s an example: In 1972 an investor bought a company which had net earnings of $4.2 million. In 1987, the company’s earnings had increased to $82 million, a 20-times increase. Nine years later, in 2007, when the investor added up all the earnings he had received to date, the amount came to whopping $1.65 billion. How much did he pay 40 years earlier for this bounty?—only $25 million. He spent $25 million and received $1.65 billion in earnings over the course of 40 years! That is the incredible power of the claim on earnings.
But what about the actual value of this stock after the earnings had increased so dramatically? What was the investor’s $25 million worth so many years later? Since the investor in this example privately owns the company, we can’t know for sure, but we can assume the following inference using the numbers just stated: He paid $25 million for $4.2 million in earnings. This means he paid about 6 times earnings and in 1987, the company’s earnings were $82 million. If we price these 1987 earnings by the same 6-times multiple, the result is $488 million.
What is this fantastic company? Perhaps a technology firm making billions changing the world or a futuristic biotech on the verge of curing cancer? Nothing so esoteric. It’s a simple candy company known as “See’s Candy” and the investor is none other than Warren Buffett.
Of course, most of us don’t have $25 million to purchase an entire company; however, our individual shares represent a pro-rata ownership in the entire enterprise. In so many ways, your experience will may be similar to Mr. Buffett’s—with probably significantly fewer zeros.
Investing In Stocks From The Master
Here’s a few lessons to learn from Uncle Warren:
- Higher stock prices in the future may be related to (among other factors) higher earnings.
- Prudent investors create wealth by being patient, not by gambling or by reckless trading.
- Buying complicated companies is not a necessary ingredient to accumulate great wealth so consider sticking with companies you understand.
- Stock picking on your own is subject to higher risk. Consider indexing or an actively managed portfolio.
Seeking professional advice before taking a risk with your financial future may be your wisest decision.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal. All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.