A Timeless Rule Followed by Every Wealthy, Sophisticated Investor
On June 15, 1998, Coca-Cola (KO) – owner of the world’s most powerful brand – traded for $ 88.94 per share.
For many years, I’ve been telling my readers to keep the bulk of their equity holdings in companies like Coca-Cola, which has fat profit margins, high returns on capital invested, a great brand name, and a sustainable competitive advantage. I call companies like Coke “World Dominators.”
Owning dividend-paying World Dominators and compounding their gains over many years is the surest, easiest, greatest way to get rich in stocks. But anyone who bought Coke in late 1998 ignored a timeless rule that wealthy, sophisticated investors hold sacred. And they suffered big losses.
What is this rule of the wealthy? How did violating this rule allow some investors to actually lose money on one of the world’s greatest companies? And how can you begin using it to make a fortune in stocks?
The rule is that the price you pay is the most important thing when it comes to succeeding as an investor. If you pay a cheap-enough price, you can make money in even the worst businesses. If you pay a dear-enough price, you can lose money for long periods of time in even the best businesses.
Back in 1998, Coke’s annual earnings amounted to $ 1.43 per share. So at the all-time high of $ 88.94, the market was valuing the business at 62 times annual earnings.
That’s crazy expensive. Investors were accepting an “earnings yield” of about 1.6%. (That’s the amount in earnings the company generates as a percentage of your purchase price. So take $ 1.43 in earnings, divided by an $ 88.94 share price, and you get 0.016… or 1.6%.)
Think about it this way: It’s like buying a $ 100,000 house that you can rent out for about $ 1,600 a year, or $ 133 a month. It would take you 62 years to get your money back out of that investment. And only another fool would pay you $ 100,000 to take the house off your hands.
When you accept terms like that, you’re almost guaranteed to lose money in stocks. And that’s exactly what happened to investors who bought Coke at the wrong time.
Less than three months after Coke nearly hit $ 90 a share, it was down more than 30%. Five years later, it was down 50%. Even 13 years later… counting dividends… those investors hadn’t made a dime in Coke… which is one of the world’s greatest companies. Nothing much changed about Coke’s business during that time. It was still one of the world’s most recognizable brands. It still sold soda all over the world. It still had high profit margins.
The losses incurred by folks who bought in 1998 were directly the result of paying a ludicrously high price to become a shareholder.
The same thing happened to investors who bought software giant Microsoft (MSFT) in 1999. Shares peaked at $ 119. Today, the shares trade around $ 53.
Investors who bought back then lost because they paid the wrong price. The stock was offering roughly a 2.4% earnings yield. At that rate, it would take you 42 years to get your money back.
I don’t know about you, but I don’t have that kind of time. I’d much rather see a “payback period” of 12 years or less. That means getting an earnings yield of 8%-10% (or more).
Smart, successful investors know that the price you pay is everything when it comes to making money in stocks, commodities, or any private business. You can lose money even in the world’s greatest businesses if you pay too much. If you take that lesson to heart, and only pay the right price – the cheap price – you’re virtually guaranteed to make money over the long term.
