When I entered this business 40 years ago, it seemed reasonable to me to study how the best investors behaved. The two investing masters that I respected the most were Peter Lynch and Warren Buffett. If I was going to be of value to others, it only made sense that I learn as much as I could from those who had amassed the best and most consistent track records. What struck me the most, as I studied these Masters, was how similar and aligned their investment philosophies were.
Therefore, I concluded that there must be profound wisdom in their investing approaches and practices.
Today, some 40 years later, what frustrates me the most, is how so much of their words of wisdom go unheeded by investors. I feel that a lot of this has to do with most people's almost uncontrollable need for instant gratification. The phrase "active portfolio management" has taken on a new meaning in modern times. Today people think in terms of holding periods of days, weeks or months. Yet, two foundational principles shared by both Warren Buffett and Peter Lynch are to invest in great businesses for the long-term, and to ignore the stock market.
Wisdom of the Masters
The following three quotes by Warren Buffett speak to these points:
"If you aren't willing to own a stock for 10 years don't even think about owning it for 10 minutes" Warren Buffett, 1996 Berkshire Hathaway annual report
"Inactivity strikes us as intelligent behavior." Warren Buffett, 1996 Berkshire Hathaway annual report
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." Warren Buffett
From Peter Lynch, we offer the following corroborative quote from his best-selling book One Up on Wall Street:
"The stock market ought to be irrelevant. If I could convince you of this one thing, I'd feel this book has done its job. If you don't believe me, believe Warren Buffett. "As far as I'm concerned," Buffett has written, "the stock market doesn't exist. It is only there is a reference to see if anybody is offering to do anything foolish."
Dividend Aristocrats - Validating the Wisdom of the Masters
In this article, our third in our series on how to know when to buy and when to sell a stock, we intend to test some of the important axioms promulgated by the investing greats Peter Lynch and Warren Buffett. We will endeavor to accomplish this by offering real-world examples as evidence of the veracity of their ideas. Our goal is not only to illuminate the lessons that these great investors have taught, but also to have a little fun along the way. In order to accomplish this, we will quote a lesson and then utilize our EDMP, Inc. F.A.S.T. Graphs to analyze dividend aristocrats that provide proof of the wisdom behind their words.
GDF-EDMP Value Formula for Moderate Growth
Before we get started some points of clarification regarding our EDMP, Inc. F.A.S.T. Graphs are in order. With the exception of one company in this article, Consolidated Edison (ED), the dividend aristocrats we will analyze will possess earnings growth rates between 5% and 15% (of course as dividend aristocrats, each will have a history of increasing their dividend for at least 25 consecutive years).
Therefore, each F.A.S.T. Graph will utilize our "GDF-EDMP" formula for valuing a moderately fast growing business. This formula is a modified version of Ben Graham's famous formula for valuing a business (best applied to low growth 5% or less) and the widely accepted PEG ratio formula (best applied to fast growers 15% or higher). Calculations based on these formulas will draw our orange earnings justified valuation line.
The essence of what the orange earnings justified valuation line represents is what we call earnings yield. This is the rate of return that the cash flows (earnings) of the business generates, based on the original capital investment into the business. In other words, this is the cash on cash return from the earnings the company produces. The slope of the line will equal the rate of change of earnings growth that the company produces over time. Therefore, if the stock price touches the orange line at the time of original investment and then touches it again at the ending date being measured, then the capital appreciation rate of return component will equal the growth rate of earnings.
To state this more simply, the thesis states that when the price touches the orange line the company is trading at fair value. When the price is above the orange line the stock is overpriced, and when the price is below the orange line the company is undervalued. However, in time the price will inevitably revert to the mean. Therefore, our F.A.S.T. Graph™ tool allows the researcher to visually determine whether the company is fairly priced, overpriced or under priced. In his best-selling book One Up on Wall Street, Peter Lynch had this to say about the relationship between a company's stock price and its earnings:
The Importance of Earnings
"You can see the importance of earnings on any chart that has an earnings line running alongside the stock price. On chart after chart the two lines will move in tandem, or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings." Peter Lynch - One Up On Wall Street
The following F.A.S.T. Graph on the VF Corp (VFC), a global apparel company, provides a quintessential example of Peter Lynch's words.