There are a few things that strike me as counter intuitive about long-term investing in the stock market. One is that groundbreaking new industries don’t necessarily equate with long term returns, as I commented the other day in an article on Tesla. The other thing that stands out is the vastly different long-term investing outcomes that can occur in the same shares made at slightly different time frames. Take Coca-Cola stock for example. Back in the late Nineties there was a bit of a bubble in Coke stock, enough to send it to about 34x earnings which was very frothy in the context of its forward growth potential.
Let’s say you invested at the worst possible moment of Coke-mania in July, 1998. The stock was trading at a split adjusted price of $43, almost exactly where it trades today some eighteen years later. That’s the level of capital impairment you’re talking about. Now imagine the same person waited a couple months instead and bought in at the beginning of October: in that case they paid just $28 per share. The difference in returns between those two investments, July versus October, is huge: you’re talking compounded annual growth of 4% compared to 2.5%. On a $20,000 investment that difference adds up to roughly an extra $10,000. Coke the company hadn’t changed at all; Coke the stock had changed a lot.
The point about those vastly different returns is that they force you to think about expected value. In other words: what’s the best that could happen and what’s the worst that could happen? Best case scenario for Coca-Cola stock in July 1998 wasn’t that good – mediocre returns as earnings grew to fit the bloat valuation. The worst case scenario was years of dead money. By October, even though you’re only talking three months, which is nothing in the context and lifetime of Coca-Cola, you see a better “best case” scenario and a not so bad “worst case” scenario.
Let’s imagine investing around the time of the Wall Street Crash. With hindsight we know that this was probably the worst time that you could possibly have chosen, with the aftermath producing an epic market crash and ensuing economic catastrophe. Consider an investment in the market at its peak in September, 1929: average stock prices were approximately 30x earnings, average price-to-book ratios were about 3x book value and the average dividend yield was something like 2.5%.
As an average figure this tends to mask the euphoria going on in certain arenas and sectors. Bank stocks had reached truly stratospheric valuations for example. National Bank of New York was trading at an average price-to-earnings ratio of 120x and at 13x book value to give you some context. The Dow Jones Industrial Average (DJIA) had spent the last decade compounding at a rate of about 25% a year.
Then the crash happens, probably very suddenly for the 99% who couldn’t imagine seeing the boom years of the roaring twenties end so badly, and leading stocks trade within wild ranges on an intra-day basis. Standard Oil of New Jersey (later becoming Exxon Mobil) went from a closing price on the Wednesday of $73 per share, to a low of $61 per share on the Thursday, and then back up to $68 per share by the closing bell.
By the end of 1930 the DJIA was down nearly 60% from its 1929 peak. What’s worse is that this was just a sideshow to wider problems in the economy and for corporate America. In 1929 corporate earnings had totalled $9bn. The following year they came in at $3bn. The unemployment rate hit 24% by 1933, exploding from about 1.5 million to 13 million in the space of four years. Real GDP collapsed some 30% from peak to trough. It surely goes down as the worst catastrophe in modern economic history.
Let’s concentrate on the stock returns over the period. Given the above, the horrible declines in GDP and corporate earnings, you’re not really expecting very good returns in the subsequent few years. In fact you’re probably assuming a total disaster. Even more so considering you put your money in during the 1929 peak. Consider the earnings per-share data during the early depression years.
In the year of the crash Coca-Cola stock traded in a valuation range of between 13x and 19x annual profits. In the depths of the depression in 1933 it had traded at about 8x earnings. Earnings per share had gone from $10.25 to $8.82 in that time frame. How about some more household names? General Mills saw earnings per share drop over 25%, from $4.85 in 1929 to $3.55 in 1933. General Electric’s 1929 earnings per share of $2.40 had collapsed to $0.38 four years later. IBM reported earnings per share of $10.92 in 1929, dropping 25% to $8.05 by 1933. Gillette saw earnings per share drop by about 80%. And so it goes on. These were some of the stronger performers too. The pattern of falling earnings, to be expected in such a savage economic environment, obviously caused havoc with stock returns and dividends.
A holder of Gillette stock would have seen an 80% collapse in the share price over that time frame. At the low point in 1933 they could have picked up more stock for just 7x earnings if they hadn’t already thrown in the towel. Colgate-Palmolive, a company that is today responsible for 40% of the world’s toothpaste by market share, saw earnings wiped out and the dividend slashed. An investor holding Procter & Gamble shares would have seen earnings halve over the period and the dividend eventually cut by 25%. All-in-all there were very few stocks unaffected during the period.
How Quickly Would You Have Made Your Money Back From The Wall Street Crash?
If you read up on what happened to stocks and the market during the depression years it is highly likely that the figure you will see quoted in answer to the above question is something like twenty-five years. That is, if you put money in at the peak of the market, pre-crash, it would have taken twenty-five years for you to break even again. Now, twenty-five years is a good chunk of an investing “lifetime”, probably even more so back then when life expectancies would have been lower, so it sounds like a terrible figure. You basically spend all that time with no returns to show for it.
The thing is that the effect of reinvesting dividends totally blows that figure away. It would have taken twenty-five years in one particular scenario – the one where you didn’t include dividends. If you did include them, it would have taken you only seven years. Despite the awful economic climate and period of falling earnings and dividends, the return accelerator that you experience with reinvesting those dividends at low valuations slashes the time it takes to get you back to breakeven. Thirty years of doing that from the market top in 1929 would have delivered returns of about 7.5% compounded annually up to 1960. No matter how bad things get, taking the long approach has nearly always made it salvageable.