That Stock is Dead Money
I've heard that time and time again: that stock has done nothing over 10 years. Why would you buy it? These arguments usually refer to many large cap tech stocks and other former amazing growth stories such as WMT. I'll use WMT as my go-to example when I need one, but a ton of tech stocks and other names also apply.
1. Stocks fluctuate from undervalued to fairly valued to overvalued to fairly valued to...you get my point.
Each point in the cycle can last anywhere from weeks to months to many years. Do you know what these stocks were 10 years ago? You guessed it: really, really overvalued. In FY 2000, WMT earned $1.21 per diluted share on revenue of $165 billion. In FY 2010, WMT earned $4.46 per diluted share on revenue of $422 billion. Adjusting for dividends, WMT closed at $41.13 on March 19, 2001. Without adjusting for dividends, WMT closed at $47.38 on March 19, 2000. On March 18, 2011 (the 19th is Saturday, of course), WMT closed at $51.52.
If you ask me, WMT was extremely expensive 10 years ago and is actually looking pretty reasonable today. That gets me to my next point...
2. Price matters. A lot.
Buy an overvalued stock and you lock in a higher cost basis forever. The higher the price you pay, the lower your expected returns. If you can pay a lower price, you will bump up those expected returns. Buying WMT at $47.38 back then when it had only earned $1.21 per share the previous year? That's called overpaying. The stock can still go up from there, but that's not such a great idea. Paying 39 times earnings or some very high multiple of sales or EBITDA for a retailer? Bad idea.
Buying WMT today is a different story, of course. The stock's virtually gone nowhere and the company's managed to almost quadruple earnings per share. Based on the current price, you even get a 2.8% annualized dividend to boot. 3. Reward-to-risk ratio
Risk to me is lost money, not volatility. Let's say you've done your homework and you have determined reasonable upside of 40% and reasonable downside of 20%. Reward (40%) to risk (20%) is 2-to-1 here. I'm quite aware that valuation work can be extremely wrong even if you've accounted for all the variables. However, if you consistently find situations where you're getting a 2-to-1 reward-to-risk, you will tend to make money: you have a built in margin of safety that seeks out much more reward than risk.
Even if you're wrong from time to time, you probably have a reasonable chance of making out on the trade, since you will make a mistake that works for you (and not against you) once in a while to balance out the inevitable mistakes.
How does this fit in? If you pay too much for a stock, your reward-to-risk is probably looking a lot worse than 2-to-1. In fact, you might even be risking more than your possible upside in some cases. If you paid so much for a stock that realistic upside is only 30% and downside is 60%, that's a reward-to-risk of 0.5-to-1. That's terrible. Just remember that if you overpay for a stock, any reasonable valuation model will probably turn in a fair value that is lower than today's price, not higher. That leads to very unfavorable reward-to-risk ratio! 4. Search for proper context
Going back to the dead money example, it's not fair to say a stock has gone nowhere for 10 years if you're comparing today's much improved valuations to bubble valuations when people were not thinking rationally. If you know people were frothing at the mouth to get a hold of tech stocks 10 years ago, that's not really a fair comparison to use a sideways stock price as justification for proof that a stock is dead money. If that sucker was trading at 60 times earnings 10 years ago and it's now trading at 15 times earnings, it's looking a lot better now.
A lot can happen for 10 years. If a drastically overvalued stock improves sales and earnings 10 years ago without improving its share price, I might start to get interested. I would have written that stock off 10 years ago, so stop telling me it's dead money! It was dead money 10 years ago when it was trading way too high. If you can manage a reasonable price today, it is not dead money.