Right Price...Important, Right Company... Critical

Some of the world's best businesses do not always generate the best returns over certain time periods. Over time one can assume that, in general, the growth in the intrinsic value of the company will equate the return one receives in its stock. This is all premised on the person buying the stock of the company at its intrinsic value or within a reasonable range of its intrinsic value.

There are also times when the market provides an opportunity to buy a good or great business at a discount to its intrinsic value (then one can get a "double-dip" of sorts....the gain in the value of the company over time plus the extra price appreciation as the stock's price eventually gets back to its intrinsic value range).

Does the price earnings ratio of a stock need to be below the market (S&P 500) price earnings ratio in order for it to outperform that index? The answer is a definitive no.

For example, I feel that Coca Cola is truly one of the world's greatest businesses. According to Jeremy Siegel in his book "Stocks for the Long Run" at the peak of the "Nifty Fifty" market of 1973, Coke's price earnings ratio was at, what seemed, a very high 46.4 times earnings. What would the return of the stock have been if one bought it at 46.4 times earnings in 1974 and held it until the end of 2006? Well, not bad....11.7% compounded annually. $1,000 invested would have turned into $38,543 at the end of 2006.

This also happened to be very close to the return of the S&P 500 over that time (11.85%). But the difference between the 2 lies in the valuation....the PE ratio for the S&P 500 in 1974 was a much more reasonable 14.3 times. So, the PE ratio for Coke was 3 times that of the market and it STILL generated market-like returns.

This clearly shows that, in investing, the company that one chooses is CRITICAL to outperforming the market over time, just as long as it's purchased at a reasonable valuation or even better if it can be bought at market-like multiples. In other words, buy only the great businesses at good prices and one is bound to outperform the market over long time periods.