Introduction
I believe, and there is plenty of evidence to back my belief, that current market conditions are at an extreme. Although rare, it’s not unusual for aberrant market action to occur. Warren Buffett once said: “The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” The important point is to understand the unpredictability of it all so as to not fall prey to the illusions. The late John Kenneth Galbraith, one of the most renowned economists of modern times once quipped: “In economics the majority is always wrong.” Therefore, what we really need to do is put our attention on and only on the important issues that are predictive in nature.
Hope Is Not An Investment Strategy
Regarding investing in common stocks, there are two primary factors that can be relied upon as true determinants of capital appreciation. Neither can be viewed in a vacuum. However, when evaluated together, they are highly accurate capital appreciation calculators. The first, and I believe the most important, is the rate of change the business grows its profits at, i.e., the company’s earnings growth rate. A company that grows at 8% can be expected to generate an 8% capital appreciation and a 15% grower a 15% capital appreciation, etc. Faster growth leads to higher capital appreciation potential that is consistent with that growth, and vice-versa. However, this principle only applies when valuation is fair or rational at both the beginning and the end of the measuring period.
Therefore, both the beginning and ending valuation must also be taken into consideration. A high beginning valuation will decrease capital appreciation relative to the company’s earnings growth. A low beginning valuation will increase capital appreciation relative to the company’s earnings growth rate. However, there are numerous combinations of beginning and ending valuation that will also impact capital appreciation relative to the company’s earnings growth rate. For example, valuation can be high at the beginning and low at the end. Or, valuation can be high at the beginning and high at the end, etc.
