H&Gs Head Boy.
Not Just A Pretty Face.
When first taking an interest in investing in stocks, most people tend to want to pull up stock market charts to see how a business has performed over time. For long-term shareholders who practice a buy-and-hold approach, this is practically useless in all but a handful of cases because the numbers you are seeing on that stock market chart almost assuredly understate the total return a man or woman could have enjoyed had he or she held ownership through the period in question. Depending on the length of time depicted, and the capital allocation decisions made by management, the error can be extraordinary.
Let’s take a moment to expand on the concept to help you understand the reasons this bizarre situation exists. You’ll never be tempted to pull up a stock market chart again because you’ll realize the way they are displayed makes them little more than scribbles.
First, let’s start with an extreme example that I’ve frequently used. Imagine you bought shares of Eastman Kodak roughly 25 years before it was destined for bankruptcy. At the time, it was one of the most prestigious blue chip stocks in the world. With the now-famous collapse of the photography giant, and the share price going to $0 for all intents and purposes, a stock market chart would provide the mistaken impression that you lost money. Hardly! Although not fantastic, the long-term owner ended up with a 425%+ return over the years despite the stock getting wiped out in the end, turning a $100,000 investment into more than $425,000.
Outcomes like this are possible for at least five reasons.
Most stock market charts don’t reflect dividends and other distributions.
In the end, all but a handful of successful businesses pay out part of their profits in the form of a cash dividend, either physically mailing you a check or direct depositing the money into your brokerage account or linked bank account. Good businesses are able to increase earnings faster than the rate of inflation, leading to rapid dividend growth. The dividend yield on practically all stocks ranges from 1% to 6% at present, with the determining factor being how quickly the firm is expanding (rapidly growing businesses trade at a higher price-to-earnings ratio, leading to a lower dividend yield, while the inverse is true).
In a case like Eastman Kodak, over the quarter-century holding period, dividends on the core stock itself totaled $173,958 on a $100,000 investment.
Most stock market charts don’t reflect spin-offs.
One of the greatest joys an investor will ever experience is receiving shares of a tax-free spin-off. These are frequently divisions or subsidiaries that either no longer fit with the core mission of the enterprise, will be best served on their own, free from consideration of the parent company, or need to be divested for some other reason, such as regulatory scrutiny. In a few cases, a spin-off can go on to be much more successful than the business that siphoned it in the first place.
Going back to Eastman Kodak, an initial $100,000 investment resulted in around $203,018 in Eastman Chemical shares as the photography business broke itself into two pieces, sending the chemical group out to owners as a distribution. (Those spun-off shares also produced $47,224 in dividends of their own!). None of this shows up in most charts beyond, depending on the methodology used, a pro-rata deduction of the historical cost at the time of separation. This means all subsequent performance is treated as if it never happened; a nonsensical assertion.
For some businesses, this wildly understates owner performance. Just ask the stockholders of PepsiCo, who received what is now Yum! Brands, the parent company of Taco Bell, KFC, and Pizza Hut, in a spin-off back in the 1990’s. While a stock market chart might make PepsiCo appear as if it lagged Coke over the past few decades, factor in the Yum! performance post-spin-off and the two software giants are nearly neck-and-neck. The old Philip Morris is another fantastic textbook example. You would have ended up many, many times richer than the stock chart alone would indicate if you went back in time, bought a block of it, and parked the shares in a bank vault.
The same goes for the old Sears Roebuck department store. While the retail business itself may be headed for bankruptcy unless something changes, there have been so many spin-offs, and spin-offs of spin-offs, an owner who bought the stock 25 years ago has beaten the S&P 500. Pull a stock market chart, though, and you’d think the latter trounced the former.
Most stock market charts don’t reflect taxes, inflation, or deflation.
Taxes matter. The exact same investment, held for the exact same length of time, will result in wildly different net worth changes for your family depending on the asset placement you utilized. Ideally, you’d opt for the twin combination of a Roth 401(k) and a Roth IRA or, at the very least, arrange your affairs to take advantage of the stepped-up basis loophole so your heirs could avoid paying taxes on your deferred tax liabilities. Likewise, stock market charts won’t indicate the tax offset you’d receive by selling one position at a loss to shield the gains from another holding, which has economic value.
Inflation and deflation are also sorely missing from most visual representation of securities performance. I’ve said it to the point of exhaustion but I’ll say it, again: It’s purchasing power that counts. There are times, such as the 1929-1933 crash, when a decrease in dollars is actually a smaller decrease in purchasing power because the cost of everything else collapsed, resulting in an offset to your wealth destruction. In other words, if the value of your portfolio falls by 50% but the price of everything else falls by 30%, 50%, or 70%, your economic situation is different than it seems at first glance.
There have been times when a slight drop in the dollar value of an asset actually led to making money in real terms! Conversely, there have been periods during which stock prices rose but the dollar depreciated much more quickly, leading to no real meaningful change for the shareholder. (Fortunately, academic research over the past few generations has demonstrated that over long stretches of time, stocks, in the aggregate, have always been successfully able to compensate for inflation despite the short-term inability to do so.)
Most stock market charts don’t reflect costs.
When it comes to growing your family’s fortune, costs matter. Every penny you lay out in expenses is a penny you don’t have to compound. If you pay a broker $500 to execute a trade (this was not out of the ordinary before the rise of discount online brokerage houses — even when I was in high school less than 15 years ago, local bank trust departments had commission schedules boasting charges as high as $500+ a percentage of the trade, which was par for the course), and you’re only investing $10,000 at a time, you’re not going to enjoy nearly as much ending wealth as someone who was paying $8.95 or less.
The personalized difference of how efficient you are in making acquisitions of shares can’t appear in the stock market charts but it’s still of extreme importance.
The real history of many companies is hidden.
Imagine you wanted to do a case study of Wendy’s, the restaurant chain. You admire the late Dave Thomas and are curious how a stockholder in the original IPO would fare today. You pull up the ticker symbol for Wendy’s and begin calculating, only to realize you’ve completely wasted your time.
The old Wendy’s was acquired by the old Arby’s, which then changed its name. When this happened, all major financial portals updated their databases so that when you entered “Wendy’s”, it pulled the new Wendy’s — which up until recently, was Arby’s! The actual enterprise Dave Thomas built, ran, and expanded has been left in the dustbin of archival history, only available to those who are willing to go pull the original SEC filings with the government or pay for very expensive professional subscriptions often tailored to academic departments at Ivy League schools.
This creates a totally distorted picture of real-world equity returns, obfuscating reality in a profound way.