When should you not buy a Buy recommendation? When it fails to meet your personal return hurdle. If you’re seeking a long-term annual return of greater than 10%, then you wouldn’t buy a stock that might only generate 5-8%.
Let’s examine what this means with a hypothetical example. Assume you know that a stock’s intrinsic value will be $10 a share in five years – and that its share price will equal its value then too. Also, assume that the annual dividend yield on your purchase price is 4%.
In reality you never know a stock’s value, let alone its future price. But you’re still implicitly making judgements about the potential returns when you buy shares.
So what price should you pay today? Table 1 shows what happens as you pay a price closer to the future value – your total annual return declines.
This inverse relationship is important to understand. You can see from the table that paying $7 a share rather than $6 lowers your annual return from 14.8% to 11.4%.
The meaning is clear – if you want higher returns, you must demand a greater margin of safety. In other words, there’s no point buying mildly underpriced stocks if you require higher returns.
|Price now ($)||Price in 5 years ($)||Annual price growth||Annual dividend||Total annual return|
Something else interesting happens as the price paid and intrinsic value converge: a greater proportion of your total return will come from the dividend yield. So how does this apply to a couple of recent recommendations?
Consider Woolworths. In Woolworths takes tough decisions we said the following:
'Woolworths is not a standout opportunity. Generally we’d expect a long-term total return of mid-to-high single digits from this price. If your investment hurdle is higher than that, you might choose to ignore this upgrade altogether and perhaps wait for a lower price.'
If Woolworths was the stock in Table 1, our current recommendation implies you’re paying $8 or $9 today for what will be a $10 stock in five years. A significant proportion of your return will come from the dividend rather than capital growth over that period.
So, while it’s a Buy, Woolworths is only mildly underpriced. As one of Australia’s 10 best businesses, we’re prepared to accept lower returns than we might for some other positive recommendations.
Wider range of outcomes
Contrast Woolworths with Myer. In Is Myer still a pariah? we had significantly greater returns in mind – more like in excess of 15% annually. The margin of safety was significantly greater but it needed to be – it’s a riskier business with a wider range of potential outcomes (hence the speculative recommendation). With Myer’s share price having risen, our future return expectations are now lower.
As you can see, not all positive recommendations are equal. In What we mean by Buy, Hold and Sell, we said that:
'Typically we’ll make a stock a Buy if we think it offers sufficient value (aka margin of safety), that most members, with typically balanced portfolios, should consider buying some.'
It’s fuzzy because a positive recommendation is a blunt tool – it can’t suit each and every person. Where our return expectations are lower than average we’ll say so, as we did with Woolworths. Here we also recommended a small portfolio weighting to start (2-3%), with the potential to increase it if the stock fell.
With Woolworths’ share price having fallen since the initial upgrade, our future return expectations are a little higher now. If the stock continues to fall, then we’ll likely indicate it’s a stronger Buy in a future review.
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