The Best Time to Buy Stocks

If you haven't had a chance to read "Triumph of the Optimists: 101 Years of Global Investment Returns" by Elroy Dimson, Paul Marsh, and Mike Staunton, I can't recommend it strongly enough. The book, released in 2001, presents a wealth of data and analysis about the performance of the U.S. and world stock markets over the past 101 years. Studying stock market history is a prerequisite for becoming a great investor; as George Santayana said, those who don't remember the past are condemned to repeat it.

Almost all of the book is interesting, but the chapters on the equity risk premium are what struck me the most. The equity risk premium is the excess return investors require to convince themselves that it's worth the risk to hold stocks instead of risk-free short-term treasury bills. The authors spend a lot of time on this topic, carefully dissecting the historical risk premiums for stock markets around the world, and offering up an estimate of the equity risk premium we'll see in the future.

Understanding the equity risk premium is vital because it's (arguably) the main determinant of P/E ratios. Unfortunately, no one knows for sure what the risk premium has been in the past, and more importantly, what it will be in the future. For that reason, it's one of the most controversial subjects in financial academia. The authors of "Triumph of the Optimists" present the most compelling argument yet on the subject, and they conclude that the U.S. equity risk premium, in real terms over the past 101 years, was 5.8%, and that the premium going forward should be around 4%. The premium should be lower in the future because, relative to the past 100 years, markets now benefit from greater liquidity, easier methods of diversification (i.e., low-cost mutual funds), and greater financial transparency.

P/E Ratios
This leads us to a discussion of what's really important: How the equity risk premium affects stock valuations, and ultimately, stock market returns. The equity risk premium has an inverse relationship with valuations. When the risk premium rises, P/E ratios (and stock prices) go down--investors need a higher return on stocks to justify holding them. We saw a classic example of this right after September 11. By paying less for each expected dollar of future cash flows today, investors are able to get a higher return on stocks tomorrow. Conversely, when the risk premium falls, as has been happening since early March, P/Es expand and stock prices rise.

So P/E ratios are determined, in large part, by the equity risk premium. And since the market is a discounting mechanism that cares only about the future, the historical risk premium doesn't matter. What matters is the future risk premium.

The other component of P/E ratios is the expected growth in future cash flows. Thus, at any given time the market is essentially "discounting," or betting on, two things: The growth rate of cash flows, and the riskiness (volatility) of those cash flows.

Wide-Moat Companies
Because stock returns are a combination of these two variables, there are two ways for an investor to generate returns in excess of what the market is already "pricing in."

First, investors can buy companies that maintain above-average earnings growth longer than the market expects. Is it possible to find these companies? Yes--these are wide-moat companies, and we publish a list of 50 of them each month in Morningstar StockInvestor. Over time, the market tends to underestimate the future earnings power of wide-moat companies, systematically undervaluing them. Only rarely are they fairly priced from a long-term perspective. And generally during these times, investors consider them wildly overvalued because they look expensive relative to stocks without wide moats.

As evidence, consider a study done by Jeremy Siegel, author of the book "Stocks For the Long Run." In it, Siegel presents data on that infamous group of companies labeled the Nifty Fifty, which included the likes of  Coca-Cola (KO),  McDonald's (MCD),  Procter & Gamble (PG),  General Electric (GE), and  3M (MMM), among others. In 1972, nearly all of them would have been considered wide-moat companies; in 2003, many still are.

According to Siegel, from December 1972 until November 2001 (29 years), the earnings per share of the Nifty Fifty stocks rose 10.14% per year, on average, far outstripping the 6.98% earnings-per-share growth of the average S&P 500 company over the same time period. But in 1972, the Nifty Fifty stocks were considered outrageously overvalued, with an average P/E of 42 compared to the S&P 500 average of 19, and subsequently crashed in the bear market the next year. Yet investors who bought the group of 50 right at the bull market peak in December 1972 and held on for the next 29 years would have generated average annual returns of 11.7%, comparable to that of the S&P 500 index over the same period. So even at times when wide-moat stocks appear extremely overvalued, they're worth owning. Wide-moat stocks do okay over very long periods because they grow their earnings faster and longer than the market expects. In other words, they consistently beat expectations.

For non-wide-moat stocks, however, that's not true. In fact, for "normal" companies, analyst estimates of long-term earnings growth are rarely too low; typically, humans (and analysts) are an optimistic bunch who tend to lump wide-moat and narrow-moat companies into the same bucket when estimating the future. Thus, it would seem that the first requirement for successful long-term investing is to buy wide-moat companies and avoid narrow-moat ones, because wide-moats are the types of companies that tend to beat expectations, while narrow-moats aren't. Unfortunately, there are very few wide-moat stocks out there; by Morningstar's count, there are less than 100 of them.

Regardless of this, paying up for wide-moat stocks so you can equal the market return isn't good enough; a stock investor's goal should be to beat the market. This is the only reason to buy individual stocks instead of an index fund.

Fear: The Real Source of Excess Returns
That brings me to what I consider the real source of excess returns: the ability to buy stocks during a panic. Or, to get more academic, during a temporary spike in the equity risk premium. Remember, when equity risk premiums increase, P/Es decrease and stock prices go down. Fear is the friend of the rational investor because it's always accompanied by its cousin, opportunity.

Let's go back to our Nifty Fifty example, but fast forward a year to 1973. This was a bad year for the market. Inflation spiked, going from 3.5 % to 9%, and the Fed raised interest rates from 4.5% to 7.5%. 1974 was arguably worse: The Fed raised rates to 8%, inflation rose to 12%, and President Nixon resigned. During these two years, the price of oil quadrupled from $3 to $12 a barrel, and the Dow Jones Industrial Average fell 40%. Although I don't have the data in front of me, I'll assume the Nifty Fifty stocks also fell 40% over this period, in line with the market. (In reality, they probably fell further than the market since they were more expensive to begin with.)

The incredible thing is that, because of rising prices during an inflationary environment, earnings per share for the Dow 30 stocks actually rose during both of these years, from $67 a share in 1972 to $86 in 1973 and $99 in 1974. Thus, earnings were rising while the market was falling 40%! Clearly, the reason for the market decline was a temporary spike in the equity risk premium; people were fearful. This resulted in lower P/E ratios. In fact, during this period, the P/E ratio of the Dow fell from 14 to 8.

An investor who bought the Nifty Fifty stocks in December 1972 would have dramatically underperformed someone who waited until September 1974 to buy, when stocks were downright bargains. In fact, these September 1974 investors would have gotten an average annual return of 14.7% through November 2001. Meanwhile, the buy-at-the-1972-peak investors would have gotten only an 11.7% average annual return through November 2001, roughly the same as the return of the S&P 500 Index. Of course, during a bear market it's impossible to know where the bottom is--except in hindsight. But even those investors who cautiously waited until the market had gone up for six straight months after September 1974 before investing in the Nifty Fifty would have gotten an average annual return at least 1.5% higher than the December 1972 investor.

The conclusion: Focusing on wide-moat companies is important, but even more important is the discipline to wait for attractive valuations before putting money into a stock, or a group of stocks. This is what really drives excess returns, and separates the great investors from the average ones. When Mr. Market is feeling "safe," it's typically not the best time to be throwing money into stocks.

A version of this article appeared May 7, 2003.