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Growth Stock Newsletter — November 2003 — Stock Price Doesn’t Matter

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NVR June 2000 - May 2001
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One misconception investors believe when considering purchasing a new stock is that a lower priced stock (share price) is actually more attractive than a higher priced stock, since it allows the investor to be able to buy more shares. Many people would consider 1000 shares of a $5 stock a better deal than 100 shares of a $50 stock. 

 

Actually, stock price doesn’t really matter. There are many different ways of valuing a stock. I think we need to focus on the P/E ratio, for that is what I believe to be the true price of the stock. Here are a few examples to show my point: 

Let’s say we are having a party for 100 people and need to load up on drinks for the big day. You go to the store and see the sign to the left. Which offer is the better deal? When you calculate unit price you would
buy the lowest price per can. When we buy into a company, we want to share in the profits, and want to know how much it will cost us to get those profits (price/earnings=P/E). 

Suppose you are retiring and want to invest a $100,000 nest egg in hot dog stands, and use the profits as income? Looking at the table on the left, would you rather have 10 cheap stands or one premiere stand? You are only concerned with the profits your $100k will make, your interest in the bottom line, so you can reinvest the money or take it as income. If the premiere stand continued to make $20,000 a year, you would have your
original investment back in 5 years, obviously the better deal. 

Would you rather own 100 shares of a $60 stock that makes $6 in profits (EPS) per year, or 1000 shares of a $6 stock that makes $0.25 in annual EPS? In this example, let’s assume all other factors are the same, such as industry, growth rate, etc. When looking at the P/E we see that the $60 stock is obviously the better deal. When you get down to it, your $6000
investment in the $60 stock would yield $600 in annual profits. If you bought the entire company and kept the profits, would get your original investment back in 10 years. The same investment in the cheap stock would only earn profits of $250 a year, and take 24 years to return your investment. 

NVR Inc (NVR) is a perfect example of how stock price really doesn’t matter. This homebuilder has managed to deliver some stellar stock growth, spurred by equally spectacular profit growth. On the opposite page, I analyzed the move NVR made since March of 2000: (see
opposite page). 

It is interesting that this stock, as well as the sector, turned up just as the tech stocks, and the market overall, was turning down. There was a changing of the guard, where the “smart money” was lightening up on tech and moving into areas where the future growth would be found. 

This is also one example of how you can make money in a bear market. Back in 1999, NVR was trading between $38 and $58 a share. This  

company would earn over $76 in profits from 2000 to 2002 (the stock price had to go up, since the company was making more in profits that the stock was selling for). 

When you think about it, we really don’t care about how many dollars a stock goes up. All we care about is our investment going up the most. A lot of times people say, “If a $2 stock goes up $1, you make a gain of 50%”. True, but many times the $2 stock is a poor investment, since it probably doesn’t make any profits. Companies that don’t make profits go out of business. 

The biggest loss when investing in poor stocks is the opportunity loss. In the past, I have invested in cheap-lower priced stocks. Some did O.K., but most did not. My biggest loss was the opportunity cost. Since I had those poor quality stocks, I had less money to invest in good, solid companies. In turn, I did not invest in NVR back in the mid 1990s like I should have. In fact, had I been looking for companies with strong profit growth then, I may have noticed that NVR had EPS up 101% in 1995, 60% in 1996, 26% in 1997, and 127% in 1998. 

Sometimes people trade cheaper stocks, trying to make a quick buck here and there. One reason I try not to trade stocks too often is the best money is made buy buying and holding good stocks. The power of compounding makes a dramatic difference, and can turn the value of one single stock into the entire portfolio’s starting value. I think the key is to find the next NVR, hold it, let it grow, and look for another NVR. Try to collect the superior stocks and make your portfolio an All-Star team. 

If NVR’s stock ever splits, it wouldn’t be any more valuable, the P/E would stay the same and that is what the money managers are looking at. They control the market. Since this stock is now trading for around $500 a share and will earn about $50 a share in profits next year the P/E is 10 (500/50 = 10). If the stock splits tenfor-one, we will be looking at a $50 stock probably making around $5 in EPS next year for a P/E of 10. Like in the Coke example, the price really wouldn’t matter, its what you get for that price. 

In fact, many of the institutional money managers prefer a higher priced share. They have millions, or even billions, of dollars to invest. When they buy, they like to buy larger blocks of shares. Getting 2000 shares of a stock and investing $1 million is considered a positive. On the other hand, if they need to get their hands on 100,000 shares to invest that $1 million, it might take them longer. And if they wanted out in a hurry, it would be tough finding a buyer for that many shares. If lower priced stocks actually did give a higher return, wouldn’t every CEO just keep splitting their company’s stock until it reached $1 a share?

David Sharek David Sharek is stock portfolio manager and CEO of DavidSharek.com. David believes a company's profits ultimately drive the price of its stock. His book The School of Hard Stocks can be found on Amazon.com.